CH 28 (WM)

Question 1

Question 5.4

Describe the treaty method of reinsurance and list the advantages & disadvantages of this method. [5]

Answer 1

A treaty is a formal arrangement between an insurer and a reinsurer. [1⁄2]

The treaty will specify the terms of the reinsurance, eg types of contract, type of reinsurance, extent of cover etc. [1⁄2]

Treaties are usually arranged so that the direct writer is obliged to pass on some of the risk in a defined manner (obligatory / obligatory). [1⁄2]
However, there may be facultative / obligatory agreements, in which the direct writer is not obliged to use reinsurance. [1⁄2]
The reinsurer is required to accept risks offered that fall within the treaty conditions. [1⁄2]

Advantages
It gives the insurer certainty of being able to have reinsurance cover, so it can do its financial and risk planning with greater certainty [1⁄2]

… and be confident that it will be able to offer products, so this helps marketability. [1⁄2]

It can be simple to operate (eg quota share), and so involve less expense. [1⁄2]

It can help the insurer control its solvency and growth requirements. [1⁄2]

Disadvantages

It takes time / expense to set up in the first place. [1⁄2]
The treaty terms may restrict the insurer’s freedom. [1⁄2]
The insurer may not be able to get the best reinsurance deals, especially for large or unusual cases. [1⁄2]
There can be a delay for the insurer in finding cover before accepting the risk. [1⁄2]

Question 2

Question 5.4

Describe the facultative method of reinsurance and list the advantages & disadvantages of this method. [3]

Answer 2

Facultative reinsurance is an individual arrangement where an insurer approaches a reinsurer to reinsure part of a particular risk.[1⁄2]
There is no obligation on the insurer to offer business and no obligation on the reinsurer to agree terms. [1⁄2]

Advantages

• It provides greater flexibility, as individually arranged, so that the arrangement that is most suitable for the insurer can be sought. [1⁄2]
• It can be used to cope with risks that fall outside the terms of a treaty, eg those that are too large or have unusual risk characteristics. [1⁄2]

Disadvantages:

• It needs to be arranged for each risk, and so can involve extra work and expense in setting up the reinsurance. [1⁄2]
• The insurer may not be able to find suitable reinsurance. [1⁄2]

Question 3

State the factors that will result in the cedant to reinsure more. [2]

Answer 3

• the less certain the company is about future claims experience ✓✓
• the lower the acceptable probability of future insolvency ✓✓
• The greater the variance of the benefit level distribution ✓✓
• the greater the value for money offered by the reinsurance market ✓✓

Question 4

Describe the impact of the size of the company’s free assets on its reinsurance strategy. [ ]

Answer 4

The size of the company’s free assets will have a major bearing on the reinsurance requirements as far as claims volatility is concerned✓✓. In fact many large companies✓ have sufficient free assets✓ to be able to dispense with risk premium reinsurance for normal policies✓, and will reinsure only exceptionally large policies✓ (eg R10 million sum at risk)✓ and against catastrophes✓.

The size of the free assets will also obviously affect the company’s financing reinsurance requirements✓✓ – the more capital a company has, the less it needs capital assistance from reinsurers✓✓.

Question 5

Define the term aggregate XL reinsurance. [3.25]

Answer 5

It is an extention of risk XL reinsurance.✓
It is also known as stop loss reinsurance.✓
Stop loss protects the insurer by covering the total losses✓ for the whole account✓, above an agreed limit✓, for a 12-month period✓.

The whole account can comprise one or several classes of insurance.✓✓

The excess point✓ (or attachment point) and upper limit✓ (or exhaustion point) for stop loss are often expressed as a percentage of the cedant’s premium income✓ for that account.
Cover might typically be given from an excess point of 110% claims ratio up to an upper limit of 130% or 140%.✓✓

Question 6

Define the term “catastrophe cover”.[5.5]

Answer 6

Catastrophe XL✓

Cover is defined in terms of a common cause✓ or peril✓ (single event)✓ over a particular period of time✓.

Examples of the above might be:

• a chemical explosion✓ (a single event)✓ giving rise to a number of claims which together might exceed an insurer’s retention, though individually they would not✓✓.
  If the total amount of all claims arising from the single event exceeds the lower limit, then the insurer can make a recovery from the reinsurer.✓✓
• a pandemic that might result in a considerable increase in the number of claims.✓✓

Event-type cover is generally available.✓✓ However, the risks associated with pandemic cover are very uncertain and so this cover is not normally available✓✓; at least not at an affordable price✓.

In the event of a severe epidemic✓, the government(s) may be likely to step in✓ – either to support the affected lives✓, or the insurance industry✓.

Question 7

List the two types of Financial Reinsurance arrangements. [0.5]

Answer 7

• Risk Premium reinsurance
• Contingent Loan

Question 8

Describe the workings of a “Contingent Loan” reinsurance arrangment.[3.75]

Answer 8

A.k.a. surplus relief reinsurance.✓

It makes use of the future profits✓ contained in a block of new or existing business✓✓ (“VIF”)✓.

The reinsurer provides a loan to the cedant✓, but, as the repayment of the loan is contingent upon the stream of future profits being generated by the business✓✓, the cedant may not need to reserve for the repayment within its supervisory returns✓ (depending on the regulatory regime)✓.

So, should the VIF profit not occur at all✓, the reinsurer would simply have made a capital gift to the insurer equal to the amount of the loan✓✓.
If the VIF profit does emerge, then the reinsurer will receive all of the specified loan repayments.✓✓

Question 9

Describe how an insurer will determine the retention limit to adopt. (A description of the specific approaches is not required.) [1.5]

Answer 9

The insurer will first estimate the statistical distribution✓ of the risk experience costs of the portfolio✓ on various assumed retention levels.✓ The insurer then needs to judge how low a probability should be aimed at✓✓ for various degrees of departure from the overall average risk costs✓.

Question 10

A company that writes just PMI has a stop loss reinsurance treaty as follows:
* lower limit of 105% of earned premium
* upper limit of 125% of earned premium
* reinsurer covers 80% of the claims in the layer.
* Suppose that the earned premiums for 2005 were R2,920 million and the total incurred claims were R3,330 million.

Calculate the amount to be recovered from the reinsurer. [2]

Answer 10

The loss ratio = 114%.
The reinsurance recovery = R211.2 million.

Question 11

Provide two examples where the contingent loan approach will be useful for the direct writing company. [1.5]

Answer 11

Where a direct writing company needs to improve its solvency position✓, for example
* after a large drop in asset values✓✓, or
* where it wishes to fund a new project✓✓, for example the setting up of a new subsidiary overseas✓.

Question 12

Question 28.17
(i) List several risks relating to the insurer’s operations that a reinsurer would face if it made stop loss cover available.
(ii) Given these risks, why would the insurer probably not want stop loss in practice?
(iii) Suggest two broad responses to the risks in (i) that the insurer may well find preferable in practice. [4.5]

Notes

Answer 12

Risks to a stop-loss reinsurer
– insurer’s premiums generally under-priced✓ (eg a competitive market)✓
– poor underwriting by insurer✓
– poor premium rating structure✓ leading to adverse selection✓
– adverse claims experience✓ (eg large claims or random events)✓✓
– poor claims handling control✓.

(ii) Why a insurer would not want to buy stop-loss reinsurance
The reinsurer would need to charge a very high premium to cover itself against the risks.✓✓

(iii) What the insurer might prefer
Preferable options for the insurer:

• set up tight internal controls✓ to ensure good premium rating✓, underwriting✓ and claims control✓
• buy particular types of reinsurance to guard against specific events✓✓ (ie buy individual excess of loss✓ and catastrophe excess of loss✓ as needed).

retention limit is expressed as claims/premiums. Use this formula to generate points on the risks to the reinsurer.

Question 13

Question 28.18
(i) Explain why reinsurers are often not prepared to provide stop loss cover.
(ii) If the reinsurer does provide stop loss cover, what conditions is it likely to impose on the business covered? [1.5]

Answer 13

(i) Reinsurers are often not prepared to provide stop loss cover because historically, some stop loss covers have been loss making.✓✓

(ii) Conditions the reinsurer may impose before providing stop loss cover are:
* impose a deductible so that insurer retains a proportion of the risk ✓✓
* require some control over UW and claims ✓✓

Question 14

Define the term Catastrophe XL. [4.5]

Answer 14

Cover is defined in terms of a common cause✓ or peril (single event)✓ over a particular period of time✓.

Examples✓ of the above might be:
* a chemical explosion✓ (a single event)✓ giving rise to a number of claims✓ which together might exceed an insurer’s retention✓, though individually they would not✓.
If the total amount of all claims arising from the single event exceeds the lower limit, then the insurer can make a recovery from the reinsurer.✓✓

• a pandemic that might result in a considerable increase in the number of claims.✓✓

Event-type cover is generally available.✓✓
However, the risks associated with pandemic cover are very uncertain✓ and so this cover is not normally available✓; at least not at an affordable price✓.

Question 15

Describe “approach 2” that insurer can follow to determine the appropriate retention limit. [4]

Answer 15

Consider the total of✓:
(a) the cost of financing an appropriate risk experience fluctuation reserve✓✓, and
(b) the cost of obtaining reinsurance✓✓ – the reinsurer naturally incorporates an expense and profit loading in its reinsurance terms✓✓, and the cedant incurs administrative expenses✓✓.

As the retention level increases✓, (a) will increase and (b) will decrease✓✓, and a retention level can be adopted that minimises the total (a) + (b)✓✓.

To calculate (a) a simulation approach would probably need to be used to determine the reserve that the company needs to hold✓✓.

Question 16

Question 5.7
A health and care insurance company transacting individual critical illness insurance business is reviewing its reinsurance retention limits. List, with reasons, the factors you would take into account in setting revised limits. [4]

Answer 16

Solution 5.7
The current retention limits will be the starting point. These will only be changed if there is evidence that this is necessary. [1⁄2]
A key issue will be the amount of fluctuation in its experience that the company finds acceptable. [1⁄2]
The lower the acceptable fluctuation, the lower the retention limit. [1⁄2]

The amount of fluctuation deemed acceptable depends on:
* the size of the company’s free assets; the lower the free assets, the lower the reinsurance retention will be [1⁄2]
* the cost of capital: the higher the cost (of using capital to reduce claim fluctuations) the lower the reinsurance retention will be [1⁄2]
* the level and quality of UW: the more strict the UW, the more certain future experience should be, and the higher the retention can be [1⁄2]
* the mix of business, especially the different benefit sizes: the more volatile the business, the lower the retention will be. [1⁄2]

Critical illness experience is especially volatile. The company may be cautious when setting limits for this class. [1⁄2]
If the reinsurance is being used wholly or partly to reduce new business strain, then as well as being sensitive to the existing level of free assets, the retention level will be particularly sensitive to the design of the product and the expected new business volume and mix. [1⁄2]

The results of modelling investigations will be crucial in order to find retention levels that maximise profits subject to acceptable risk, and/or provide adequate protection of the company’s free assets against new business strain for minimum cost. [1⁄2]

The company might reinsure more than purely financial factors would suggest if it is looking to obtain reinsurer’s assistance in certain areas, eg underwriting. [1⁄2]

The retention limit will also be affected by the cost / types of reinsurance available. [1⁄2]
[Maximum 4]

Question 17

Define the term Financial Reinsurance. [3.5]

Answer 17

Commonly referred to in short as “Fin Re”.✓

It is a means of improving the apparent accounting or supervisory solvency position of the cedant.✓✓

One feature of a financial reinsurance contract is that it tends to involve only a small element, if any✓, of transfer of insurance risk from the cedant to the reinsurer.✓✓

Financial reinsurance is not effective✓ under accounting or supervisory regimes✓ where credit can already be taken for the future profits✓ and/or where a realistic liability✓ has to be held in respect of the loan repayments✓.

With the increased global movement✓ towards realistic reporting bases✓, there is likely to be reduced adoption of such arrangements✓.

Question 18

Describe “approach 1” that insurer can follow to determine the appropriate retention limit. [2.5]

Answer 18

Set the retention level at such a level as to keep the probability of insolvency (or ruin probability) below a specified level.✓✓

Using a stochastic model✓ for expected claims rates✓ and a model of the business✓, expected claims can be projected forward together with the value of the company’s assets and liabilities✓✓.

By using simulation✓ a retention level can then be determined such that the company stays solvent for 995, say, out of 1,000 runs✓✓.

Question 19

Describe the workings of a “Risk Premium” reinsurance arrangement.[2.5]

Answer 19

It is one type of a financial reinsurance arrangement✓ whereby the reinsurer relieves the cedant of part of its new business financing requirement✓✓.

A straightforward loan from the reinsurer would not achieve the purpose, as the cedant would usually have to add the amount of the loan to its liabilities.✓✓

So, the “loan” is usually presented as a reinsurance commission related to the volume of business reinsured.✓✓

The “repayments” – spread over a number of years – are added to the reinsurance premiums.✓✓

The reinsurer takes into account the expected lapse experience of the portfolio of reinsurances in determining the loan repayments.✓✓

Question 20

Describe how excess of loss (XL) operates. [3.75]

Answer 20

In its simplest form, the reinsurer agrees to indemnify the cedant for the amount of any loss above a stated excess point.✓✓
More usually, the reinsurer will give cover up to a stated upper limit✓, with the insurer purchasing further layers of XL cover✓, which stack on top of the primary layer✓, from different reinsurers✓.
The higher layer cover(s) come into operation on any particular loss only when the lower layer cover has been fully used (or “burnt through”).✓✓
The top layer of XL reinsurance might be unlimited (ie there is no upper limit).✓✓
The layers of reinsurance should be arranged so that there are no gaps✓, ie the lower limit of the 2nd layer of XL reinsurance starts at the upper limit of the 1st XL reinsurance✓.
The expression generally used to describe the cover provided under an excess of loss reinsurance treaty is✓:
“Amount of layer in excess of lower limit”.✓✓

Question 21

How would a XL treaty that provides cover for claim amounts between a lower limit (excess point) of R500,000 and an upper limit of R2,000,000 be described as? [0.5]

Answer 21

R1,500,000 in excess of R500,000 ✓✓

Question 22

Describe the workings and purpose of indexed limits. [3.5]

Answer 22

Where inflation has a significant effect✓ on the cost of claims✓, a stability clause✓✓ may be applied to the excess point✓;
this provides for the indexation of the monetary limit✓ in line with a specified inflation index✓.

This is done to achieve a more equitable division✓ between the reinsurer and cedant of the inflationary element of claims covered under the treaty✓.

The cedant will normally be required to pay an extra premium to compensate the reinsurer for the added risk if the excess point is not indexed.✓✓

The upper limit✓ may similarly be indexed to preserve the original real value of the cover✓.

The basis for indexation should be a reliable inflation index✓ that bears some relation to the inflationary effects on the claim sizes✓.

Question 23

Describe the workings and purpose of “deductibles”. [3.5]

Answer 23

For all forms of XL✓, it is possible that the reinsurer will cover only a proportion of the claims✓ within the layer✓, by applying a deductible.

The reason for this type of arrangement is to give the cedant more incentive to keep the claim settlements low.✓✓

Otherwise the reinsurer may feel exposed to the “moral hazard”✓ of the cedant having sloppy settlement procedures✓ for large medical claims✓.

It is a.k.a “proportional within non-proportional” cover.✓✓

Question 24

Define the term Risk excess of loss (Risk XL). [1.5]

Answer 24

This is a type of excess of loss reinsurance that relates to individual losses.✓✓
It affects only one insured risk at any one time.✓✓
This is sometimes found under private medical insurance portfolios✓ where individual large losses sometimes occur✓.

Question 25

Question 28.15
A insurer has two layers of risk XL cover. The first is 1,000,000 in excess of 1,000,000, the second is 3,000,000 in excess of 2,000,000. All limits are indexed, and the chosen index starts the treaty at a value of 100.
Two separate claims are made: one of 3,500,000 (when the index was 105) and the other of 6,000,000 (when the index was 110).
Assuming that the treaties cover these claims, calculate how much each insurer pays for each. [3.25]

Answer 25

Claim of 3,500,000 (when index was 105)
When the index is 105, the layers of reinsurance cover become 1,050,000 in excess of 1,050,000 and 3,150,000 in excess of 2,100,000. ✓✓

Therefore:
* Insurer pays the first 1,050,000 ✓
* First XL reinsurer pays the next 1,050,000 ✓
* Second XL reinsurer pays the remaining 1,400,000 ✓

[1.5]

Claim of 6,000,000 (when index was 110)

When the index is 110, the layers of reinsurance cover become 1,100,000 in excess of 1,100,000 and 3,300,000 in excess of 2,200,000. ✓✓

Therefore:
* Insurer pays the first 1,100,000 ✓
* First XL reinsurer pays the next 1,100,000 ✓
* Second XL reinsurer pays the next 3,300,000. ✓

• Insurer is left with the remaining 500,000, ie paying 1,600,000 in total ✓✓
  [1.75]

Question 26

Question 5.2
Explain the possible consequences of the failure of a reinsurer for a health and care insurance company.[4]

Answer 26

Solution 5.2
If the insurer does not use the failed reinsurer, there would probably be no
consequences. [1⁄2]
However, even then, the availability or cost of reinsurance in the future may suffer. [1⁄2]

The rest of this answer assumes that the insurer did use the reinsurer.

The insurer will be liable for the reinsurer’s share of claims that would otherwise have been recoverable. [1⁄2]

This will not only be for future claims on existing business, but may also affect reported claims in payment, for which recoveries may no longer be able to be made. [1⁄2]

This means that it may have to pay a greater share of many claims, in the case of proportional arrangements, …
[1⁄2]
… or may now be liable for very large claims in the event of non-proportional arrangements. [1⁄2]

This could have a serious adverse impact on the financial stability of the insurer … [1⁄2] … which may result in premium rate increases. [1⁄2]

In addition, the statutory solvency position of the insurer may worsen. [1⁄2]

The company should therefore attempt to replace the reinsurance for its in-force portfolio of policies that are not claiming, to prevent being exposed to large new claims from that business. [1⁄2]
The company would then only be losing, in effect, the unexpired reinsurance premium for these policies. [1⁄2]

The insurer will also have to review its reinsurance arrangements for new business by seeking cover elsewhere. [1⁄2]

Both of these arrangements may now, however, prove to be expensive.
[1⁄2] [Maximum 4]

Question 27

Question 5.5
(i) Describe the aim and main features of excess of loss reinsurance from the point of view of a ceding health and care insurance company.
[8]

Answer 27

(i)
Excess of loss
The aim is to help protect the ceding company from large adverse fluctuations in claim costs, in order to help stabilise the company’s profit flow and ultimately to protect the company from ruin. [1]
It also helps the company to write individual risks that could lead to large claims. [1⁄2]
Excess of loss reinsurance comes in three forms:
* risk excess of loss [1/4]
* aggregate excess of loss / stop loss [1/4]
* catastrophe excess of loss. [1/4]

Risk excess of loss
This operates on an individual policy basis, for any kind of policy that has uncertain claim amounts (like PMI). [1⁄2]
Claim amounts in excess of a specified loss level (the excess point) are covered by the reinsurance, up to an agreed maximum amount. [1⁄2]
Alternatively, only a proportion of the claim above the excess point may be payable by the reinsurer.
[1⁄2]
The excess point may be index linked, to reflect the expected inflation of claim costs. [1⁄2]

**Aggregate excess of loss / stop loss **
This reinsurance extends cover to all causes or all events during the year. [1⁄2]
Aggregate excess of loss / stop loss does this by covering the total losses for the whole account, above an agreed limit, for a certain period (usually a year). [1⁄2]

The whole account can be one or several classes of insurance. [1⁄2]

The excess point and upper limit are often expressed as a percentage of the cedant’s premium income for that account, ie as a claims ratio. [1⁄2]

Claims payable under the contract would be assessed after any other individual reinsurance (eg risk excess of loss) recoveries had been made. [1⁄2]

Unlike risk excess of loss, this kind of cover can apply to fixed benefit insurances – such as cash plans or long-term insurance – as well as to variable benefit contracts like PMI.
[1⁄2]
This kind of cover is especially important for group health insurance, … [1⁄2]
… where the common association of the employees (in the workplace) can lead to an increased incidence of large aggregate claims due to non-independence of some of the individual health risks. [1⁄2]

Long-term insurance claims are rarely sufficiently volatile to warrant paying for this protection, so usually this is just used for short-term classes of health insurance. [1⁄2]

Catastrophe excess of loss
This reinsurance covers claims arising from a single event and is likely to be used for very large events, …[1⁄2]
… eg where claims from the event could be could be potentially solvency threatening, or pandemics. [1⁄2]

All types:
The reinsurance premium would need to be renewed and renegotiated on a yearly basis. [1⁄2]

[Maximum 8]

Question 28

Define the term coinsurance. [1.5]

Answer 28

Coinsurance is the general term given to a PMI policy condition, whereby the PH is required to pay, at least in part, for medical expenses incurred, maybe on a % basis. [1⁄2]

In other contexts, coinsurance also refers to the situation where two or more insurers share the contract with the policyholder. [1⁄2]

It also may refer to reinsurance on an original terms basis. [1⁄2]

Question 29

Question 5.6
A private medical insurance (PMI) insurer has the following reinsurance cover:
* a 20% quota share (QS) treaty with reinsurer X
* an excess of loss (XOL) reinsurance treaty whereby reinsurer Y meets claim amounts falling between £0.5m and £1.25m on the insurer’s net account
* a further XOL reinsurance treaty whereby reinsurer Z meets claim amounts exceeding Y’s upper limit on the insurer’s net account.
(i) Calculate the amounts paid by each of the four parties following a gross claim for £2m. [2]

The PMI insurer’s situation in part (i) is repeated except that the two XOL reinsurance treaties now operate on the original gross claim, and the QS treaty operates on the insurer’s residual net account after Y and Z have accepted their shares of the risk.

(ii) How much will each party now pay? [2]
The situation in (ii) is repeated except that the two XOL treaties have been drawn up to include a stability clause, which has resulted in all the limits increasing by 8% pa compound to the date the claim is paid.
(iii) How much will each party now pay if the claim amount is again £2m, paid nine years after the treaty was established?
[2] [Total 6]

Answer 29

Solution 5.6 (i)
Amount paid by each party (scenario 1) X takes 20% of all claims. Therefore X pays 0.2  £2m = £0.4m. [1⁄2]
The net claim after QS, which is £1.6m (ie 2  0.4), is over Y’s band of cover. Hence, Y must pay £0.75m (ie 1.25  0.5).
[1⁄2]
The insurer has to pay the slice below Y’s band of £0.5m. [1⁄2] This leaves £0.35m to be paid by Z (ie 1.6 – 1.25).
(ii) [1⁄2] [Total 2]
Amounts paid by each party (scenario 2) Z pays everything over £1.25m = £0.75m. [1⁄2] Y still pays £0.75m. [1⁄2] The reinsurer X pays 20% of £0.5m = £0.1m. [1⁄2]
The insurer pays 80% of £0.5m = £0.4m. [1⁄2] [Total 2]
(iii) Amounts paid by each party (scenario 3)
The calculations can be simplified because (1.08)9 almost exactly equals 2. Therefore Y’s boundaries become £1m and £2.5m.
Hence, following the same logic in part (ii), the insurer and X share the claim below Y’s level of cover in the proportion 80:20, ie the insurer pays £0.8m and X pays £0.2m. [1] The total claim is now less than Y’s upper limit, hence Z pays nothing.
The remainder of the claim is £1m, which is all paid by Y. [1⁄2]
[Total 2]

Question 30

Question 5.8 Two PMI insurers have had the following loss ratio experience over the last five years:
Year A B 2012 77% 81% 2013 23% 76% 2014 63% 75% 2015 87% 69% 2016 75% 49%
(i) Calculate the mean and standard deviation of the observed loss ratios for each insurer. On the evidence of these statistics, state, with reasons, which insurer should pay more for each of the following stop loss covers:
(a) all losses over 70% (b) all losses over 100% (c) losses in the layer 25% excess 90%.

(b) Calculate the historic burning cost premium (as a %) for each insurer for each of the stop loss covers and comment on your results.

Answer 30

Solution 5.8 (i)
Mean and standard deviation A Mean: 65% Standard deviation: 25% B Mean 70% Standard deviation 12.5%
(i)(a) All losses over 70% B has the highest probability of making a stop loss claim.
The probability of making a claim will be 50% if the distribution is symmetrical, …
[1⁄2] [1]
[1⁄2] [1]
[1⁄2] [1⁄2]
… but the distribution is likely skewed so the probability is likely to be less than 50%. [1⁄2]
A makes a stop loss claim if the loss ratio is 0.2 standard deviations above the mean. [1⁄2] There is a lower probability of making a stop loss claim for A than for B, …
[1⁄2] … but the recovery is likely to be greater, so the premium is likely to be higher.
(i)(b) All losses over 100% B has lower probability of making a stop loss claim, …
… so the premium for A is likely to be higher.
(i)(c) Losses in the layer 25% excess 90% The stop loss will cover the layer from 90% to 115%.
Looking at the number of standard deviations above the mean this corresponds to: A +1.0 to 2.0 (ie 65% 1.0 25% 90% and 65% 2.0 25% 115%
       [1⁄2] [1⁄2] [1⁄2] [1⁄2]    ) [1] B +1.6 to 3.6 (ie 70% 1.6 12.5% 90% and 70% 3.6 12.5% 115%) [1] Therefore A is likely to have a higher premium [1⁄2] [Maximum 9]

(ii) Historic burning cost premium
(a) A: 5.8% (average of 7%, 0%, 0%, 17%, 5%) B: 4.4% (average of 11%, 6%, 5%, 0%, 0%)
(b) A: 0% (c) A: 0% B: 0% B: 0%
[1⁄2] [1⁄2]
[1⁄2] [1⁄2]
Since the burning costs are 0% for both arrangements (b) and (c), a burning cost method is not useful for rating this cover
[1]
[Total 3]

Question 31

Describe a method for rating a stop loss treaty, commenting on the likely issues that may arise. [3]

Answer 31

The distribution of the loss ratio needs to be determined. [1⁄2]
The premium is then calculated from the distribution. [1⁄2]
However, the results are very sensitive to weight of tail of the chosen distribution. [1⁄2]
A good estimation technique/package and large volumes of data are required. [1⁄2]
It will be necessary to allow for:
* any experience rating procedures used in setting premiums [1⁄2]
* the effects of inflation [1⁄2]
* the effects of the insurance cycle. [1⁄2]

[Maximum 3]

Question 32

Question 5.13
A medium-sized, short-term insurance company has decided to start writing a medical benefits policy that will cover payment of hospital fees, surgeons’ fees and convalescence fees. It will be sold on an individual and group basis.
and
(i) Outline, with reasons, the types of reinsurance arrangement that might be suitable for the company in respect of this business.
[4]

Answer 32

Individual business
A quota share arrangement may be used to provide some diversification. [1⁄2]
Quota share may be used as part of a reciprocal agreement. Reciprocity is an arrangement between two insurers who agree to reinsure risks with each other, in order to diversify the insurers’ overall portfolios. [1⁄2]
An individual claim would need to involve a serious operation plus extensive hospital or nursing home fees before it would cause significant financial difficulties for a medium-sized insurer. [1⁄2]
The effect would depend on what limits, if any, the insurer placed on the total claim or on each category of claim for any one set of treatments. [1⁄2]

However, as it’s a new class of business being written, which is another reason for using quota share, …[1⁄2]
… the company may wish to minimise exposure initially by using excess of loss, perhaps at quite a low level.
[1⁄2]
Group business
Most of the comments above relating to individual cover will apply to group cover. [1⁄2]
Depending on the nature of the group contracts, there may be the possibility of a concentration of risk of many claims from one event (eg medical treatment following an explosion in a large factory). [1⁄2] Catastrophe excess of loss would be necessary here. [1⁄2]

Stop loss reinsurance could be considered for both individual and group business if it is felt that claims experience might be volatile in the early years, …[1⁄2] … but may not be available at a suitable cost. [1⁄2]
Technical assistance from the reinsurer might be useful, particularly as this is a new product. [1⁄2]

[Maximum 4]

Question 33

(ii) Describe circumstances in which an insurance company may decide not to use reinsurance.
[3]

Answer 33

• the insurer already has plenty of diversification (by class or by territory) [1⁄2]
• no large risks have been accepted [1⁄2]
• the insurer has very large free reserves [1⁄2]
• the insurer not listed so stable results not required [1⁄2]
• the insurer has no need for technical and administrative assistance [1⁄2]
• financial support is available from parent company [1⁄2]
• the insurer has no possible exposure to a catastrophe [1⁄2]
• there are no possible tax or solvency arbitrage opportunities [1⁄2]

[Maximum 3]

Question 34

Discuss the working of a “deposit back”. [2.75]

Answer 34

In certain countries, the supervisory authority may require the reinsurer to “deposit back” its share of the total reserve under a reinsured contract with the cedant.✓✓

Even where it is not a requirement, this is sometimes done so that the cedant gets the benefit of reinsurance✓ whilst at the same time✓ being able to maintain a reserve for the whole contract✓ and hence maximise the funds it has to invest✓.
However, the arrangement can also be an advantage to the reinsurer.✓ For example, in the case of a large international reinsurer✓, it may avoid any problems with having to invest in an unfamiliar market✓.

The deposit back arrangement will also serve to mitigate the reinsurer default risk to which the cedant is exposed.✓✓

Question 35

Define quota share reinsurance. [4]

Answer 35

Quota share is a type of proportional reinsurance✓
and is always by treaty✓.
It is a simple mechanism✓ for ceding a portion of the business✓.

It can be used for long-term business✓
either on an original terms or risk premium basis✓,

or for short-term business✓ on an original terms basis✓.

A constant proportion of each and every risk within the scope of the treaty is automatically passed to the reinsurer.✓✓

The treaty will specify the proportion to be ceded to the reinsurer, R% say✓. This is often referred to as an R% quota share treaty✓.

The premiums can either be calculated on a risk premium or original terms basis.✓✓
The reinsurer pays the the insurer R% of the claims from the risks covered by the treaty.✓✓

Question 36

List the advantages of a quote share arrangement. [2.5]

Answer 36

• It helps spread the risks, reducing parameter risk in particular ✓✓
• there might be some reciprocal business from the reinsurer ✓✓
• administratively simple ✓✓
• used for financing NB strain ✓✓
• can help reduce solvency ratios for ST business ✓✓

Question 37

List the shortcomings of a quote share arrangement. [1.75]

Answer 37

It cedes the same proportion of each risk✓, irrespective of size✓; the insurer may, however, wish to cede a greater proportion of the larger risks than the smaller ones✓✓, owing to their greater loss potential✓.

For QS, written on an OT basis✓, it passes a share of any profit to the reinsurer✓.

Question 38

Define the term reciprocity. [0.5]

Answer 38

Reciprocity is an arrangement between two insurers who agree to reinsure risks with each other✓, in order to diversify the insurers’ overall portfolios✓.