CH29 - Risk transfer

Question 1

When faced with a risk, each stakeholder needs to decide whether to (6)

Answer 1

1. avoid the risk altogether
2. reduce the risk (probability, severity or both)
3. reject the need for financial coverage, e.g. if a risk is trivial or largely diversified
4. retain in full
5. transfer in full (through payment of a premium)
6. partly retain and partly transfer

Question 2

The choice of mitigation approach will depend on (5)

Answer 2

1. impact on frequency, consequence and severity of the risk
2. feasibility and cost of implementation
3. overall impact of each option on profit (on distribution of NPV)
4. secondary risks arising (a strategy that reduces one element of risk could introduce an additional)
5. how secondary risks might be dealt with (e.g. insurance with several insurers to minimise default risk)

Question 3

The extent of risk transfer will depend on (5)

The extent to which a stakeholder will choose to pass on all or some of the risk will depend on several factors

Answer 3

1. probability of the risk occurring
2. risk appetite and
3. existing resources to finance the risk event if it happens
4. cost of transferring the risk
5. willingness of a third party to accept the risk

Question 4

Reinsurance - benefits and costs

Answer 4

The benefits of reinsurance have to be weighted up against the cost. The reinsurance premium will include loadings for profits and contingencies.

Question 5

Reinsurance - benefits (3)

Answer 5

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
   and hence
   - a reduced risk of insolvency
   - increased capacity to write larger risks
3. Access to the expertise of the re-insurer

Question 6

Types of reinsurance (2)

Answer 6

The two main types of reinsurance are

1. proportional
2. non-proportional

Question 7

Reinsurance may be arranged on (3)

Answer 7

1. A case-by-case basis
2. A non-obligatory basis (‘facultative’)
3. An obligatory basis using a treaty

Question 8

Proportional reinsurance

Answer 8

Under proportional reinsurance, the reinsurer covers an agreed proportion of each risk.
This proportion may:
- be constant for all risks covered (i.e. quota share)
- vary by risk covered (i.e. surplus)
Both forms have to be administered automatically, and therefore require a treaty.

Question 9

Quota share reinsurance

Answer 9

Quota share reinsurance is widely used by ceding providers to spread risk, write larger portfolios of risk and encourage reciprocal business.

Question 10

Advantages(1) and disadvantages(2) of quota share reinsurance

Answer 10

+
1. It is simple to administer.

-

1. Cedes the same proportion of low variance and high variance risks and of small and large risks
2. Does not cap the cost of very large claims

Question 11

Surplus reinsurance treaty

Answer 11

A surplus reinsurance treaty specifies a retention limit and a maximum level of cover available from the reinsurer.
The proportion of risk ceded is the used in the same way as for quota share. The retention limit may be fixed for all risks or variable at the discretion of the cedant.

Question 12

Advantages of surplus reinsurance treaty

Answer 12

1. Surplus cover enables a ceding provider to write larger risks, which might otherwise be beyond it writing capacity.
2. It is flexible and enables the ceding provider to “fine-tune” its experience for the class concerned.

Question 13

Non-proportional reinsurance

Answer 13

Under excess of loss reinsurance the reinsurer agrees to indemnify the ceding company for the amount of any loss above a stated excess point.
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.

Question 14

Different forms of non-proportional reinsurance (4)

Answer 14

1. Risk XL - relates to individual losses and affects only one insured risk at any one time
2. Aggregate XL - covers the aggregate of losses, above an excess point and subject to an upper limit, sustained from defined peril (or perils) over a defined period, usually one year
3. Stop loss - a form of aggregate XL that provides cover based on total claims, from all perils on a ceding company’s whole account (or a major class of business)
4. Catastrophe XL - pays out if a ‘catastrophe’, as defined in the reinsurance contract, occurs (there is no standard definition of what constitutes a catastrophe)

Question 15

The main uses of excess of loss reinsurance (3)

Answer 15

1. To permit a ceding provider to accept risks that could lead to large claims
2. To stabilise the results of the ceding provider by reducing claims fluctuations
3. To reduce the risk of insolvency from large losses

Question 16

An insurance company is planning to launch a critical illness product.
Suggest areas in which it might it seek assistance from a reinsurer (5) + (2)

Answer 16

1. Product design - in particular in deciding which critical illness should be included and obtaining details of other products in the market
2. Pricing - the reinsurer will be able to provide past claims experience data to assist in setting pricing assumptions and may even determine appropriate premium rates for the insurer
3. Guidance in setting underwriting policies and claims controls
4. Wording on policy documents, e.g. the definitions of critical illnesses, exclusion clauses
5. Establishment of suitable administration systems

This technical assistance is in itself a means of risk management because:
1. it reduces business risk, i.e. of pricing being based on inappropriate assumptions
2. it can reduce operational risk by transferring certain activities to the reinsurer
Both of these risks are only reduced and not transferred.

Question 17

Reinsurance terminology - cede

Answer 17

‘pass on’ or ‘give away’, as in ‘cede some risk to a reinsurer’

Question 18

Reinsurance terminology - treaty

Answer 18

Covers a group of policies; the reinsurer is obliged to accept these risks from the insurer, subject to conditions (which are set out in the treaty)

Question 19

Reinsurance terminology - direct writer

Answer 19

An insurer with a direct contract with the policyholders (as opposed to a reinsurer. which has a contract with the direct writer); also called the primary insurer or cedant

Question 20

Stop Loss reinsurance

Answer 20

When all perils are covered for a ceding company’s whole account, or for a major class of business within the whole account, this is sometimes referred to as Stop Loss reinsurance