Reserving paper - KG > Chapter 24: Determining appropriate reinsurance > Flashcards
Chapter 24: Determining appropriate reinsurance Flashcards
3 Causes of risk accumulations
- Too much risk underwritten in a particular area
- Too much risk of one particular type or class underwritten
- Risks where claims may arise under different classes of business
Coinsurance
A method of sharing a risk among a number of direct insurers, each of which has a separate direct contractual relationship with the insured, and is therefore liable only for its own contractual share of the total risk.
Why would a new company use reinsurance?
- To reduce new business strain
- Limited experience, so they need technical assistance:
- — guidance on pricing,
- — policy design,
- — claims management,
- — underwriting management
- — access to data
- There is considerable uncertainty in the form of parameter risk (if it gets its pricing wrong)
How can reinsurance increase value to shareholders
Reinsurance reduces the need for capital, so that there is more efficiency in the use of existing capital and therefore better returns to shareholders.
List 20 claims characteristics of a generic class of business
DELAYS: event, reporting, settlement
CLAIMS DISTRIBUTION: frequency, severity, volatility
moral hazard
CURRENCY
INFLATION
TRENDS
LARGE claims
CATASTROPHES
REINSURANCE
ACCUMULATIONS
DEFINITION of a claim LATENT claims NIL claims REOPENED claims PARTIAL PAYMENTS
10 Reasons for using reinsurance
- Diversification - Rather than writing a few large risks, the direct writer can write lots of smaller risks. This is achieved by surplus and excess of loss. Reciprocity (through quota share) is also very helpful in diversifying the portfolio
- New classes - Insurers can get experience in a new class without being exposed to too much risk (although they are unlikely to make much profit).
- More business - By reducing the variation in claim payments, less risk capital is needed. Conversely, more gross business can be written on the same amount of capital.
- Larger risks - The office can increase the scope of business it writes, for example through surplus and also perhaps excess of loss
- Protection of free assets/solvency margin- The solvency margin (excess of assets over liabilities) is protected from large claims (through excess of loss).
- Catastrophes - Helps prevent risk of insolvency from catastrophes or other accumulations. Use catastrophe excess of loss or other aggregate excess of loss as appropriate for the class.
- Regulation - The authorities may reduce the required level of statutory solvency to allow for the extent to which reinsurance has reduced the company’s level of risk.
- Smooth profits - Net results are more stable over time (especially with excess of loss).
- Financial assistance - Via favourable commission agreements (proportional) or through the direct writer hanging on to the gross premium before passing anything on to the reinsurer. Also, using reinsurance as a favourable alternative to capital.
- Technical assistance- Reinsurers and brokers may provide useful technical services and advice to insurers that are not experienced in a particular class.
Reasons for using reinsurance:
Diversification
Rather than writing a few large risks, the direct writer can write lots of smaller risks.
This is achieved by surplus and excess of loss.
Reciprocity is also very helpful in diversifying the portfolio.
Reasons for using reinsurance:
Larger risks
The office can increase the scope of business it writes, for example through surplus and perhaps excess of loss.
Reasons for using reinsurance:
More business
By reducing the variation in claim payments, less risk capital is needed. Conversely, more gross business can be written on the same amount of capital.
Reasons for using reinsurance:
Protection
The solvency margin is protected from large claims.
Reasons for using reinsurance:
Smooth profits
Net results are more stable over time (especially with excess of loss).
Reasons for using reinsurance:
Catastrophes
Helps prevent risk of insolvency from catastrophes or other accumulations.
Use catastrophe excess of loss or other aggregate excess of loss as appropriate for the class.
Reasons for using reinsurance:
Technical assistance
Reinsurers and brokers may provide useful technical services and advice to insurers that are not experienced in a particular class.
Reasons for using reinsurance:
New classes
Insurers can get experience in a new class without being exposed to too much risk.
Reasons for using reinsurance:
Regulation
The authorities may reduce the required level of statutory solvency to allow for the extent to which reinsurance has reduced the company’s level of risk.
Reasons for using reinsurance:
Financial assistance
Via favourable commission agreements or through the direct writer hanging on to the gross premium before passing anything on to the reinsurer.
Also reinsurance as a favourable alternative to capital.
How does the class of business influence the required reinsurance?
The class directly indicates the likely - size - range - volatility of the risks.
Clash cover
XL cover for liability business,
obtained by insurers to limit their exposure to the risk that
- ONE EVENT gives rise to CLAIMS on MORE THAN ONE POLICY,
where otherwise the insurer might be liable for claims up to any retention limit for each individual policy.
Factors influencing the amount and type of reinsurance (KG)
- Class of business
- -class of business: The class directly indicates the likely size, range and volatility of the risks. In particular, the claims characteristics of each class of business are important in determining the most appropriate form and structure of a reinsurance programme.
–size and range of risks: Surplus reinsurance is likely to be appropriate for cover for damage to large properties, such as commercial property. For risks that can give rise to individual claims that are large in comparison to the size of the insurer, several layers of risk XL reinsurance may be required.
For those liability types of cover where there is no clear limit on the size of claims, the top layer of reinsurance cover should, ideally, be unlimited; but in practice, unless there are legislative reasons, there are always upper limits.
–volatility of experience: For some classes, the overall claims experience may vary considerably from year to year. Everything else being equal, an insurer would choose to use more reinsurance where there is greater volatility.
If the volatility is largely in the size of individual claims then individual risk XL will be more appropriate. Arguably then, if the volatility is more in the number of claims than their individual size then a stop loss treaty or an aggregate XL, based on cause, would be appropriate.
- Amount of capital held: Capital is available to absorb, amongst other things, the cost of excessive claims. The larger the amount of loss absorbing capital held, the less the need for reinsurance. It is not there to eliminate the need for reinsurance but will enable the insurer to have a higher retention before reinsurance is needed. However, the purchase of reinsurance is likely to be more cost effective than holding an excessively high level of capital.
- Total Written Premium:
This is closely related to the amount of capital held, as an insurer will usually require a large amount of capital to support large volumes of business.
However, where the premiums written are large in comparison to capital held, the insurer may choose to set up some quota share treaties to reduce its net written premium relative to its capital. - Geographical regions in which the risks are located: Many perils relate only to particular geographic regions. For example, in buildings insurance, subsidence and flood occur only in certain areas. Where such perils can lead to large claims, the need for per risk and per event XL reinsurance is greater for an insurer exposed to those regions than for one that is not.
Similarly, there is a much greater need for per event XL reinsurance for insurers who write risks in the specific regions that are commonly exposed to hurricanes, typhoons or earthquakes, eg European windstorms. - Accumulations of risk
–Too much risk underwritten in one particular area: Where regional perils occur from any one event, any accumulations of risk increase the maximum loss that may occur and hence the need for aggregate and/or catastrophe XL cover. Quota share cover may also be used to spread the risk, possibly with a reciprocal agreement relating to business in another independent region.
To determine the amount of reinsurance required, we should estimate the total probable maximum loss under each type of event. We can then consider this alongside the other matters that influence the need for reinsurance. We should also consider the exposure at company or group level to avoid accumulations across several classes of business.
–Too much risk of on particular type or class has been underwritten:
–Risks where claims may arise under different classes of business: This danger is subtler in its occurrence as few causes would be expected to lead to excessive claims throughout a whole class. However, such an accumulation can certainly be a danger where there is an economic link to the claims; for example, in a class such as mortgage indemnity guarantee cover.
Quota share and stop loss reinsurance, if available, may be appropriate ways of reducing such risks.
–Risks where claims may arise under different classes of business:
Here the same risk generates different claims in different classes. For example, for marine hull and liability classes of business, the full insurance of a tanker may give rise to several types of claims if it goes aground or is in a collision. The hull will need repair, oil cargo will be lost, crew members may be injured or killed, or oil spillage may pollute a coastline.
In such situations, clash cover or facultative excess of loss might be used to reduce the risk. Clash cover is XL cover for liability business, obtained by insurers to limit their exposure to the risk that one event gives rise to claims on more than one policy, where otherwise the insurer might be liable for claims up to any retention limit for each individual policy. It should be noted that some versions of clash cover will not be effective in the above situation, where the cover applies to different policies on a liability account.
–Accepted reinsurance:
The same considerations apply to accepted reinsurance, which must be considered together with the direct (ie insurance) business to determine the true accumulation.
A further problem exists, however, where the insurer has accepted retrocessions for which it is not possible to determine the detailed background of the risks. Here the insurer may not be aware of an accumulation of risk by region, or indeed may have accepted an individual risk to which it is already exposed
- Current market conditions
- -Availability of reinsurance: An insurer’s ability to obtain reinsurance of the desired type and the desired amount at an acceptable price will depend on the willingness and capacity of the reinsurance market at any time. Often insurers may find that they are only able to place a proportion of a reinsurance layer. A related point is the price at which reinsurance can be placed.
–Opportunities available to find coinsurers: In theory, if very large risks are written, the insurer merely needs additional layers of reinsurance. If the risk becomes extremely large, the proportion retained by the insurer can become very small. In this situation the risk of default by a reinsurer may become too large to bear. In practice, therefore, it becomes preferable to coinsure risks above a certain size, provided suitable coinsurers can be found, rather than using proportional reinsurance. Each coinsurer will then reinsure its share of the risk as appropriate. This is the basis under which most of the London Market operates.
–Perceived value for money of additional reinsurance: Provided that the reinsurance is adequately priced, the purchase of it is likely to mean the passing on of potential profits. However, this cost has to be weighed against the value of the increased stability and security that the reinsurance may provide.
–Security status of the available reinsurers: Reinsurance is a relatively high-risk business and so the possibility that a reinsurer becomes insolvent should not be overlooked by a ceding insurer. The cedant is interested in the long-term survival of its reinsurers, because of the long period that may elapse between the occurrence of an insured event and the eventual recovery from reinsurers. Thus, insurers will be influenced by the rating agencies’ views on the security status of reinsurers.
However, reinsurers with a higher default risk may be cheaper than those with a better credit rating, which needs to be considered when deciding which quotes to accept.
–Regulatory environment: Regulatory authorities may reduce any required statutory capital requirements to allow for the reduced volatility resulting from reinsurance purchased. We can use quota share reinsurance to reduce the net written premium income of general insurers that have capacity restrictions (for example, Lloyd’s syndicates). The extent of any reduction to statutory capital requirements is likely to be limited in proportionate and/or absolute terms. Regulators might also specify a maximum level of credit that can be taken for exposure to any one reinsurer, perhaps based on the reinsurer’s financial strength. Regulators may prescribe reinsurance. There are tax benefits in some cases.
- Insurer’s preferences
–Risk appetite and tolerance: As for individuals, insurance companies will have differing opinions on the amount of risk that they are willing to take. A more cautious insurer will be likely to cede more risk away to reinsurers than a company adopting a less risk-averse strategy.
An insurer that has more financial backing, whether it is through a parent company or easy access to additional funds, will have a higher level of risk tolerance.
–Underwriter influences: Company underwriters may influence how much is spent on reinsurance. For example, an underwriter given the aim of growing the company’s commercial property portfolio by 10% per annum, may decide to take on a particularly large risk and thus influence the reinsurance purchases by the need to arrange corresponding facultative cover.
An underwriter with influence over the reinsurance purchase may be more or less risk averse than would normally be appropriate. There may also be occasions when the underwriter is influenced by more personal motives, such as protecting their bonus or job.
–The need for technical assistance: Reinsurers can provide assistance for reserving, pricing and establishment, if a company is considering a new product launch or the development of business for the first time in a different territory. However, in the UK at least, much of this assistance is provided by specialist reinsurance brokers, and not by the reinsurers themselves
–Financial objectives: Financial objectives can be a strong motivator in reinsurance purchases. By purchasing an efficient reinsurance programme, we can use reinsurance as a means of achieving certain financial objectives. For example, an insurance company may have an overall business objective of reducing its probability of ruin in the next 10 years to below 0.5%. By carefully modelling the insurer’s business, we should be able to structure its reinsurance so as to reduce the likelihood of ruin to a specified level.
Alternatively, suppose a company has the objective of providing its shareholders with a smooth return over a five-year period. Then we could use non-proportional reinsurance of the more volatile lines such as liability to help it to achieve this.
- Expectations of the reinsurer: Often reinsurers will require the insurer to have a minimum level of retention of a risk or collection of risks. They may achieve this by providing surplus reinsurance or by requiring the insurer to retain a layer, or proportion of a layer, of an excess of loss programme. This will help to keep the interests of the cedant and reinsurer aligned.
- Relationships: A general insurer may also consider its existing relationships with reinsurers and reinsurance brokers. For example, an existing reinsurer may offer a good price in order to maintain a good relationship with its clients
Impact of capital management on reinsurance purchasing
i.e. the use of capital (or free reserves) as an alternative to reinsurance
An insurer with access to cheap capital in its group is less likely to take out reinsurance compared to a small company with no parental backing.
Insurers can change their regulatory capital requirement, by purchasing reinsurance. The interplay of capital and reinsurance has become an important consideration in reinsurance structuring and buying decisions
1. Using reinsurance to reduce capital requirements: An insurer may wish to purchase (additional) reinsurance to reduce its regulatory capital requirements.
Regulators will require insurers, on writing a book of business, to allocate capital against this business to cover future losses.
Through an effective reinsurance strategy, we reduce the amount of capital required to support this book because the insurer is transferring exposure to the risk of losses to the reinsurer.
2. Using reinsurance as a form of capital:
Following the previous point that reinsurance can be used to reduce the amount of capital required, we can consider it to be a form of capital. By purchasing an effective reinsurance programme, an insurer can free up capital that is otherwise allocated to support the premium income against future uncertain losses. Therefore, reinsurance can be an effective means of reducing the capital required and may be cheaper than raising extra capital by other means. The insurer could use the extra capital to generate increased revenue by writing additional business.
3. How does the cost of reinsurance capital compare with the cost of an insurer’s capital or alternative forms of capital?
The cost of reinsurance capital will differ from the cost of alternative sources of capital, such as that obtained through the more traditional capital markets. Reinsurance may be a cheaper way for an insurer to reduce the capital it needs, enabling it to increase its overall return on equity and increase its value to shareholders.
4. Reinsurance for new companies:
New companies use reinsurance to reduce the capital strain of financing new business. They usually do this by ceding large proportions of business to reinsurers via quota share reinsurance. This is an addition to many of the points made earlier in this chapter which covers issues that also apply to new companies.
In addition to relieving new business strain, a new company has limited experience, so may appreciate technical assistance, eg guidance on pricing, policy design, claims management, underwriting management and access to data.
There is considerable uncertainty for a new company in the form of parameter risk (it may get its pricing wrong), in which case reinsurance will relieve this uncertainty, through sharing arrangements such as proportional reinsurance, and through capping arrangements such as non-proportional reinsurance.
If you are asked to discuss an insurer’s reinsurance strategy in the exam, you should work through the following four key processes:
- Analyse the class(es) of insurance. Consider particular features that justify calling on the reinsurers, for example:
- What different types of claim exist (ie property, liability, etc)?
- How big is each risk?
- Could there be any very large claims, and if so how likely are they (consider the tail of the distribution)?
- Is there a possibility of accumulations of risk?
- What is the claim frequency and the distribution of claim amounts? - Analyse the needs of the direct writer. Consider the key points from Section 1 concerning the company: –
- How big are the free reserves?
- How well do the new risks complement the risks already covered?
- What do we want to achieve by using reinsurance?
- Do we have experience of this class? - Consider all the different reasons for using reinsurance (summarised in Section 3.1 below). Do any of these reasons apply here?
- Finally (and only as a final check) consider the different types of reinsurance and quickly justify using or not using each type.
Case study
Describe, giving reasons, the main features of a reinsurance package that you think would be most appropriate for a small rapidly-expanding company writing only domestic household insurance.
Company requirements
The small rapidly expanding part of the scenario leads us to make the following comments. If you missed any of these comments ask yourself why, and think about how you can make sure that you think (note that we say think and not remember) of them next time you see a similar question.
Quota share could be arranged to reduce new business strain. If the reinsurer pays override commission to the insurer, this would help meet the insurer’s acquisition expenses. Quota share could also lead to the insurer receiving profit commission.
Quota share reciprocal arrangements would also help the insurer to get a more diverse portfolio and help prevent accumulations of risk building up.
If the company is fairly new (possibly implied by the small, rapidly expanding comment), it may not have enough of its own data and experience. Technical assistance from reinsurers and brokers would be available in return for business placed with them.
Domestic property requirements
Having focused on the particular needs of this company, we now turn our attention to the claim characteristics of the business written, ie domestic property.
Property portfolios are often exposed to the possibility of many claims from one event, eg floods, storms. Catastrophe XL will give the insurer protection against many claims arising from the same storm.
The retention level chosen should reflect the total expected maximum loss from a major storm and the insurer’s solvency position.
An hours clause (probably 72 hours) would be necessary to define the period over which claim events could be aggregated.
Several storms may hit this area in any particular year. Thus, we need to consider numbers of reinstatements available and size of any reinstatement premium.
Many subsidence claims may occur within a short period of time given a long dry summer. Insurer should use aggregate XL reinsurance to protect against such aggregations.
The insurer will also need to use individual XL reinsurance to protect the solvency position against the occasional large public liability claim. Given the small size of the company and possible capital restrictions, retention limits should start quite low. Cover should be arranged in several layers with different reinsurers to reduce the credit risk of reinsurer failure. The insurer is unlikely to be concerned about individual property claims, except possibly the very largest domestic properties. The volume of policies and reasonable homogeneity means that the sophistication of varying the percentage of each risk retained is unwarranted. Hence surplus is inappropriate here. (It is used primarily for larger commercial properties where volumes of business are lower and the risks are more heterogeneous.) Stop loss cover may well be appropriate to protect the whole account, but is unlikely to be available at a reasonable price for this class of business. Financial reinsurance is unlikely to be a main feature of the required reinsurance package in this scenario, as a small company may not have expertise in this area. Arguably, however, financial quota share could be used to help alleviate new business strain.
Testing the appropriateness of alternative reinsurance structures - outline
Testing the appropriateness of alternative reinsurance structures - outline
- Quantitative testing:
- 1 Modelled loss ratios:
- 2 Capital impacts
- 3 Ceded return on equity
- 4 Return periods:
- 5 Historical ‘as-if’ performance
- Qualitative testing
- 1 Risk appetites:
- 2 Alignment to underlying exposures
- 3 Reinsurance contract
- 4 Reinsurer security:
- 5 Other factors
Testing the appropriateness of alternative reinsurance structures - detailed
Reinsurance is typically one of the most significant areas of decision making for a general insurer, involving large upfront costs and having a material impact on a business’s risk profile, capital requirements and ultimate profitability.
The impact is most pronounced for companies that are, for example:
-small
-inexperienced, eg lacking data and expertise
-writing volatile lines of business, eg aviation or excess of loss reinsurance.
Most purchases will be scrutinised in a variety of ways to ensure that they are appropriate. In the following sections we outline some possible ways to assess reinsurance structures, but this is by no means exhaustive and other tests may be appropriate, particularly if there are unusual features of the programmes being considered or the underlying business being protected.
Regardless of the methods used, any testing should be considered by an appropriate group of stakeholders to ensure that decisions are being made well. This should ideally include representation from claims, underwriting, reinsurance, risk, exposure management, reserving, capital management and, for material purchases, senior management.
- Quantitative testing:
In this section, we suggest some possible quantitative tests to carry out to assess the performance of a reinsurance programme. When considering the outcome of these tests, it is important to ensure that decision makers understand the credibility of the parameters or the prior data used for testing and any limitations that might place on the credibility of the test outcomes. Otherwise there is a significant risk that tests may appear robust because they are presented in technical and quantitative terms, while in fact being essentially qualitative as they are based on highly subjective parameters or extremely sparse data.
It is also important to take a long-term view when assessing the suitability of a reinsurance programme. In some years, there may be a net loss from the programme and in others a net gain.
1.1 Modelled loss ratios:
The mean loss ratio for the reinsurer is based on underlying modelling assumptions (whether pricing assumptions or capital model parameters). When calculating this, consideration should be given to the treatment of reinstatements. These can be added to the reinsurance premium used as the denominator, which is aligned to the accounting treatment if a loss did occur. Alternatively, they can be allowed for as a deduction to the likely level of recoveries to be received, which may be of more value if assessing the level of profit to be ceded on an initial upfront reinsurance spend.
Modelled impacts on net or final net loss ratios can also be considered. This could be done by, for example, comparing the expected:
net and gross loss ratios of the insurer loss ratios of the insurer with those of the reinsurer.
1.2 Capital impacts
The amount of capital saved as a result of the reinsurance programme being purchased is a useful metric to consider, as this is both a practical indication of the amount of capital saved and an indicator of the extent of mitigation provided to the overall risk profile.
As with any capital allocation exercise, there are a variety of potential methods, each of which have various advantages and disadvantages as capital modelling involves the interaction between a number of different variables. As each reinsurance programme mitigates the risk for a line of business, the relative significance of other risk drivers will increase. The modelled impact for any individual programme can therefore change as other programmes are amended.
One approach is to consider the marginal capital impact of adding or removing a particular programme. For this approach, one would carry out two capital model runs, one with and one without the programme being considered, and compare the two capital outputs. This is one of the simpler potential approaches, but may risk overstating the capital significance of an individual programme if it tests against a portfolio that is generally well balanced other than the line of business being tested. This can also place high demands on the capital modelling team as it requires a series of separate runs for each programme being tested.
Another approach is to consider the contribution of recoveries from different programmes to simulations around the target return period (eg 1 in 200), and to use this as a way of allocating the overall capital benefit of reinsurance (which can be calculated by running the capital model with all reinsurance cover removed). This recognises some of the interaction between reinsurance programmes and avoids the need for multiple separate capital model runs.
There may also be value in considering a lifecycle capital view. The capital benefit of a catastrophe programme for example, might be significant to current capital requirements but the continuing benefit of that same programme to future years’ capital requirements may be limited once the business has earned. Conversely, capital benefits from a quota share of a long-tailed portfolio may be low in any individual year but might continue to provide benefits over multiple years as the underlying exposures remain volatile for a number of years.
1.3 Ceded return on equity
Expected profit ceded divided by modelled capital saved (whichever method is used) provides a useful single metric for the effectiveness of a reinsurance programme.
This produces a return on capital metric that can then be compared against other return on capital measures used for other decision making; although it should be noted a lower value is preferable, ie better reinsurance programmes do not need to cede away as much profit to achieve the same reduction in capital.
For example, if a reinsurance programme is expected to cede away $100,000 of profit for a $1m reduction in capital then it would have a 10% ceded return on equity. If there are alternative opportunities available at 8% return on capital, then the $1m of capital saved in theory can only be deployed to generate $80,000 of profit so the programme would reduce the overall profit achievable. It may however, still be appropriate to place if it achieves risk mitigation or other objectives.
Other objectives might include:
-maintaining a target credit rating standard
-smoothing year-on-year results
-improving the solvency margin.
1.4 Return periods:
It can be valuable to assess the likelihood of certain outcomes with different reinsurance programmes, for example the return periods at which:
-the reinsurance programme begins to be utilised
- individual losses go above the upper limit of the programme
-the reinsurance programme and associated reinstatements are exhausted leaving no cover remaining
-any parametric triggers (eg for an industry loss warranty) are reached.
It may also be useful to assess the modelled outcomes of the overall loss distribution or components of a loss distribution at various return periods, either to align to regulatory reporting requirements or to internal risk appetites. An example might be managing the 1 in 30 modelled aggregated catastrophe losses for Lloyd’s reporting.
1.5 Historical ‘as-if’ performance
Programmes can also be tested against internal historical experience, by assessing the recoveries and reinstatements that would have been incurred if the programme had been in place historically. This provides an alternative to a modelled loss ratio view, although credibility is dependent on data volumes which may be limited for many organisations, particularly for higher layers.
Consideration should be given to the need for any adjustments to historical losses, for example indexation for claims inflation or adjustments for exposure levels.
- Qualitative testing
In this section, we suggest some examples of more qualitative testing to ensure that the programme is appropriate for the underlying portfolio, the organisation and any internal risk appetite or other requirements.
2.1 Risk appetites:
Organisations will have internal risk appetites in place. Reinsurance is an effective way of managing these risk appetites, which may often be explicitly expressed on a net or final net basis.
Examples of potential risk appetites might be:
- Maximum outputs from catastrophe models, either for aggregate (AEP) or event (OEP) losses. These might be in aggregate or for specific regions or perils, eg North Atlantic Windstorm.
There are two bases for catastrophe model output files: –
–
OEPs – an occurrence exceedance probability file, which considers the probability that the largest individual event loss in a year exceeds a particular threshold.
AEPs – an aggregate exceedance probability file, which considers the probability that the aggregate losses from all loss events in a year exceeds a particular threshold.
Maximums for defined risk scenarios, such as the Lloyd’s Realistic Disaster Scenarios or internally defined extreme events or accumulation scenarios.
Maximum allowable line sizes for a particular class of business, either in the absolute or relative to premium expectations.
Portfolio balance metrics requiring minimum or maximum size thresholds for net premiums in any line of business, ensuring that no class is too small to justify internal management time or too large to unbalance the overall business.
Each organisation will have its own risk appetites, and these should be considered in the design of any reinsurance assessment framework to ensure that they are not inadvertently breached.
2.2 Alignment to underlying exposures
Reinsurance programmes should, as far as possible, provide appropriate back to back protection for the underlying exposures being mitigated.
Some possible factors to consider are:
Term of the contract. If protecting multi-year underlying business, reinsurance should ideally be written on a ‘risks-attaching’ rather than ‘losses-occurring’ basis or should provide for a similar term of cover. If annual losses-occurring cover is purchased, this can become extremely expensive in a run-off situation.
Exclusions or any sub-limits should be consistent with the terms used for the underlying business, to avoid the risk of any uncovered exposures. If this is not possible, these uncovered exposures should be explicitly monitored and managed to different risk appetites.
Territorial or coverage scope should also align to the underlying business, with any minor exposures out of scope monitored separately.
Currency of the contract should be aligned to the settlement currency of the underlying business ideally with multiple currency limits or specified exchange rates to avoid disputes over timing or currency of payments.
2.3 Reinsurance contract
: A programme might potentially appear efficient on quantitative measures, but then provide unacceptable gaps in cover. Purchasing decisions should be supported by an expert review of the particular wording of the contract to ensure that its intended operation would be upheld in any legal dispute.
The majority of contracts will use well-established standard market wordings which should have a limited risk of dispute, with bespoke terms likely to be the highest risk. Examples of potential areas that benefit from additional scrutiny are:
exact definitions of qualifying events and loss triggers specification of hours clauses and the basis for selecting an appropriate time period
any named event clauses, for example, allowing insurers to accumulate hurricane losses from a single named storm impacting the Caribbean and the mainland US, even if falling outside of the hours clauses
rules governing the assessment of loss outcomes, for example, for stop loss business or for profit commission calculations on quota share business
provisions around the timing, nature and currency of payment indexation of loss or layer clauses
collateralisation rules, including release of ring-fenced funds In collateralized reinsurance, the reinsurer lodges collateral in an account at the start of the contract, to provide security against its obligations to the cedant. The source of the collateral could be, for example, investors purchasing insurance-linked securities.
treatment of ex-gratia payments. There may be situations in which an insurer makes a payment outside of their absolute contractual entitlement; for example, to support a good commercial relationship with a broker or to avoid a protracted loss dispute. Reinsurers may or may not choose to cover such payments.
2.4 Reinsurer security:
Even a well-designed reinsurance contract is only effective if the reinsurer remains adequately solvent to be able to pay claims when they arise. The credit rating of a reinsurer will be one of the key indicators, or the amount of funds ring-fenced for collateralised contracts.
It is likely that there will be risk appetites relating to concentrations with any particular reinsurers, so the extent of other existing arrangements may affect the choice of reinsurer for a new contract
Potential reinsurers may also have a history of disputing claims, which should be considered before including them on the reinsurer panel.
In most instances these factors may not affect the selected programme structure provided sufficient alternative reinsurers are available to place the required cover, but if the only reinsurer offering a particular contract poses a potential security risk then this may affect the decision-making process.
2.5 Other factors:
There may be other reasons driving individual purchasing decisions, with some examples being:
Strategic partnerships or strong commercial relationships with a reinsurer, potentially involving some element of reciprocity or strong support for unusual reinsurance requirements.
Acting as a fronting agent for a particular portfolio. Technical assistance, analysis, advice or other support from the reinsurers.
Protecting new portfolios with significant parameter uncertainty. A programme might, for example, provide poor value based on the assumed profile of the risk being protected, but would also mitigate the risk of materially misunderstanding the underlying exposures.
Desire to maintaining credit ratings, eg with this in mind, an insurer may feel that it is safest to keep the reinsurance programme the same.
Maintaining relationships with reinsurance brokers. Improving the solvency position.
Market conditions, eg insurers may be more inclined to purchase reinsurance when it appears to be cheap.
