Ch 30: Risk Transfer Flashcards
1
Q
When faced with a risk, each stakeholder can decide whether to:
A
- Avoid the risk altogether
- Reduce the risk (probability, severity, both)
- Reject the need for financial coverage - risk trivial / largely
diversified - Retain in full
- Transfer in full - payment of a premium
- Partly retain and partly transfer
2
Q
The extent of risk transfer will
depend on the:
A
- Probability of the risk occurring
- Risk appetite
- Existing resources to finance
the risk event if it happens - Cost of transferring the risk
- Willingness of a third party to
accept the risk
3
Q
The choice of mitigation approach will depend on:
A
- Impact on frequency and severity of the risk
- Feasibility & cost of implementing the option
- Cost and impact on profit
- Secondary risks arising and how they might be dealt with
Overall impact on distribution of NPVs
4
Q
The extent of risk transfer will
depend on the:
A
- Probability of the risk occurring
- Risk appetite
- Existing resources to finance
the risk event if it happens - Cost of transferring the risk
- Willingness of a third party to
accept the risk
5
Q
Cost
A
- Cost of transferring risk & profit
- If risks are transferred, the cedant (party
transferring the risk) removes potential
downside and upside exposure - If upside
exposure preserved - increased costs
6
Q
Counterparty risk
A
- Investment bank / reinsurer
- Failure / default returns risk to cedant
- May be regulatory restrictions that reduce the
effectiveness of risk transfer - Maximum permissible amount that can be
transferred - Capped reduction in regulatory capital reduces
attractiveness of option - Effectiveness constrained by capacity / risk appetite
of market
7
Q
Reinsurance - benefits & costs
A
- Benefits of reinsurance have to be weighed up
against the cost - Reinsurance premium - loadings for expenses,
contingencies, and profits - Reinsurer may be able to offer very
competitive terms for administration, actuarial
services, and other insurance advice if
contract is purchased - Technical assistance - reduces business and
operational risk
8
Q
Areas in which insurance company might
seek assistance from reinsurer:
A
- Product design
- Pricing
- Guidance in setting underwriting
policies and claims controls - Wording of policy documents
- Establishment of suitable
administration systems
9
Q
Benefits of reinsurance:
A
- Reduction in claims volatility and hence
- Smoother profits
- Reduced capital requirements
- Increased capacity to write more business and achieve diversification
- Limitation of large losses arising from
- Single claim on a single risk
- Single event
- Cumulative events
- Geographical and portfolio concentrations of risk and hence
- Reduced risk of insolvency
- Increased capacity of writing larger risks
- Access to expertise and data of the reinsurer
10
Q
Cost of reinsurance:
A
- Reinsurance premiums
- Cost in management
- Providing policy and claims details to
reinsurer - Managing recoveries
11
Q
Cost vs benefit:
A
- Calculate realistic estimate of net cost of
reinsurance (premium - expected benefits) - Together with a range over which this net
cost may vary depending on experience - Consider liquidity risk
12
Q
Basic product types
A
- Main types - proportional and non-
proportional - May be arranged on
- Case-by-case, non-obligatory basis
(facultative) - Obligatory basis using a treaty
13
Q
Reinsurance terminology
A
- Cede: ‘pass on’ or ‘give away’
- Treaty: covers a group of policies, reinsurer is
obliged to accept these risks from insurer, subject
to conditions - Direct writer: insurer with direct contract with
policyholders – primary insurer /cedant
14
Q
Proportional reinsurance
A
Reinsurer covers an agreed proportion
of each risk - proportion may
* Be constant for all risks covered -
quota share
* Vary by risk covered - surplus
Have to be administered automatically -
require treaty
15
Q
Advantages of quota share reinsurance:
A
- Simple to administer - written by treaty
and constant proportion - Helps diversify risk
16
Q
Quota share reinsurance
A
- Fixed percentage of each and every risk is
reinsured - Widely used by ceding providers to
- Spread risk
- Write larger portfolios of risk
- Encourage reciprocal business
17
Q
Disadvantages of quota share reinsurance:
A
- Same proportion ceded for large and small
risks - Same proportion ceded for low and high
variance risks - Does not cap the cost of very large claims
18
Q
Surplus reinsurance
A
- Treaty specifies retention level and maximum level of cover available from reinsurer
- Proportion of risk ceded is then used in the same way as quota share
- Retention level / estimated maximum loss
- Retention level may be fixed for all risks / variable at the discretion of the cedant
19
Q
Advantages
A
- Enables ceding provider to write larger risks which
might otherwise be beyond writing capacity - Helps ceding provider spread risk
- Flexible - can fine-tune experience for class
concerned
20
Q
Disadvantage
A
- More complex administration - assess
and record risks separately - Does not cap cost of very large claims
21
Q
Non-Proportional reinsurance
A
- Reinsurer agrees to indemnify ceding company
for the amount of any loss above a stated
excess point - Cover is up to a stated upper limit
- Insurer purchases further layers of XL
cover, which stack on top of the primary layer,
from different reinsurers
22
Q
Uses of non-proportional reinsurance:
A
- To permit a ceding provider to accept risks
that could lead to large claims - caps losses - To stabilise the results of the ceding
provider by reducing claims fluctuations - Profits and dividends less volatile
- More efficient use of capital, since lower
free assets required - To reduce the risk of insolvency from large
losses
23
Q
Different forms:reinsurance
A
- Risk XL
- Relates to individual losses
- Affects only one insured risk at any time
- Aggregate XL
- Covers the aggregate of losses, above an excess
point and subject to an upper limit, sustained from a
defined peril(s) over a defined period - usually 1 year - By event, peril / class of business
- Stop loss
- Form of aggregate XL
- Provides cover based on total claims, from all
perils on a ceding company’s whole account / major
class of business - Catastrophe XL
- Pays out if a catastrophe, as defined in the
reinsurance contract, occurs - Providing coverage for very high aggregate losses
arising from a single event - Aim is to reduce potential loss due to non-
independence of risks insured - Usually only available on a yearly basis and has to
be renegotiated each year
24
Q
Advantages of XL reinsurance
A
- Caps losses – allows cedant to take on
risks that could produce very large claims - Protects cedant against individual
aggregate large claims - Helps stabilize profits from year to year
- Help make more efficient use of capital by
reducing variance of claim payments
25
Disadvantages:XL reinsurance
* Premium payable - can be greater than
expected recoveries
* Premiums may be greater than pure risk
premium for the cover
26
Alternative risk transfer
* Non-traditional methods by which organisations can
transfer risks to third parties
* Involves tailor-made solutions for risks that the
conventional reinsurance market would regard as
uninsurable / does not have the capacity to absorb
* Uses both banking and insurance techniques
27
ART contracts:
* Integrated risk covers
* Securitisation (e.g., catastrophe bonds)
* Post loss funding
* Insurance derivatives
* Swaps
28
Integrated risk covers:
* Typically arranged between insurers and
reinsurers
* Covers several lines / classes of general insurance
business over several years
* Commonly include cover of financial risks - market
and credit
* Excess point and upper limit in relation to
aggregated risks
* Multi-year, multi-line covers – will give premium
savings due to cost savings
* Substitute for debt and equity
Uses of integrated risk covers:
* Avoid buying excessive cover
* Smooth results
* Lock into attractive terms
Premium savings due to:
* Cost savings - not several arrangements and not
renegotiated each year
* Greater stability of results due to diversification by
- Type of risk insured
- Time
29
Disadvantages:Integrated risk covers:
* Credit risk in relation to the cover provider
* Lack of availability
* Expenses arising from tailor-made aspect - need full
insight into dealings
* Difficulty in structuring the provider’s risk
management programme in a holistic, multi-line way
- separate risk managers for separate risk types
30
Securitisation:
* Transfer of insurance risk to banking and
capital markets - risk → financial security
* Used for managing catastrophe risks
* Special purpose vehicle (SPV) is separate
legal entity between investor and insurer
* High-risk investment - probability that
return will be 0
* Insurance catastrophe risk is
uncorrelated with market risk - benefit to
investors
31
Post loss funding:
* Guarantees that, in exchange for a
commitment fee, funding will be provided
on the occurrence of a specific loss
* Funding often loan on pre-arranged terms
or equity
* Way of raising capital to cover losses from
a risk after the risk event has happened
* Securing terms in advance under which
capital can be raised following
catastrophe
* Lower commitment fee → cheaper
32
Insurance derivatives:
* Catastrophe / weather options
* Majority of market is OTC although
exchange-traded contracts exist
33
Swaps:
* Organisations with matching, but negatively correlated / uncorrelated risks can swap packages of risk
so that each organisation has a greater risk diversification
* Reinsurance swap, longevity swap, weather swap
* Unit of trading required - sum assured / amount of revenue or profits
34
Reasons why providers take out ART contracts:
* Provision of cover that might otherwise be unavailable
* Stabilisation of results
* Cheaper cover
* Tax advantages
* Greater security of payment
* Management of solvency margins
* More effective provision of risk management
* As a source of capital
