Chapter 30: Risk transfer Flashcards
Choices faced by each stakeholder when faced with risk
- Avoid the risk all together
- reduce the risk - probability or severity
- reject the need for financial coverage of the risk because it is largely diversified or trivial
- retain all the risk
- transfer all the risk
- transfer part of the risk
How does a stakeholder evaluate each option for mitigating the risk ?
- the likely effect on frequency, consequence and expected value
- any feasibility and cost to implementing the option
- any ‘secondary risks’ resulting from the option
- further mitigation actions to respond to secondary risks
- the overall impact of each option on the distribution of net present values
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What will the extend to which a stakeholder will choose to pass on all or some of the risk depend on ?
- how likely the stakeholder believes the risk event is to happen
- the resources that the stakeholder has to finance the cost of the risk event should it happen
- the amount required by another party to take on the risk
- the willingness of another party to take on the risk
cost of risk transfer over and above the expected loss
- the reward that the party to which the risk is being transferred to requires in order to accept that risk and potentially also contribute to their own profit
- if risks are transferred the cedant forgoes both downside and upside risk
- preserving the upside has costs associated with it
main benefits of reinsurance to an insurance company
- a reduction in claims volatility
- the limitation of large losses
- Access to expertise and the data of the reinsurer
Explain the following benefit of reinsurance:
* a reduction in claims volatility
* the limitation of large losses
* Access to expertise and the data of the reinsurer
a reduction in claims volatility
* smoother profits
* reduced capital requirements
* an increased capacity to write more business and achieve diversification
The limitation of large losses
* Single claim on a single risk
* a single event
* cumulative events
* geographical and portfolio concentrations of risk and hence
* *reduced risk of insolvecy
* increased capacity to write larger risks
Access to expertise and the data of the reinsurer
Explain the following benefit of reinsurance:
* a reduction in claims volatility
* the limitation of large losses
* Access to expertise and the data of the reinsurer
a reduction in claims volatility
* smoother profits
* reduced capital requirements
* an increased capacity to write more business and achieve diversification
The limitation of large losses
* Single claim on a single risk
* a single event
* cumulative events
* geographical and portfolio concentrations of risk and hence
* *reduced risk of insolvecy
* increased capacity to write larger risks
Access to expertise and the data of the reinsurer
Explain the following benefit of reinsurance:
* a reduction in claims volatility
* the limitation of large losses
* Access to expertise and the data of the reinsurer
a reduction in claims volatility
* smoother profits
* reduced capital requirements
* an increased capacity to write more business and achieve diversification
The limitation of large losses
* Single claim on a single risk
* a single event
* cumulative events
* geographical and portfolio concentrations of risk and hence
* *reduced risk of insolvecy
* increased capacity to write larger risks
Access to expertise and the data of the reinsurer
How is the technical assistance offered by reinsurance a risk management tool?
- it reduces business risk - appropriate assumptions
- it reduces operational risk by transferring some activities to the reinsurser
Quota share reinsurance
is it propotional or non- propotional
A fixed percentage of each and every risk is insured
If the reinsurer covers say 8%, then it will be referred to as ‘an 8% quota share treaty’
propotional
Why do ceding parts use quota share reinsurance
- spread risk
- write larger portfolios of risk
- encourage reciprocal business
Advantages of quota share reinsurance compared to other reinsurance products
- easy to administer
- helps diversify risk as the insurer can write more business for the same capital
Disadvantage of quota share reinsurance over other reinsurance types
- the ame proportion of each risk is ceded regardless of size
- the same proportion of each risk is ceded regardless of volatility / risk profile
- it does not cap the cost of very large claims
surplus reinsurance treaty
specifies the retentiion level and a maximum level of cover available from the reinsurer
the proportion ceded is then used in the same way as for quota share
Advantages of surplus reinsurance treaty relative to other reinsurance products
- It allows the ceding party to accept risks that would have otherwise been too big
- it helps the ceding provider in ceding risk
- it is flexible - can retain the less volatile risks
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Disadvantages of surplus reinsurance treaty relative to other reinsurance products
- complex administration compared to quota share
- does not cap the cost of very large claims
Excess of loss (XL) reinsurance
- 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 reinsurancem the excess will revert back to the ceding company
- Usually expressed as ‘amount of layer in excess of lower limit’
Types of excess loss reinsurance
- risk XL
- aggregate XL
- catastrophe XL
Risk XL
Relates to individual losses and affects only one insured at a time
Aggregate XL
covers the aggregate of losses, above an excess point and subject to an upper limit, sustained from a defined peril over a defined period, usually a year
What can one aggregate with respect to ?
event
peril
class of business
Stop loss reinsurance
a subset of aggregate XL where the all perils are covered for a cedant or for a major class of business within the whole account
Catastrophe XL
- Reduce the potential loss, to the ceding company, due to any non-independence of the risks covered
- the cover is usually available on a yearly basis and has to be renegotiated each year
- it usually very specific, like number of claims within a 24hr period
Outline the advantages of excess of loss reinsurance
- Caps losses, hence allows the cedant to take on risks thaat could produce very large claims
- protects the cedant against individual or aggregate claims
- helps stabilise profits from year to year
- helps make more efficient use of capital by reducing the variance of the claim payments
Disadvantages of excess of loss reinsurance
- The ceding provider will pay a premium to the reinsure, which, in the long run, will be greater than the expected recoveries under the treaty as it must include loadings for the reinsurer’s profits and loadings
- From time to time, excess of loss premiums may be considerably greater than the pure risk premium for the cover
Types of Alternate Risk Transfer contracts
- Integrated risk covers
- Securitisation
- Post loss funding
- Insurance derivatives
- swaps
Integrated risk covers
ART
. Instead of purchasing separate insurance policies for different types of risks, a company might opt for an integrated approach that covers a range of risks under a single agreement
* They cover financial risks that traditional reinsurance contracts do not
* They typically run for multiple years
* There will be an upper limit for aggregate risks
What are integrated risk covers often used for
- avoid buying excess cover
- smooth results
- lock into attractive terms
Disadvantages of integrated risk covers
- Credit risk in relation to the cover provider - might not be able to cover the catastrophe
- Lack of availability
- expenses arising from the tailor made aspect of the deal, as the cover provider would need full insight into the dealings of the insurer seeking cover
- difficulty in structuring the provider’s risk management programme in a holistic, multi line way
Securitisation
- Transfer of the insurance risk to the banking and capital markets
- Financial markets are large and capable of absorbing catastrophe shocks
relative advantages and disadvantages of a catastrophe bond and an aggregate XL reinsurance contract to manage risk
- Credit risk from the possibility of reinsurance failure
- Asymmetry of information in the bond
- Market capacity of reinsurer likely to be known and stable
- Different levels of administrative burden
- Technical assistance with reinsurer
- New business might not be covered by bond
Post loss funding
- a way of raising capital after a risk has occured
- typically covered by a bank
- usually a loan on pre-arranged terms
- Can purchase a put option on its share price, so that if the share price falls, the insurer can sell at a pre-determined price
Swaps
Organisations with matching, but negatively correlated risks can swap packages of risks so that each organisation has a greater risk diversification
Reasons why providers take out ART contracts
- 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
