Ch 30: Reinsurance 2 Flashcards
List various reasons why insurer’s may use reinsurance (12)
Reinsurance mainly allows cedant to transfer risks from its balance sheet to reinsuerer’s balance sheet and acheive the following goals
- increase (raise)
- capital (where permitted)
- profits or risk adjusted return on capital
-
reduce
- insurance parameter risk that claims might differ to expected
- claim payout flactuation by reducing cedant’s claim cost variance
- costs (cost reduction)
- new business strain
- overall capital requirements
- limit
- amount paid on any particular claim
- total claims payout
- receive technical assistance
- seperate out different risks from a product
- manage aggregation of risks
SADLIFE
What is insurance parameter risk, and what form of reinsurance best transfers this this type of risk? (2)
How might reinsurance assist with reducing parameter risk?
Broadly speaking, insurance parameter risk (also known as pricing risk) is,
- the risk that level of claims differ compared to what is expected
- may be caused by incorrect pricing, underwriting failures, fraudulent activities, etc
- best reinsurance for transfer this risk is through quota share reinsurance
- individual surplus reinsurance wouldn’t be useful for this, as significant portion of pols’ claims may fall below insurer’s retention limit
- under quota share reinsurance, the reinsurer would regulalry review insurer’s premium rates/controls and give expertise to assist with setting assumptions and carving actual experience which better represents assumptions
Describe 2 factors which lead to variance of claim amounts being high relative to the mean, and what forms of reinsurance can be used for each factor? (9)
One of the key benefits of reinsurance is its ability to help reduce risk by reducing the variance of its claim costs.
Claims costs may have high variance relative to the mean if
- _there are a small number of contracts, with very high levels of cover
- forms of reinsurance that help with this:
- either original terms reinsurance (coinsurance), or
- risk premium reinsurance, usually on an individual surplus basis
- RE bigger prop of larger risks and less of the smaller ones
- forms of reinsurance that help with this:
-
lives insured not independant risks
- forms of reinsurance that could help are
- excess of loss reinsurance
- catastrophe / stop loss reinsurance
- excess of loss reinsurance
- Var tot claims= Sum(100) [1* #D] = 1^2 * sum(100) Var (#D) = 100Var(#D)
- 1 PH with SA=100 => var = 100^2 Var(#D) much bigger
- forms of reinsurance that could help are
Why would fluctuations in claim costs be undesirable for an insurer? (6)
What else can be down to reduce claim costs? (2)
Fluctuations in claim costs are bad for an insurer for a number of reasons
- may make life company insolvent
- big risk for small companies, this have an strong need for reinsurance.
- for larger companies mortality fluctuations managed with capital
- may reduce value of company’s free assets below the level desired by the company
- may reduce rate of return on free assets below level desired by company in some years
- may cause fluctuations in shareholder dividends
Reduce claim costs
* Mortality reserve (gate):
* cover excess claims> expected
* + in value when claims<exp (profits)
- Don’t sell high SA’s
Explain how reinsurance can be used to reduce new business strain? (2)
What is the benefits of reducing new business strain? (1)
Which types of reinsurance would be used for the purpose of reducing new business strain? (6)
Provided it’s permitted under relevant supervisory regime, reduce financial risk associated with new business:
* increasing its available capital, or
* reducing its financing requirement
Reducing new business strain has the benefit that
* more new business can be written for the same amount of capital
Types of reinsurance which might help reduce new business strain include
* original terms coinsurance usually on quota share basis
* usually pass % liability to reins, so insurer can hold less reserves
* hence, reducing new business strain by around same %
* more significantly, large initial reinsurance comm contributes to insurer’s assets, effectively discounting future profits that would’ve been tied up in the large reinsurance premiums
* risk premium reinsurance usually on quota basis
* financial reinsurance (if effective under regulatory regime)
* improve balance sheet of insurer immediately, thereby increasing available capital
Why is invididual surplus reinsurance less useful than quota share reinsurance for reducing new business strain? (2)
Individual surplus reinsurance would be less useful than quota share for reducing new business strain because
- new business strain is a funtion of many constituents (init comm, init expenses, prem income, initi supervisory reserves, etc) relating to new business sold, whether made up of many small individual pols, or fewer individual larger pols
- using individual surplus reinsurance for financing would generate capital support that would be a function of new business mix by size (which is irrelevant to total amnt of strain)
Explain the circumstances in which an insurer may benefit from the technical assistance a reinsurer can provide (4)
What form of reinsurance best allows insurer to benefit from technical assistance from the reinsurer? (1)
Reinsurance can provide the following technical assistance to the insurer
- Reinsurer may have considerable degree of expertise on underwriting, product design, pricing and systems design
- This is particularly important when cedant starts a new line of business, as it can receive technical assistance from reinsurer until it has built up its own expertise
- Likewise for recently established insurance company.
- Reinsurer can give support for existing lines in areas such as underwriting, eg treatment of unusual cases.
Best form of reinsurance to benefit insurer regarding technical assistance is
- original terms reinsurance (with high quota share reinsured)
Discuss how reinsurance may help insurer’s in terms of cost reduction (6)
Cost reduction benefit of reinsurance can be from reinsurer being able to price risk at lower cost than insurer due to
- different capital requirements it faces
- diversification benefits of due to reinsurer having greater spread of risks than any individual cedant in terms of
- number lives covered, geographical region, original sales channel, etc
- reduce reinsurer’s random flactuation risk relative to any insurer
- …and quantity of data should help reduce parameter risk
- hence reinsurer won’t need to build in such large risk margins into reinsurance prems, potentially making it more profitable for cedant to cede this business than retain risk on it
- tax differences across regions/regimes, across certain types of business
- different assessments of risks
What are the considerations before the use of reinsurance? (3)
Before deciding on the use of reinsurance, an insurer should ask itself the following questions:
- whether or not to use reinsurance
- which types of reinsurance to use
- how much reinsurance to use
Considerations before Reinsurance
List considerations that an insurer will take into account in deciding on the answers to these questions (5)
What kind of risks does the use of reinsurance introduce? (2)
Key considerations for insurer when answering above questions about reinsurance
- reasons for acquiring reinsurance
- type of business being reinsurance
- cost of reinsurance
- retention limits - ie maximum amount of risk retained by cedant on any individual risk
- legal conditions applying types of reinsurance available and way in which amount reinsured is specified
In addition, the use of reinsurance introduces the following important risks:
- Legal risk: ir reinsurance treaty incomplete
- Counterparty risk: risk that reinsurer defaults in event of claim
Reinsurance considerations: cost of reinsurance
What factors influence the cost of reinsurance? (1)
What key considerations should be factored into a decision about reinsurance regarding the cost thereof? (6)
The cost of reinsurance is influenced by the following factors
- the reinsurer intends to make profit as well as meet its cost of capital and expenses when writing reinsurance, which will reduce the expected absolute level of profit for the cedant
-
The return/risk adjusted return on capital
- risk reduction from reinsurance may leverage up return or risk adjusted RoC
- given insurer holds less capital, RoC will increase (leverage up return)
- implying lower RDR for future profit stream, making them more valuable to shareholders (increasing the risk adjusted RoC)
-
The balance between risk and return
- balance must be struck between increased cost of reinsurance against increased risk of loss from adverse experience if less reinsurance used
Reinsurance considerations: Retention Limits
What factors should the insurer/cedant consider when determining its retention limit? (9)
Max amt of risk retained by cedant on indiv risk
Factors to consider when setting retention limits
- the average benefit level and the expected distribution of the benefit
- insurer’s/cedant’s insurance risk appetite
- level of company’s free assets and the importance attached to stability of its free asset ratio
- terms on which reinsurance can be obtained and dependence of such terms on retention limit
- company’s familiarity with underwriting the type of business involved
- effect on company’s regulatory capital requirements of increasing or reducing retention limit
- existence of profit-sharing arrangement in the reinsurance treaty
- the company’s retention on its other products
- the nature of any future increases in sums assured
Reinsurance considerations: Retention Limits
State 3 ways in which a cedant can use stochastic simulation to determine its retention limit (1,5)
(1,1)
(2,4)
(3,2)
-
Stochastic simulation - reinsurance only
- Determine retention limit such that probability of loss/insolvency (ruin probability) kept below certain level
- Or target prob of loss in one year less than some % earnings
- Proj A+L+Claims and set retention so solvent in 990/1000 simulations
- RE more if
- Less certain about mort experience
- Acceptable prob ruin is low
- Variance of claims is high
- Size of free assets also det how RE take out.
- Stochastic simulation - reinsurance and fluctuation reserve
- Use stochastic simulation to determine minimum total of
- cost of financing an appropriate mortality fluctuation reserve, and
- cost of obtaining reinsurance
- as retention limit increases, (1) will increase and (2) will decrease
- choose retention limit that minimises total of (1) and (2)
- Stoch sim to calc reserve needed (1.)
-
Financial economics approach
- Based on the theory of efficient investment frontiers, and looks at reinsurance as an asset class that allows the company to optimise its risk and reward trade off.
- Allows identification of asset portfolios including reinsurance, which cannot be bettered in terms of either reducing risk for no reduction in return, or increasing return for no increase in risk.
Reinsurance considerations: Retention Limits
Process to determine suitable retention limit (10)
- Criterion for max claim volatility
- eg 1% chance net loss claims = 25m
- Stoch model
- (Tot claims net of RE) - (Tot risk prems net of RE)
- Done for diff retention limits
- X = (Gross claims - Recovered claims) - (Risk prem to ins - Risk prem to RE)
- Choose retention limit that satisfies criterion
- P(X>25m) = 0.01
- Check is RE is avail and cost
- Compare to cost of mort fluctuation reserve
- Cost of holding reserve size M is M( j - i )
- j=exp rate of ret on capital , i= exp ret on backing assets
- Tying up capital in reserve, cannot invest freely
- Account for % of risk prem used to finance reserve
- eg 60% of annual prem
- M= 60%(P) / ( j - i ) => 30P => size of reserve purchase in a year
- 40%P left to buy RE => adj retention to match cost
- Model X under new retention limit and mort fluct reserve
- X =(Gross claims - Recovered claims) - (Risk prem to ins - Risk prem to RE) - M
- Check criterion is satisfied => using reserve cheaper than RE
- Try diff combinations of RE and Fluc reserve
- Most protection for given cost
Reinsurance considerations: Counterparty risk
When an insurer is deciding on reinsurance, describe how factors relating to counterparty risk may arise (2)
How might an insurer reduce its counterparty risk? (1)
Counterparty risk arises as follows
- Cedant retains liability to the policyholder for the benefits even if the reinsurer becomes insolvent and can not meet claim payments as they become due.
- Amount of exposure known as credit risk.
- The greater the counterpaty risk, the less valuable the value of reinsurance
An insurer may reduce its counterparty risk by:
* reinsuring with multiple reinsurers, thereby diversifying its risk
