C29 : Risk Transfer Flashcards
Outline 6 possible responses from which the a stakeholder can choose when faced with a risk
When faced with a risk each stakeholder can choose whether to:
1. avoid the risk altogether
2. reduce the risk, ie by either reducing the probability of occurrence or the consequences or both
3. reject the need for financial coverage of that risk because it is either trivial or largely diversified
4. retain all the risk
5. transfer all the risk – for example by paying a premium to another party to transfer all the risk to that party
6. transfer part of the risk – for example by retaining some of the risk and paying a premium to transfer the balance of risk to another party.
List 5 aspects that could be assessed in order to evaluate different options for mitigating a risk
Each option for mitigating a risk can be evaluated by assessing:
- the likely effect on frequency, consequence and expected value
- any feasibility and cost of implementing the option
- any ‘secondary risks’ resulting from the option
A strategy that reduces one element of risk could introduce an additional, but less important, element of risk (eg the use of insurance introduces the small risk that the insurer could become insolvent). - further mitigating actions to respond to secondary risks e.g. insurance could be arranged with a number of insurers instead of just one in order to reduce the exposure to any one insurer defaulting.
- the overall impact of each option on the distribution of net present values (NPVs).
Outline 5 factors on which the decision to transfer some or all of the risk to a third party will depend
The extent to which a stakeholder will choose to pass on all or some of the risk will depend on :
1. how likely the stakeholder believes the risk event is to happen
2. the stakeholder’s risk appetite
3. the resources that the stakeholder has to finance the cost of the risk event should it happen
4. the amount required by another party to take on the risk
5. the willingness of another party to take on the risk.
Describe the benefits of Reinsurance
Reinsurance is a way of reducing, or removing, some of the risks.
The main benefits of reinsurance to an insurance company are:
1. a reduction in claims volatility and hence:
– smoother profits
– reduced capital requirements
– an increased capacity to write more business and achieve diversification
2. the limitation of large losses arising from:
– a single claim on a single risk
– a single event
– cumulative events
– geographical and portfolio concentrations of risk
3. a reduced risk of insolvency
4. increased capacity to write larger risks
5. access to the expertise of the reinsurer ( design, pricing, admin, underwriting, policy doc)
Describe cost of reinsurance
- The reinsurer will wish to make a profit from the risks it takes on.
- Effectively part of the profit from the business is passed to the reinsurer.
-The cost of reinsurance is principally the reinsurance premium(s) payable. - Costs incurred in putting the reinsurance arrangements into place and their subsequent management (eg providing policy and claims details to the reinsurer and managing recoveries).
- Liability may not be fully matched by reinsurance
- Possible liquidity issues (e.g. for a pension scheme insuring annuities)
- Reinsurer may default
- Reinsurance may not be available on terms sought
Describe how an insurer can assess the costs and benefits of reinsurance
- the actuary can place a realistic estimate on the value of the
benefits that would be paid by the reinsurance provider. - This is likely to be lower than the cost of the reinsurance, as the reinsurance premium will include loadings for profits and contingencies.
- Values will also need to be placed on the range of likely benefit costs so that an assessment of the risk can be made in comparison to the cost of the reinsurance.
i.e. Net cost of reinsurance = reinsurance premiums - expected benefits
- the liquidity risk of retaining the risk or buying reinsurance also needs to be considered in making a decision
List Factors influencing type of reinsurance used
Factors influencing type of reinsurance used
1. Type of business – homogeneous (QS) or heterogeneous (surplus)
2. Size and volatility of claims. Is the insurer worried about single risks (risk XL), accumulations (agg XL) or catastrophes (cat XL)?
3. Level of free assets or financial assistance required (e.g. commissions associated with proportional reinsurance)
4. Is insurer a mutual (worried about financial assistance) or proprietary (worried about smoothing profits)?
5. Does insurer need expertise in a new or unusual product or new territory?
6. Does the insurer want diversification through reciprocal arrangements (QS)
Describe how effective reinsurance may be in removing risk for a provider
- Some types of reinsurance completely remove a risk from the provider.
- Many others leave the liability with the provider but provide a payment to the provider that is aimed at covering that liability. (counterparty risk)
Two ways in which a reinsurance contract might be structured ion terms of what is covered by the contract
Reinsurance may be arranged on
1. a case-by-case basis (‘facultative’)
2. a defined series of risks may be covered (‘treaty’).
Outline the key features of proportional reinsurance
Under proportional reinsurance, the reinsurer covers an agreed proportion of each risk. This proportion may:
- be constant for all risks covered (called quota share reinsurance), or
- vary by risk covered (called surplus reinsurance).
Both forms have to be administered automatically, and therefore require a treaty.
Describe quota share reinsurance
List uses of quota share reinsurance
Under quota share reinsurance a fixed percentage of each and every risk is reinsured.
Quota share is widely used by ceding providers to:
1. spread risk
2. write larger portfolios of risk
3. encourage reciprocal business.
Reciprocal quota share reinsurance involves one company reinsuring part of its business to another, in exchange for accepting part of its reinsurer’s business.
Outline the advantages and disadvantages of quota share reinsurance relative to other forms of reinsurance.
+ simplicity of administration, as it is written by treaty and a constant proportion is ceded for all risks.
+ diversify risk, because the insurer can write more business for the same amount of capital.
+ Useful for small, new or expanding cedants who want to diversify their risk, write more risks or who would like reciprocal business
+ May provide financial assistance through reinsurance commissions
+ Large providers may use quota share because the commission rates look attractive
- the same proportion of each risk is ceded regardless of its size (large / small)
- the same proportion of each risk is ceded regardless of its likely volatility / risk profile
- it does not cap the cost of very large claims.
Describe the operation of surplus reinsurance
- A surplus reinsurance treaty specifies a retention level and a maximum level of cover available from the reinsurer.
- The proportion of risk ceded is then used in the same way as for quota share.
Describe the operation of Non-proportional (excess of loss) reinsurance
- Cedant specifies a retention limit
- Cedant pays an amount up to that retention limit; reinsurer pays claim amount over retention
- May be an upper limit on what the reinsurer is prepared to pay
- May be different layers of XoL, each with a different reinsurer.
- Cedant may be required to retain a proportion of risk, so as to retain an interest in the risk
- Limits may be indexed over time for inflation
- Reinsurer determines reinsurance premium
- Can cap claims paid by cedant
- May or may not be written using a treaty
Discuss how Excess of loss reinsurance can be used to manage risks
Uses of XoL
- Opportunity to write larger risks
- Reduces risk of insolvency from a large single claim, an aggregation of claims or a catastrophic event
- Smooth profits by reducing claim fluctuations
Types of XoL Reinsurance
Types of XoL
1. Risk XL: Covers losses from a single claim or one insured risk
2. Aggregate XL: Cover the aggregate (sum of) losses from several insured risks, sustained from a defined peril(s) over a defined period (usually one year)
3. Catastrophe XL: A form of agg XL that pays out if a ‘catastrophe’ as defined in the reinsurance contract, occurs. No standard definition of what constitutes a cat but it is likely to be an extreme event leading to very high losses in a short period (e.g. 48 or 72 hours)
4. Stop Loss: A form of agg XL that provides cover based on aggregate losses, from all perils, arising on a company’s whole account over a specified period (usually one year)
Describe the concept of alternative risk transfer (ART)
Alternative risk transfer (ART) is an umbrella term for non-traditional methods by which organisations can transfer risk to third parties.
Broadly, these products combine traditional insurance and reinsurance protection with financial risk protection, often utilising the capital markets.
ART often uses both banking and insurance techniques, producing tailor-made solutions for risks that the conventional market would regard as uninsurable.
Explain how ART expands the list of organisations that accept risks from financial product providers
ART contracts serve to expand the list of organisations that accept risks from financial product providers away from traditional reinsurance companies.
- The banking and capital markets are used because of capacity issues. - - The risks involved in ART transactions are typically ones with which the banking and capital markets are more comfortable, such as catastrophe risk.
List the 6 types of ART contract
There are many types of ART contract, including: (ID PISS)
- Integrated risk covers
- Discounted covers
- post loss funding
- insurance derivatives
- securitisation
- swaps.
Describe Type of ART contract : Discounted Covers
- Represent a form of reinsurance where premiums calculated are based on discounted value of O/S claims
- Therefore, cedant removes a full (undiscounted) liability from its regulatory balance sheet, but with a corresponding reduction in assets equal to the discounted value of the liability, creating a surplus on a regulatory basis
3. Discounted covers are used for managing solvency, transferring risk and capping losses
Describe Type of ART contract : Integrated risk covers
- Multi-year, multi-line reinsurance contracts between insurers and reinsurers
- They give premium savings due to:
~Cost savings (of not having to negotiate reinsurance separately for
each class each year)
~Greater stability of results over time and across more diversified
lines
They are used to:
1. Avoid buying excessive cover
2. Smooth results
3. Lock into attractive terms
Suggest possible disadvantages to the insurer of integrated risk covers.
Disadvantages of integrated risk covers include:
credit risk in relation to the cover provider
lack of availability
expenses arising from the tailor-made aspect of the deal, as the cover provider would
need full insight into the dealings of the insurer seeking cover
difficulty in structuring the provider’s risk management program in a holistic, multi-line way – as typically separate risk managers would be used for separate risk types.
Describe Type of ART contract : Post Loss Funding
Post Loss Funding
1. Guarantees that, in exchange for a commitment fee, funding will be provided on the occurrence of a specific loss
2. Funding is often a loan on pre-arranged terms or equity
3. Commitment fee will be lower than equivalent insurance cost (because the cost of funding will in the most part be borne after the event has happened)
4. Thus before the loss happens the contract appears cheaper than conventional insurance
Describe Type of ART contract : Insurance Derivatives
Insurance Derivatives
- Include catastrophe and weather options
- Strike price will be based on a certain value of a catastrophe or weather index
- Whether or not the option is exercised will reflect by how much the value of the index is different to that on which the strike price is based
