Chapter 30: Risk transfer Flashcards
What is risk control?
Involves deciding whether to reject, share or fully accept each identified risk. This stage also involves identifying different possible mitigation options for each risk that requires mitigation.
What are the main risk control strategies?
Accept/retain the risk
Reject/avoid the risk
Transfer the risk
Share the risk
Mitigate or reduce the risk
- Typically internal actions so risk is still retained to some extent
What are the main factors to consider when determining risk control methods?
Risk appetite
Cost
Available capital and capital constraints
- As well as possible reduction in capital requirements
Counter-party risk
- Loss of profits
- Default risk
Secondary effects
- Strategy to reduce one element of risk could introduce an additional element of risk
- Pros and cons should be compared for relative importance
Overall effect on discounted profits
- aka impact on NPV’s
Above is from lecture, extra points included in notes are:
Likely effect on frequency, consequence and expected value
Feasibility
What are some of the main risk transfer techniques.
Reinsurance
Alternative risk transfer (ART)
Derivatives
What are the main benefits of reinsurance?
Reduction in claims volatility
- Smoother profits
- Reduced capital requirements
- Increased capacity to accept new business
Limitation of large losses
- From single claim, single event , or cumulative events
- From concentrations of risk within the portfolio or geographical locations
- Results in reduced risk of insolvency and and increased capacity to write business
Access to expertise and data of reinsurer
What considerations should be made when performing a cost benefit analysis for reinsurance (i.e. deciding whether or not to use reinsurance)?
Risk appetite
Net cost of reinsurance
Availability & cost of own capital
Strength of reinsurers
- Liquidity
- Credit rating
Need for reinsurer expertise
Opportunity costs
- What could we have done with the money going into reinsurance
Policy wording & operation of reinsurance
Regulatory framework
What is ART?
An umbrella term for non-traditional methods by which organisations can transfer risk to third parties. Broadly, these products combine traditional insurance and reinsurance protection with financial risk protection, often utilising the capital markets. ART can be tailor-made to suit the needs of the company. A combination of insurance and banking risk management techniques are used.
- This is ActEd definition, but is not a standard one
- Basically ART is anything other than reinsurance which transfers risk to a third party.
List some types of ART.
Integrated risk covers
Securitisation
Post loss funding
Derivatives
- Insurance specific
Swaps
- Insurance specific
What are integrated risk covers?
Typically an arrangement between insurer and reinsurer
Comprehensive reinsurance covering
- multiple product lines
- multiple years
- and may include financial and market risks.
It is used to
- avoid buying excessive cover,
- smooth profits/overall experience and
- lock in attractive terms
Some disadvantages include
- lack of availability
- large set-up costs
- concentrated counter-party risk
- Another possible risk is that the reinsurer may be too involved in the business bordering on takeover, so companies will work closely together (may be advantageous too)
What is securitisation?
Transfers insurance risk to banking and/or capital markets
- Turns insurance portfolio into a bond
- Often used for catastrophe risk
Mechanism:
- Investor pays capital over to insurer (loan amount)
- Repayment contingent on risk event not occurring, i.e. if specified catastrophe event/s do not occur
- If risk event occurs, investor capital used for losses
- Remaining capital and interest paid to investor at the end of the term
Rationale
- Insurance risk largely uncorrelated to market risk related to banks
- Hence demand from capital markets for risk bonds
In practice:
- Bonds delivered via a special purpose vehicle
- Higher risk than corporate bonds in insurer
- Priced similarly to Cat XL reinsurance
- Interest may be payable more regularly than at end of term
What is post loss funding?
Guaranteed funding if risk event occurs
- Insurer pays commitment fee in advance, which may be less than a suitable reinsurance premium
- Other party agrees to offer loan on pre-arranged terms
- Should the event occur, insurer gets money to cover losses
- BUT insurer incurs initial loss and must pay back loan, but loss is effectively spread out over longer term
Rationale
- Difficult to raise capital quickly on favourable terms
- Especially after risk event depletes insurer
- Allows insurer to lock in terms prior to needing loan
What are insurance derivatives and swaps
Wide range of derivative possibilities
- Designed according to business needs
- E.g. weather derivatives and catastrophe derivatives
Swaps apply same principle as interest rate swaps
- Trade matching but negatively correlated/uncorrelated cash flows
- E.g. trade units of life insurance for property insurance
What are the main reasons for ART?
Provision of cover otherwise unavailable
Stabilisation of profits
Cheaper cover
Tax advantages
Greater security of payment
Management of solvency margins
Reduced capital requirements
More effective provision of risk management
A source of capital
