Chapter 30: Risk transfer Flashcards
List 6 possible responses from which a stakeholder can choose when faced with a risk.
PIRATE
- Partially transfer (to another party)
- Ignore (reject then need for financial
coverage as the risk is either trivial or
largely diversified) - Reduce (frequency and/or severity)
- Accept (retain all)
- Transfer (to another party)
- Evade (avoid the risk altogether)
What factors affects the choice of mitigation approach?
FIRM
- Feasibility and cost
- Impact on frequency / severity / expected
value - Resulting secondary risks
- Mitigation required in response to
secondary risks
What factors affect the extent to which risk is transferred?
- probability of the risk occurring
- risk appetite
- existing resources to
finance the risk event if it happens - cost of transferring the risk
- willingness of a third party to accept the
risk
Outline the main benefits and costs of reinsurance.
Benefits:
- Reduction in/removal of risk.
- Reinsurer may offer competitive terms for
admin, actuarial services and advice.
Costs:
- 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.
Outline the reasons why a provider might purchase reinsurance.
- A reduction in claims volatility and hence:
- smoother profits
- reduced capital requirements
- an increased capacity to write more
business and achieve diversification.
- The limitation of large losses arising
from:- a single claim on a singe risk
- a singe event
- cumulative events
- geographical and portfolio
concentration of risk
and hence:
- a reduced risk of insolvency
- increased capacity to write larger risks
- Access to the expertise and data of the reinsurer.
Outline the two contract variations on which reinsurance may be arranged.
- 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. - 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.
What are the key features of proportional reinsurance?
- Claims are split between the cedant and
the reinsurer in pre-defined proportions. - Does NOT CAP the claim paid to the
cedant. - Is written by TREATY.
- The two types are Quota Share and
Surplus. - Under QS, the proportion claim split is the
same for ALL risks. - Under Surplus, the proportion can vary by
risk:
% retained = (retention limit)/(estimated
maximum loss) - The reinsurer may also pay the cedant a
reinsurance commission, which can be
used to provide financial assistance.
What are the advantages and disadvantages of quota share reinsurance?
Advantages:
- QS is useful for small, new or expanding
cedants who want to diversify their risk,
write more risks or who would like
reciprocal business.
- Administration is relatively simple, since it
is written by treaty and a constant
proportion is ceded for ALL risks.
Disadvantages:
- It is inflexible in that the same proportion
of each risk is ceded, irrespective of the
size or potential volatility.
- A share of profits will also be passed to
the reinsurer.
- It does not cap large claims.
For which type of business is a fixed retention level Surplus reinsurance used?
Used for high volume, relatively homogeneous classes of business, such as life insurance or personal lines general insurance.
For which type of business is a variable retention level Surplus reinsurance used?
Used for heterogeneous classed of business, eg. commercial property and business interruption insurance.
What are the advantages and disadvantages of surplus reinsurance?
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.
What are the key features of non-proportional reinsurance?
- The cedant specifies a retention level. The
cedant pays the claim amount up to the
retention level; the reinsurer pays the
claim amount over the retention level. - There may be an upper limit on what the
reinsurer is prepared to pay. - There may be different layers of excess
of loss reinsurance, each with a different
reinsurer. - The cedant may be required to retain a
proportion of risk within each layer, so as
to retain an interest in the risk
(insurable interest). - The retention level / upper limit may be
indexed over time for inflation. - XOL can cap the claims paid by the
cedant. - XOL may or may not be written using a
treaty.
Define 4 different types of XOL reinsurance contracts.
- Risk XL covers losses from a single claim
from one insured risk. - Aggregate XL covers the aggregate losses
from several insured risks, sustained
from a defined peril (or perils) over a
defined period, usually one year. - Catastrophe XL is a form of aggregate XL
reinsurance that pays out if a
“catastrophe”, as defined in the
reinsurance contract, occurs. - 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.
State the 3 main uses of XOL reinsurance.
- Opportunity to write larger risks.
- Reduces risk of insolvency from a large
single claim, a aggregation of claims or a
catastrophic event. - Soothes profits by reducing claims
fluctuations.
In what situation would surplus reinsurance and risk XL reinsurance provide the same cover?
Where the risk event can only result in the payment of the full sum assured, there is no difference between risk XL and surplus.
In the case of life insurance, the estimated maximum loss will normally be equal to the claim amount, as they are fixed, known amounts.
What factors influence the type of reinsurance products used?
- Type of business - homogeneous (QS) or
heterogeneous (Surplus). - The size and volatility of claims. Is the
insurer worried about single risks (risk
XL), accumulations (agg XL) or
catastrophes (cat XL). - Does the insurer have lots of free assets
or does it need financial assistance? (e.g.
the commissions associated with
proportional reinsurance). - Is the insurer a mutual (worried about
financial assistance) or proprietary
(worried about smoothed profits)? - Does the insurer need expertise in a new
or unusual product or new territory? - Does the insurer want diversification
through reciprocal arrangements (QS)?
Alternative risk transfer (ART)
ART is an alternative to traditional reinsurance. It involves tailor-made solutions for risks that the conventional reinsurance market would regard as uninsurable or does not have the capacity to absorb.
List 5 ART products
- Integrated risk covers
- Securitisation
- Post loss funding
- Insurance derivatives
- Swaps
‘integrated risk covers’
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
Securitisation
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.
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.
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.
Insurance derivatives
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.
Swaps
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).
List the 9 main reasons for using ART.
DESCARTES
- Diversification
- Exploits risk as an opportunity
- Solvency improvement / source of capital
- Cheaper than reinsurance
- Available when reinsurance may not be
- Results smoothed / stabilized
- Tax advantages (possibly)
- Effective risk management tool
- Security of payments improved
