Chapter 30 Flashcards
What are the reasons for reinsuring?
FAIR STATION
- F - Fluctuations in claim payouts reduced by reducing the variance of claims
- A - Amount paid on any particular claim limited and
- A - Avoid having to decline any business, i.e. sell more business
- I - Insurance parameter risk reduced
- R - Raise capital (Fin Re)
- S - Separate out different risks from a product
- T - Technical assistance
- A - Allow aggregation of risks that the cedant cannot manage on its own, so allowing manufacture of product lines (e.g. concentration risk by location)
- T - Total claims paid out is limited
- I - Increase in profits or return/ risk-adjusted return on capital
- O - Overall capital requirements reduced by using a reinsurer’s capital - reinsurers may have lower capital requirements due to risk diversification or regulatory position. Can result in lower overall capital requirements for industry and lower RI prices.
- N - NB strain reduced
What is the reason for fluctuations in claim payouts? Also provide a reinsurance solution for each.
The variance relative to the mean can be high because:
* There are a small number of contracts for very high levels of cover (high concentration risk)
— Reinsurance solutions:
Original terms (coinsurance) or the risk premium method, usually on an individual risk basis - reinsure a high proportion of very large risks, but none for its small cases
- Lives insured are not independent risks
— Reinsurance solutions
Catastrophe XOL
Stop loss
Other types of XOL
Why can large fluctuations in the claim costs be a bad thing for an insurance company?
- May result in insolvency
- Reduces the company’s free assets
- May reduce the rate of return on free assets below the company’s desired level
- May cause fluctuations in dividends to shareholders
Apart from reinsurance, what are other solutions to reduce fluctuations in claim payouts?
- A payout or mortality fluctuation reserve - pot of money the company sets aside
- To decline high sum assured proposals - companies wish to avoid doing this
What is insurance parameter risk with regards to claims?
It is the risk that the level of claims is different from expected - due to incorrect pricing, underwriting failures, fraudulent activities, etc.
Even without any claim fluctuations, if the assumed mean mortality assumptions turn out to be an underestimate of the actual experience, then the company will make mortality losses.
How can insurance parameter risk be reduced?
- Through QS reinsurance, parameter risk can be shared with a reinsurer.
- Reinsurer also reviews the premium rates and the insurer’s controls such as underwriting and fraud detection to make improvements and reduce parameter risk.
How does reinsurance companies provide technical assistance to insurance companies?
- Reinsurance companies have considerable expertise on matters such as:
Underwriting and pricing - reducing parameter risk
Product design - important when cedant is launching a new line of business
Systems design - Even for more established companies, assistance from reinsurers on underwriting is useful - this is especially the case in unusual underwriting situations where reinsurers may have a much wider experience
By getting expert advice on underwriting and pricing, the company is reducing the extent of parameter risk - the reinsurance that follows further dilutes the remaining parameter risk by sharing exposure with the reinsurer - Original terms reinsurance (with a high QS reinsured, reduced over time) would likely be used. QS would reduce over time as the insurer’s experience and expertise develop.
How does reinsurance increase profits or risk-adjusted return on capital for an IC?
- Different capital requirements between the IC and reinsurer - e.g. the reinsurer may have lower capital requirements for writing certain kinds of business than the direct writer, and therefore the reinsurer may be able to pass on profits to the insurer by offering more favourable terms for RI (regulatory arbitrage)
- Diversification benefits
- Different taxation (tax arbitrage) - reinsurer taxed more favourable for certain lines of business
- Different assessment of risks - reinsurer may be able to price the risk at a lower cost than the cedant
- Due to lower capital requirements, greater free assets are available, take on more risky investment strategy and increase the return on free assets.
How are the overall capital requirements reduced by using the reinsurer’s capital?
- Reinsurers may have lower capital requirements due to risk diversification or regulatory position
- This can result in overall lower capital requirements for the industry and lower reinsurance premiums
How does reinsurance reduce NB strain?
- It can be used to increase the available capital or reduce the financing requirements which can help a cedant to reduce the financial risk associated with NB
- Original terms reinsurance (QS) or financial reinsurance can be used, if effective in the particular accounting or supervisory regime
- FinRe of an existing block of business will improve the BS immediately - increasing the available capital. More NB may be written before the resulting NBS leads to unacceptable low solvency position
- RP reinsurance can also be used to reduce NBS (QS) - NBS reduced by negotiating high initial reinsurance commission in return for higher risk premiums
- Reducing NBS means that more NB can be written for the same amount of capital
How can reinsurance be used to separate out risks from a product?
- Products contain multiple risks - e.g. immediate annuities with longevity and investment risk
- Reinsurance can disaggregate these risks, allowing the cedant to optimise its risk management and capital requirements, e.g. a longevity swap
What are some of the considerations before reinsuring?
- Whether or not to reinsure
- Which type(s) of reinsurance to use
- How much reinsurance to use
- The cost of reinsurance
- Retention limits
- Counterparty and credit risk
- Legal risk
Which components of reinsurance reduce the absolute level of profit for the cedant?
- The reinsurers profit loading
- The reinsurers loading for expenses
- The reinsurers loading for cost of capital
With regards to reinsurance, what balance must be struck by the direct writer?
- The direct writer must balance the increased cost of reinsurance against the increased risk of loss due to adverse experience if less RI were to be used
- More reinsurance the lower the risk of adverse claims fluctuations but the lower the expected return
As a result of reinsurance, the risk inherent in the stream of profit flows are reduced. How does this increase the value to shareholders?
- As a result of lower risk, the insurer is required to hold less capital - return on capital will increase
- As a result of lower risk the future profit stream, a lower RDR can be used, making them more valuable to the shareholders
What are the factors to consider when deciding on the retention limits?
FINAL REP
F - Familiarity level of the company with underwriting the type of business involved
I - Insurance risk appetite of the IC
N - Nature of any future increases in the sums insured
A - Average benefit level for the product and the expected distribution of the benefit
L - Level of the company’s free assets and the importance attached to the stability of its free assets ratio
R - Reinsurance terms that can be obtained and the dependence of such terms on the retention limit and
R - Retention of the company’s other products
E - Effect on the company’s regulatory capital requirements of increasing or reducing the retention limit
P - Profit sharing arrangement existing in the reinsurance treaty
S - Solvency position in the future as projected using a model office
What are the different approaches that the cedant can use to determine the level at which the cedant should set its retention level?
- Stochastic simulation - reinsurance only
- Stochastic simulation - reinsurance with a fluctuation reserve
- Financial economic approach
Explain how stochastic simulation can be used to determine the level at which the cedant should set it retention level. Consider the use of reinsurance only.
- Set the retention limit at such a level to keep the probability of:
Insolvency or ruin below a specified level
The loss in any quarter/ year below a proportion of the earnings of the business - Use a stochastic model to project the claim rates and use a model of the business so that the claims can be projected forward with the value of the company’s assets and liabilities
- By using the simulations, a retention level can be determined such that the company stays solvent, or earnings stay above a certain level 995/1000 simulations
- The company would decrease the retention limit if:
– They are less certain about the future mortality experience
– There is a lower acceptable probability of future solvency
– There is a greater variance in the distribution of the SAs
Explain how stochastic simulation can be used to determine the level at which the cedant should set it retention level. Consider the use of reinsurance and a mortality fluctuation reserve.
- Consider a total of:
(a) The cost of financing an appropriate mortality fluctuation reserve
(b) The cost of obtaining reinsurance - As the retention limit increases, (a) will increase and (b) will decrease - a retention limit can be adopted to minimise the total of (a) + (b)
- Step 1-8 or determining a suitable retention limit and an optimal balance between mortality fluctuation reserve and reinsurance
How does the financial economics approach work to determine the level at which the cedant should set its retention level?
- It is based on the theory of efficient investment frontiers and looks at reinsurance as an asset class that allows the firm to optimise its risk and reward trade-off
- The approach allows you to identify “asset” portfolios which cannot be bettered in terms of either reducing risk for no reduction in return, or increasing return for no increase in risk
What is counterparty risk in terms of reinsurance?
The direct writer remains liable for paying claims to PHs even if the reinsurer is insolvent and cannot meet their part of the claim.
What is credit risk in terms of reinsurance?
The risk of the counterparty defaulting on obligations to the insurer or there will be a change in the market’s perception of risk of default.
How is counterparty risk, in terms of RI, managed in certain countries?
- The supervisory authority may require the reinsurer to collateralise or “deposit back” its share of the total reserve under a reinsured contract with the cedant - the reinsurer pays the reinsured part of the reserve to the cedant.
- The reinsurer simply has to make up the shortall between the reserve and the SA on a death claim.
What is the purpose of reinsurers paying their part of the reserve to the cedant?
- It protects the PH
- It gives the regulator confidence
- Reduces financial instability
- It gives the cedant the benefit of reinsurance - maintain a reserve for the whole contract and maximise funds it has to invest - makes the arrangement more profitable to the direct writer as it will retain all of its potential investment profit.
- Advantage to the reinsurer - by depositing back reserves it will avoid investment risk.
