Ch 28.1 Reinsurance 1

Question 1

Define reinsurance (6)

Answer 1

Reinsurance is

• an agreement whereby on party (the reinsurer)…
• …in return for a premium…
• …agrees to indemnify another party (the cedant)
• …against part or all of the liability assumed by the cedant
• under one or more insurance policies, or under one or more reinsurance contracts.

Direct writer cedes to reinsurer (through a cession), who in turn may cede its liability to a second reinsurer (through a retro cession).

Question 2

What are the main “types” of reinsurance? (7 points)

Answer 2

• Facultative and obligatory reinsurance
• Original terms reinsurance (coinsurance)
• Risk premium reinsurance
• Excess of loss reinsurance
  
  • Catasrophe
  • Stop loss
• Financial reinsurance
  
  • risk premium financial reinsurance
  • contingent loan financial reinsurance

Question 3

Describe factultative vs obligatory reinsurance (4)

What kind of facultative/obligatory agreements might we find between insurer and reinsurer? (3)

What is a treaty and what type of agreements are typically formalised via a treaty? (2)

What benefits does a treaty have? (2)

Answer 3

The use of facultative vs obligatory essentially refers to ‘having choice’ vs being ‘obliged/obligated’ within an insurance treaty

• The term ‘facultative’
  
  • applied to cedant’s part of reinsurance means it’s free to place reinsurance with any reinsurer
  • so far as reinsurer is concerned means it may accept/reject the reinsurance offered
• The use of ‘obligatory’ removes this freedom of action

Agreements between ceding company vs reinsurer may be (cedant’s view first)

• (a) facultative/facultative
• (b) facultative/obligatory
• (c) obligatory/obligatory

A treaty is

• a legal contract which formalises the terms of reinsurance and is usully set up when either party has obligation ie type (b) and type (c) conctracts above
• where both are factultative, usually no treaty, though to avoid having to make up treaty documents at times these are prepared in advance

Treaties are advantageous in that

• allows insurer to write large cases without having to refer to reinsurer to ‘ask permission’ which may stall sales process
• they apply to specified products reinsurer is happy with, so even though reinsurer might be obligated to accept, as long as it knows the busienss insurer is writing, it can then charge appropriate reinsurance premium

Question 4

Define original terms reinsurance (4)

What key aspects of original terms reinsurance/coinsurance shall we consider? (6)

Answer 4

Original terms insurance involves

• sharing of all aspects of original contract
• hence, premium split between insurer and reinsurer in fixed proportion
• and any claim is split in same proportion
• reinsurer shares in full risk of policy including investment/early lapse risks

For original terms reinsurance (coinsurance) we consider the following key points

• Determining the reinsurance premium
  
  • provision of premium rates
  • reinsurance commission
    
    • its impact on cedant’s cost of reinsurance
    • other factors to consider in addition to it
    • what determines how much is paid
• Specficying the amount to be reinsured

Question 5

Describe the 3 steps involved in determining the reinsurance premium rates to charge for original terms reinsurance (coinsurance)

(1,1)

(2,2)

(3,5)

Answer 5

• Cedant provides premium rates (aka retail rates) to reinsurer for business class to be insured, for reinsurer to check adequacy.
• Reinsurer determines reinsurance comm rates prepared to pay cedant for business
  
  • reinsurance comm thus determines overall net cost of reinsurance for cedant
  • higher commission, lower reinsurance cost; insurer then decides to accept/not
• Alternatively, reinsurer provides prem rates to insurer upon which they load costs/profit test against intended retail rates
  
  • ie reinsurer decides level prem rate for risk, to charge cedant for reins
  • also called ‘level risk premium reinsurance’, common for risk business
  • prems/claims not strictly shared in fixed %, so more risk premium reins
  • reins comm likley much less with this variation, as reins prem probably has lower margins than retail rates
  • more common approach, given recent competition level in retail markets requires frequent prem rates changes

Question 6

What is the main impact of reinsurance comm offered on an original terms reinsurance (coninsurance) contract?

Under original terms reinsurance (coinsurance), when considering which reinsurer, in addition to considering reinsurance commission being offered by a reinsurer, in what other ways may a reinsurer appear more attrative over another? (3)

Answer 6

Reinsurance comm will have main impact of

• reducing net reinsurance cost for insurer who will then have to decide whether or not to accept reinsurance, or consider other factors in favour of the reinsurer
• reinsurance comm is usually based on reinsurance prem paid
  
  • eg usually defined as % of reinsurance premium

In addition to reinsurance commission, insurer can consider following attractive features of an insurer

• financial strength:
  
  • reinsurer with greater strength will be less likely to default
  • coverage offered:
• reinsurer offering broader coverage will be more attractive eg
  
  • accept higher sums assured or accepting older-age applicants
• profit-sharing arrangements:
  
  • reinsurers offering a profit sharing arrangement, or more generous arrangement will appear more attractive

Question 7

Under original terms reinsurance (coinsurance), what factors may influence the level of reinsurance commission the reinsurer is willing to pay to the cedant?

Overview of main considerations (3)

Additional considerations which may be looked at (10)

Answer 7

Reinsurance commission paid by reinsurer to cedant may be influence by various factors:

1. profits it expects to make from the cedant’s business
2. risks it takes on (eg likely uncertainty in cedant’s future claim experience)
3. how much it wants to obtain the business, accounting for competition from other reinsurers.

Additional consideration:

1. expected future mortality experience
2. extent of uncertainty associated with future experience and with insurer’s pricing basis
3. expected level of reinsurer’s other expenses
4. cost of reinsurer’s capital
5. reinsurer’s profit criteria, including required return on capital
6. insurer’s premium rates
7. quality of insurer’s underwriting
8. likely persistency of insurer’s business
9. extent of any recovery of reinsurance commission that would be paid back when policy lapses
10. extent of any profit sharing there may be between the two parties.

Question 8

Under original terms reinsurance (coinsurance) what 2 methods may be used to determine the amount of risk to be reinsured?

What method is used in practice to set the amount reinsured under original terms reinsurance (coinsurance)? (6)

Answer 8

Amount of risk to be reinsured can be determined in following 2 ways:

• Quota share:
  
  • amount reinsured specified % of each policy is specified
  • eg 30% quota share: 30% reinsured, and 70% risk retained by cedant
• Individual surplus:
  
  • reinsured amount is excess of
    
    • original benefit
    • over cedant’s reterntion limit on any inividual life
  • eg for 100 000 sum assured, with cedan’ts retention limit of 40 000
    
    • 40% of risk would be retained, 60% of risk would be reinsured

In practice, cedant is likley to adopt a mixture of quota share and invidual surplus

• eg 30% quota share, subject to retention limit of 40 000
• for sum assured of 100 000
  
  • amnt reinsured under quota share = 30% * 100 000 = 30 000
  • amnt retained under quota share = 100 000 - 30 000 = 70 000
  • but under combined agreement, cedant has 40 000 retention limit
  • so will actually only retain 40 000, and cede 60 000 to reinsurer

Question 9

Define risk premium reinsurance (5)

What key aspects of risk premium reinsurance do we consider? (3)

Answer 9

Under a risk premium reinsurance arrangement

• cedant reinsurers part of..
  
  • sum assured, or
  • sum at risk ie excess of benefit over reserve
• …on the reinsurer’s risk premium basis
• which can be either
  
  • annually renewable or
  • guaranteed

For risk premium reinsurance, we consider the following key points

• Determining the reinsurance premium
• General features specific to this type of reinsurance
• Specifying the amount to be reinsured
• How it compares with original terms reinsurance (coinsurance)

Question 10

Describe the steps involved in determining the reinsurance premium rates to charge for risk premium reinsurance:

the general steps of the process (3)

the calculation of the risk premium (3)

Answer 10

Reinsurer determines risk premium rates by

• assessing likely experience of the business it is to reinsure
• and then adding expense and profit margins
• reinsurer may or may not guarantee these rates for the term of the policy

Risk premium calculated reflects claim probability multiplied by amnt covered by reinsurer

• RP_(t) = q_(x+t:R) * B_(t)
• where
  
  • q_(x+t:R) is the reinsurer’s risk premium rate
    
    • may include loading for expenses/profits, or loaded seperately
  • B_(t) is the reinsured amount at time t.
• similar to risk charge for additional death benefits under unitised contracts

Question 11

What 4 general features of risk premium reinsurance are specific to it?

(1,2)

(2,3)

(3,2)

(4,1)

Answer 11

Risk premium better reflects risk of claim over coming period (year/month, etc)

• risk premium reflects claim probability multiplied by amnt covered by reinsurer
• similar to risk charge for additional death benefits under unitised contracts

Risk premium may change annually, due to

• changes to sum assured, maybe leading to changes in amount reinsured
• risk premium will be based on the older age of the policyholders (tend to only happen on policy anniversary).
• reinsurance pricing basis may not be guaranteed, could change because reinsurer carried out pricing review

Risk premium may be guaranteed for term of policy

• depends on treaty agreeement
• insurer will wish to have similar guarantees as that provided to it PHs

May have profit share arrangement

• whereby share of profits to reinsurer from portfolio reinsured are paid back to direct writer

Question 12

Under risk premium reinsurance what 2 methods may be used to determine the amount of risk to be reinsured? (4)

Within these 2 methods, what ‘sub-variations’ may be used to calculate the amount reinsured in relation to the benefit and reserves?

Answer 12

The 2 main methods to calculate how much is reinsured are similar to original terms reinsurance, as follows:

• Individual surplus
  
  • also known as constant retention
  • excess over specified level is reinsured; excess of either
    
    • sum at risk over specified level
    • sum assured over specified level
      
      • • Quota share
  • also known as reducing retention
  • specified % of
    
    • sum at risk, or
    • sum assured

We can see see that under risk premium reinsurance, the amount reinsured is for either (a) individual surplus or (b) quota share is based on either

• the full sum assured
  
  • ​full sum assured typically used for term assurance contracts
  • small reserves compared to sum assured, so risk premium/reinsurance would be quite similar whether sum assured/sum at risk used
    
    • so advantages of sum at risk not justified by extra cost
    • sum at risk administratively more expensive
• the sum at risk
  
  • where sum at risk represents benefit in excess of reserves
    
    • reserves used to calc sum at risk specified in reinsurance treaty
    • reserves needn’t necessarily be same as insurer’s reserves held, but should be correct order of magnitude
  • sum at risk typically used for non-temporary life insurance
    
    • eg whole life and endowment
    • these have very large reserves, and is in insurer’s best interests to keep as much of reserves as possible for investment, eg
    • think about reason for reins: reduce exposure to adverse mortality experience for best cost
    • since reserve doesn’t constitute any risk to insurer from mortality (it needs to be available whether PH dies/survives during year)
    • …sum at risk allows insurer to retain full reserve under contracts
    • additionally, using sum assured would allow reinsurer to set up own reserve, meaning it’ll benefit from investment risk
    • additional administration effort (more expenses) is another reason why not on term assurance contracts

Question 13

What are the similarities between risk premium reinsurance and original terms reinsurance (coinsurance)? (3)

Answer 13

Both risk premium reinsurance and original terms reinsurance (coinsurance)

• can speficy how much is reinsured using either
  
  • quota share arrangements or
  • individual surplus arrangements.

Question 14

Cover the differences between the coinsurance and risk premium insurance by considering

coinsurance on original terms (2)

coinsurance on level risk premium terms (3)

risk premium reinsurance (5)

Answer 14

Differences can be summarised as follows:

• coinsurance, original terms
  
  • insurer sets premium, reinsurance premium in direct proportion to this.
  • reins comm agreed with reinsurer sets price of reinsurance and usually very significant.
• coinsurance, level risk premium
  
  • reinsurer sets premium for its share of the risk, based on its share of the full sum assured.
  • insurer then calcs own premium rates with knowledge of the reinsurance premiums it will be paying.
  • reinsurance comm usually not significant.
• risk premium reinsurance
  
  • reinsurer sets reinsurance premium rates.
  • risk premium operates as recurring single premium, with each premium covering the immediate period of risk.
  • reinsurer may cover part of full sum assured or part of the sum at risk.
  • risk premium will vary from period due to changes in the sum at risk, age of policyholder, or result of rate reviews.
  • reinsurance commission usually not significant.

Question 15

Define excess of loss reinsurance (3)

What key aspects of excess of loss reinsurance shall we consider? (4)

Answer 15

This is a form of reinsurance that cane be enacted on

• a risk basis, where the reinsurer pays any loss on an individual risk in excess of a predetermined retention.
• an occurrence basis where the aggregate loss from any one occurrence of an event exceeds the predetermined retention.
• in practice, the ‘occurance basis’ is more commonly enacted form of reinsurance

For excess of loss reinsurance we consider the following key points

• General features of the form of reinsurance
• Main types of excess of loss reinsurance used in life assurance
  
  • catastrophe reinsurance
  • stop loss reinsurance

Question 16

What are the general features of excess of loss reinsurance? (4)

Answer 16

Excess of loss reinsurance has the following general features

• This reinsurance useful where loss unknown until it occurs
  
  • For insurance contracts with known sum assured, can be used to protect against an exceptionally large number of claims, even if insurer’s retention under each individual policy may be capped at an acceptable level.
  • Covers total claims occurring in a portfolio as a result of such an event and which would not have been known in advance of losses occurring.
• Renegotiated annually
  
  • Insurer will pay risk premium (basis reflects uncertainty of total claim amount) to cover the reinsurer’s expected loss allowing for expenses and profit margins at the start of the year of cover.
• Non-proportional form of reinsurance
  
  • In contrast with original terms and risk premium reinsurance types.
• May be organised in levels/lines eg
  
  • eg
    
    • Cedant retains first $Xm of losses.
    • The first $Ym over the $Xm will have one price,
    • the next $Zm over $(X+Y)m will have a different price and so on.
  • Different reinsurers may then take different proportions of each line
  • Within lines, reinsurer may also pay only a percentage of loss actually incurred
  • Mainly for group life for life insurance.

Question 17

The main types of excess of loss reinsurance used in life assurance are catastrophe reinsurance and stop loss reinsurance.

What is the main aim of catastrophe excess of loss reinsurance? (2)

Answer 17

The main aim of catastrophe reinsurance is to:

• reduce the potential loss to the cedant due to any non independence of risks insured (where non-independence usually leads to catastrophes)
• particulalry important for group business, where group contract is for many

Question 18

The main types of excess of loss reinsurance used in life assurance are catastrophe reinsurance and stop loss reinsurance.

How frequently is cover renegotiated under catastrophe excess of loss reinsurance, and what benefit does this have? (3)

Answer 18

Cover under catastrophe excess of loss reinsurance usually renegotiated annually

• allows reinsurer to vary premiums (e.g. if premium expressed as some factor multiplied by the sum at risk that factor could be changed) if felt that risk posed by the direct writer’s portfolio has changed. Such a change would often be made in the year after any claim by the direct writer in respect of the catastrophe cover.
• freedom should result in lower rates (advantage to direct writer).
• direct writer has freedom to shop around different reinsurers.

Question 19

The main types of excess of loss reinsurance used in life assurance are catastrophe reinsurance and stop loss reinsurance.

Under what circumstances will a catastrophe excess of loss reinsurance contract pay out? (2)

Answer 19

Reinsurer for catastrophe excess of loss contracts will pay out if

• catastrophe occurs as defined in reinsurance contract
• no standard definition, but usually requires minimum number of deaths, from a single incident, with deaths occuring within a specified period

Question 20

Describe the cover typically provided by a catastrophe excess of loss reinsurance contract (7)

Answer 20

Cover provided is usually as follows:

• contract specifies how much reinsurer will pay if catastrophe happens
• typically, this might be excess of total claim amount, net of any amounts already reinsured, over cedant’s retention limit
• maximum may exist
  
  • reinsurer’s liability in respect of single catastrophe claim subject to maximum amount, and any amount above this would revert to cedant
  • there is also usually a maximum amount of cover per life
• reasons for maximiums could be
  
  • so that reinsurer doesn’t face unlimited liability
  • to help reduce cost of reinsurance for cedant
  • regulation/legislation may require this

Question 21

What kind of catatrophes are usually excluded from standard catstrophe excess of loss reinsurance contracts? How might the cedant work around such exclusions? (4)

Answer 21

Catrastrophe excess of loss reinsurance cover usually excludes

• war risks
• epidemics
• nuclear risks
• however, seperate catrasrophe covers may be avialable for excluded risks

Question 22

The main types of excess of loss reinsurance used in life assurance are catastrophe reinsurance and stop loss reinsurance.

How does stop loss excess of loss reinsurance operate? (2)

Answer 22

Stop loss excess of loss reinsurance operates as follows

• Reinsurer pays the aggregate net loss over the predetermined retention for a portfolio over a given time period, usually a year. So cedant’s loss on a portfolio in any such period is capped
• As with catrasrophe excess of loss reinsurance, reinsurer’s liability is limited to specified maximum amount, and reinsurance needs to be renegotiated annually

Question 23

What are the key features of financial reinsurance? (3)

Under which situations would financial reinsurance not be effective? (3)

Answer 23

Key features of financial reinsurance

• to improve apparent cedant’s accounting/supervisory solvency position
• help insurer manage its capital position
• normally only involves a small element, if any, if transfer of insurance risk from cedant to reinsurer

Financial reinsurance not effective under accounting/supervisory reserving regimes where

• credit can already be taken for future profits
• a realistic liability has to be held for the loan repayments under fin re
• in addition, given global movemebnt towards realistic reporting bases, there’s likely to be reduced adoption of such basis

Question 24

Describe how risk premium financial reinsurance can be used to facilitate a financing agreement between insurer and reinsurer (9)

Answer 24

Risk premium financial reinsurance financing arrangements typically work as follows

1. reinsurer relieves cedant of part of its new business financing requirement
2. to facilitate this, a loan is presented to insurer in the form of initial reinsurance comm, as part of the risk premium reinsurance agreement
3. the repayments for the ‘loan’ are
   
   1. spread over several years and are added to the reinsurance premiums
   2. reinsurer essentially just increases risk premium rates in future years…
   3. …and in return for charging higher prems, give more reinsurance com,
4. reinsurer takes into account the expected future lapse experience of insurer when determining repayments
   
   1. loan is effectively repaid by insurer from its future premium receipts - it doesn’t have to set up any additional liability for the repayments, as they are only payable for as long as policy remains in force
5. so assets increase by amount of reinsurance comm, the liabilities are unaffected, and therefore net assets of reinsurer will increase
6. a straighforward loan from reinsurer would not achive this as cedant would have to add amount of loan to its liabilities

Question 25

What sort of traditional (i.e non-financial reinsurance) contract would achieve the same result as a risk premium financial reinsurance financing arrangement? (3)

Answer 25

Same result can be achieved by

• original terms reinsurance
• in return for large loadings that reinsurer received, a substantial reinsurance comm would be paid to insurer, producing similar effect
• original terms actually more natural method, as premiums don’t need to be artificially increased to cover reinsurance comm payments

Question 26

Describe how contingent loan financial reinsurance works (5)

Answer 26

Contingent loan financial reinsurance works as follows

1. may also be referred to as surplus relief or asset enhancing renisurance
2. makes use of future profits contained in a block of new or existing business
   
   1. regulation usually requires assets well in excess of realistic liabilities
   2. over time, this is returned to company as profit (VIF)
3. reinsurer, again, provides loan to cedant, but
   
   1. repayment of loan is contingent upon stream of future profits being generated by business
   2. hence, cedant may not need to reserve for the repayment within its supervisory returns (depending on regulatory regime)

Question 27

What impact on EV would we expect due to use of contingent loan financial reinsurance? (3)

Answer 27

We would expect contingent loan financial reinsurance to have

1. little effect on EV as
   
   1. assets increase by loan amount, increasing EV, but
   2. expected PV(future profits) will be reduced by loan repayments, which would typically be higher than for non-contigent loan (because not all of them may be made)

Question 28

How does an insurer’s risk change due to contingent loan financial rensurance, with respect to its realistic EV? (2)

Answer 28

Impact on insurer’s risk with respect to realistic EV

• there will be less uncertainty about insurer’s profits because…
• ….VIF profit, which is included in EV, may not materialise without this reinsurance..
• …but by using it, part of that profit has been converted into current cash, making it certain.