Chapter 30 - Risk transfer

Question 1

When faced with a risk, each stakeholder can choose whether to:

Answer 1

TRAP RR

• Transfer al the risk
• Retain all the risk
• Avoid the risk altogether
• transfer Part of the risk
• Reduce the risk ; either by reducing the prob. of occurence or consequence
• Reject the need for financial coverage bcz it is either trivial or diversified

Question 2

Each option for mitigating a risk can be evaluated by assessing:

Answer 2

SAME

• any SECONDARY risks resulting from implementing the option
• ANY cost of implementing the option
• MITIGATING actions for secondary risks
• the likely EFFECT on frequency, consequence and expected value

Question 3

The extent to which stakeholders will pass on all or some risks depends on:

Answer 3

HR RAW

• HOW likely the stakeholder believes the risk event is to happen
• RISK appetitive of stakeholder
• RESOURCES that the stakeholder has to finance the cost of the risk event should it happen
• AMOUNT required by another party to take on the risk
• WILLINGNESS of third party to take on the risk

Question 4

What are the benefits of reinsurance?

Answer 4

EVIL W

• access to EXPERTISE and data of reinsurer
• reduction in claim VOLATILITY and hence:
  – smoother profits
  – reduced capital requirements
  – increased capacity to write more business
• reduce INSOLVENCY risk
• LIMIT large losses arising from:
  – a single claim on a single risk
  –a single event
  – cumulative events
  – geographical and portfolio concentrations of risk
• increased capacity to WRITE larger risks

Question 5

What are the main costs of reinsurance

Answer 5

• Profit is passed from cedant to reinsurer
• Reinsurance premium is likely to exceed cost of benefits (in the long run) as it will contain loadings for expenses, profit and contingencies.
• Liability may not be fully matched by reinsurance
• Possible liquidity issues
• Reinsurer may default
• Reinsurance may not be available on terms sought

Question 6

Define cede

Answer 6

pass on

Question 7

Define treaty

Answer 7

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 8

Define direct writer

Answer 8

an insurer with a direct contract with the policyholders

Question 9

Outline the two contract variations on which reinsurance may be arranged.

Answer 9

1. Facultative:
   - Arranged on a case-by-case basis.
   - This is typically done for particularly large risks, but the insurer is not obliged to cede these risks to the reinsurer, but neither is the reinsurer obliged to accept them.
2. Treaty
   - A defined GROUP of policies is covered by the treaty.
   - The reinsurer is OBLIGED to accept these risks, subject to conditions as set out in the treaty.

Question 10

What is proportional reinsurance

Answer 10

the reinsurer covers an agreed proportion of each risk

this proportion may:
- be constant for all risks covered ( quota share reinsurance)
- vary by risk covered ( called surplus reinsurance)

Question 11

What are the key features of proportional reinsurance?

Answer 11

1. Claims are split between the cedant and the reinsurer in pre-defined proportions.
2. Does NOT CAP the claim paid by the cedant.
3. Is written by TREATY.
4. The two types are Quota Share and Surplus.
5. Under QS, the proportion claim split is the same for ALL risks.
6. Under Surplus, the proportion can vary by risk.
7. The reinsurer may also pay the cedant a reinsurance commission, which can be used to provide financial assisstance.

Question 12

What are the advantages and disadvantages of quota share reinsurance?

Answer 12

Advantages:
1. QS is useful for small, new or expanding cedants who want to diversify their risk, write more risks or who would like reciprocal business.

2. Administration is relatively simple, since it is written by treaty and a constant proportion is ceded for ALL risks.

Disadvantages:
1. It is INFLEXIBLE in that the same proportion of each risk is ceded, irrespective of the size or potential volatility.

2. A share of profits will also be passed to the reinsurer.
3. It does not cap large claims.

Question 13

What is surplus reinsurance?

Answer 13

it is proportional reinsurance and is written under a treaty. the terms of the treaty will give the direct writer the flexibility to choose how much risk to retain, but often within limits. the treaty would specify a retention level and a maximum level of cover available from the reinsurer

Question 14

In what situation would surplus reinsurance and risk XL reinsurance provide the same cover?

Answer 14

Where the risk event can only result in the payment of the full sum assured or no payment tt all, there is no difference between risk XL and surplus. e.g life insurance, since payment amount is known with certainty before the time

Question 15

What are the advantages and disadvantages of surplus reinsurance?

Answer 15

Advantages:
- The proportion of each risk passed to the reinsurer can vary from risk to risk, allowing the cedant the opportunity to ‘fine-tune’ its exposure. It is therefore useful where risks are heterogeneous in nature.

• Surplus is useful for cedants who want to diversify their risk, write more risks or who would like to be able to write larger risks.

Disadvantages:
- Surplus treaties are more complex and expensive relative to quote share due to the extra administration in particular of assessing and recording each risk separately. Therefore, surplus is generally more appropriate for larger, more heterogeneous risks such as commercial property.
- It does not cap large claims.

Question 16

Define XS of loss reinsurance

Answer 16

it is a non-proportional cover where the cost to a ceding company of such large claims is capped with the liability above a certain level is passed to a reinsurer. However, if the claim amount exceeds the upper limit of the reinsurance, the excess will revert back to the ceding company

Question 17

Define 4 different types of XS OL reinsurance contracts

Answer 17

1. Risk XL covers losses from a single claim from one insured risk.
2. Aggregate XL covers the aggregate losses from several insured risks, sustained from a defined peril (or perils) over a defined period, usually one year.
3. Catastrophe XL is a form of aggregate XL reinsurance that pays out if a “catastrophe”, as defined in the reinsurance contract, occurs.
4. Stop loss is a form of aggregate XL that provides cover based on aggregate losses, from all perils, arising on a company’s whole account (or major class of business) over a specified period, usually one year.

Question 18

State the 3 main uses of XOL reinsurance

Answer 18

1. Opportunity to write larger risks
2. Reduces risk of insolvency from a large single claim, a aggregation of claims or a catastrophic event.
3. Smoothes profits by reducing claims fluctuations.

Question 19

What are the advantages and disadvantages of XS OL reinsurance?

Answer 19

Advantages:

• Caps losses, which allows the cedant to take on risks that could produce very large claims
• protects the cedant against individual or aggregate large claims
• helps stabilise profits from year to year
• helps make more efficient use of capital by reducing the variance of the claim payments

Disadvantages:

• the ceding provider will pay a premium to the reinsurer which in the long run will be greater than the expected recoveries under the treaty as it must include loadings for the reinsurer’s expenses and profits
• from time to time, the XOL premiums may be considerably greater than the pure risk premium for the cover.

Question 20

List 5 ART products

Answer 20

I PISS

• INTEGRATED risk covers
• POST loss funding
• INSURANCE deravitaves
• SWAPS
• SECURITISATION

Question 21

Describe ‘integrated risk covers’

Answer 21

These are multi-year, multi-line reinsurance contracts between insurers and reinsurers.

They give premium savings due to:
- the cost of savings (of not having to negotiate reinsurance separately for each class of business)
- greater stability of results over time and across more diversified lines

They are used to:
- avoid buying excess cover
- smooth results
- lock into attractive terms

Question 22

Describe securitisation

Answer 22

This is the transfer of risk (often catastrophe risk) to the banking and capital markets.

The banking and capital markets are used because of their capacity and because insurance risks provide diversification to their more usual credit and market risks.

Securitisation may be packaged as a catastrophe bond. The repayments of interest and capital from the insurer to the banking and capital markets are contingent on the specified catastrophe NOT happening.

The yield on such bonds is likely to be HIGHER than similar rated corporate bonds.

Question 23

Describe post loss funding

Answer 23

Post loss funding guarantees that, in exchange for a commitment fee, funding will be provided on the occurrence of a specific loss. The funding is often a loan on pre-arranged terms or equity.

The commitment fee will be lower than the equivalent insurance cost (because the cost of funding will in the most past be borne after the event has happened). Thus, before the loss happens the contract appears cheaper than conventional insurance.

Question 24

Describe insurance derivatives

Answer 24

Insurance derivatives include catastrophe and weather options.

The strike price will be based on a certain value of a catastrophe or weather index. Whether or not the option is exercised will reflect by how much the value of the index is different to that on which the strike price is based.

Question 25

Describe swaps, including examples

Answer 25

Organizations with matching but negatively correlated or uncorrelated risks can swap packages of risk so that each organization has a greater risk diversification.

Examples:
- A reinsurer with exposure to Japanese earthquakes may swap some of this risk with a reinsurer with exposure to hurricane in Florida.

• Longevity swaps may exchange expected annuity payments (the ‘fixed leg’) with actual annuity payments (the ‘floating leg’)
• Energy companies (which have lower profits in warm weather) may swap temperature risk with household insurers (which suffer more claims in cold weather)

Question 26

List the 9 main reasons for using ART

Answer 26

SRC PG MAT

• STABILISATION of results
• RISK management , effective provision
• CHEAPER covers
• PROVISON of cover that might otherwise be unavailable
• GREATER security of payments
• MANAGEMENT of solvency margins
• AS a source of capital
• TAX advantages