Chapter 30 - Risk Transfer Flashcards
Responses to Risk
- avoid the risk altogether
- reduce the risk, i.e. by either reducing the probability of occurrence or the consequences or both
- reject the need for financial coverage of that risk because it is either trivial or largely diversified
- retain all the risk
- transfer all the risk
- transfer part of the risk
A risk mitigation option can be evaluated by :
- the likely effect on frequency, consequence and expected value any feasibility and cost of implementing the option
- any ‘secondary risks’ resulting from the option
- further mitigating actions to respond to secondary risks
- the overall impact of each option on the distribution of net present values (NPVs)
Reinsurance Benefits
Benefits:
- Reduction in claims volatility and hence:
- smoother profits
- reduced capital requirements
- increased capacity to write more business and achieve diversification
- Limitation of large losses arising from:
- single claim on a single risk
- a single event
- cumulative events
- geographical and portfolio concentrations of risk
and hence: - reduced risk of insolvency
- increased capacity to write larger risks
- Access to the expertise and data of the reinsurer
Proportional Reinsurance
Reinsurer covers an agreed proportion of each risk
This proportion may:
- be constant for all risks covered (called quota share reinsurance), or
- vary by risk covered (called surplus reinsurance)
Quota share is widely used by ceding providers to:
- spread risk
- write larger portfolios of risk
- encourage reciprocal business
Surplus reinsurance treaty specifies a retention level and a maximum level of cover available from the reinsurer. The proportion of risk ceded is then used in the same way as for quota share
Non-Proportional Reinsurance
Proportional reinsurance does not cap the cost of very large claims that may occur, either as a single claim, or a set of claims from related incidents, or on an insurer’s whole account. ‘Large’ in this context means large relative to the ceding provider’s solvency margin or annual premiums.
Non-proportional reinsurance
- enables the provider to accept risks that might give rise to large claims
- stabilises the technical results of the ceding provider by reducing claims fluctuations
Excess of loss (XL) reinsurance is non-proportional cover where the cost to a ceding company of such large claims is capped with the liability above a certain level being 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
There are three main types of excess of loss reinsurance:
1. Risk XL which is a type of excess of loss reinsurance that relates to individual losses and affects only one risk at a time
2. Aggregate XL which covers the aggregate of losses, above an excess point and subject to an upper limit, sustained from a defined peril (or perils) over a defined period, usually 1 year. 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
3. Catastrophe XL has the aim to reduce the potential loss, to the ceding company, due to any non-independence of the risks insured
The cover is usually only available on a yearly basis and has to be renegotiated each year. The reinsuring company will agree to pay out if a ‘catastrophe’, as defined in the reinsurance contract, occurs. There is no standard definition of what constitutes a catastrophe
Alternative Risk Transfer
ART is 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 often uses both banking and insurance techniques, producing tailor-made solutions for risks that the conventional market would regard as uninsurable.
There are many types of ART contract, including:
1. Integrated risk covers
- Usually arranged between insurers and reinsurers
- Often written as multi-year, multi-line covers and will give premium savings due to cost savings and to greater stability of results over longer time periods and across more (uncorrelated) lines
They are used to:
- avoid buying excessive cover smooth results
- lock into attractive terms.
- can be used as a substitute for debt or equity in the investment portfolio of the original insurer
- Securitisation
- Is the transfer of insurance risk to the banking and capital markets
- Used for managing risks associated with catastrophes, as the financial markets are large and capable of absorbing catastrophe risk
- Involves turning a risk into a financial security - Post Loss Funding
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 - Insurance Derivatives
- Swaps
Organisations with matching, but negatively correlated risks can swap packages of risk so that each organisation has a greater risk diversification.
ART Benefits
- provision of cover that might otherwise be unavailable
- stabilisation of results
- cheaper cover
- tax advantages
- greater security of payment
- management of solvency margins
- more effective provision of risk management
- as a source of capital
