Chapter 30: Risk transfer

Question 1

Who is the cedant / direct writer

Answer 1

The insurance company

Question 2

What is a treaty

Answer 2

A treaty is a contract between an insurer and a reinsurer that specifies what risks the reinsurer is obligated to accept from the insurer and what the conditions are of the reinsurance arrangement

Question 3

What is facultative reinsurance

Answer 3

An alternative to writing reinsurance through a treaty, under this type risks is transferred on a risk-by-risk basis

Question 4

What is proportional reinsurance and name two types of proportional reinsurance

Answer 4

Proportional reinsurance: Is a type of reinsurance where a proportion of each risk is ceded

Types:

1. Quota sare reinsurance: Same proportion of risk is ceded for each risk
2. Surplus reinsurance: Different proportions of each risk are ceded

Question 5

Quota share reinsurance

• Main uses (3)
• Advantages (2)
• Disadvantages (2)

Answer 5

Main use

• Spread risk
• Homogenous risks as same proportion is ceded
• Smaller insurers who share their risks in a simple manner
• Diversification
• Benefit from reinsurers’ expertise - as reinsurer and insurer share in same claim experience, so it benefits the reinsurer to help manage insurers risks

Advantages

• Simple to administer, as written by a treaty and a constant proportion of each risk is ceded
• Diversify risks, as more risks can be written

Disadvantages

• Same proportion ceded, regardless of size and risk profile
• Does not cap costs of very large claims

Question 6

Surplus reinsurance

• Main uses (3)
• Advantages (2)
• Disadvantages (2)

Answer 6

Main use

• Gives direct writer more flexibility to fine-tune the experience, e.g., retain a small proportion of large risks and cede more small stable risks
• Written under a treaty - specifies the retention level and maximum level of cover
• Appropriate for heterogeneous risks
• Can write larger risks

Advantages

• Help to accept risks otherwise too big to spread
• Flexible, as the same proportion of each risk isn’t ceded, gives a better-balanced portfolio

Disadvantages

• Administratively more expensive
• No cap on large claims

Question 7

How is the proportion of risks to be ceded under surplus reinsurance decided on

Answer 7

For homogenous risks, the insurer may have a monetary retention limit that it uses to determine an appropriate % retain

For heterogeneous risks, the issuer will choose a % based on the individual risk

Question 8

What are non-proportional reinsurers and give 4 types?

Answer 8

Non-proportional reinsurance, the insurer will ay up to the retention level, after which the reinsurer will pay up to an upper limit, after which the insurer will pay the remaining. Can purchase several layers.

Types
1. Risk XL: Retention level and upper limit apply to individual claims for individual risks. It applies to specified perils, e.g., flooding

2. Aggregated XL: Retention level and upper limit apply to aggregate claims. It applies to specified perils, e.g., adds all flooding
3. Catastrophe XL: Retention level and upper limit apply to aggregate claims. It applies to specified event, e.g., earthquake
4. Stop loss: Retention level and upper limit apply to all aggregate claims from all perils

Question 9

What are the advantages and disadvantages of non-proportional reinsurance

Answer 9

+ Caps losses, hence allow cedent to take on risks that could produce large claims
+ Protects a cedent against large claims
+ Help stabilise profit from year to year
+More efficient use of capital as it reduces variance in claims

• Same proportion ceded regardless of size
• Does not cap costs of very large claims

Question 10

What are the reasons for reinsurance?

SAD LIFE

Answer 10

S: Smooth profit (through reducing the volatility of claims)
A: Avoid single large losses, e.g., large liability claim
D: Diversification

L: Limit exposure to single or accumulation of risks can also reduce exposure to features of contract design, e.g., guarantees
I: Increase capacity to accept risks (singly and cumulatively)
F: Financial assistance (solvency, NB strain) e.g., financial reinsurance or reinsurance commissions
E: Expertise, e.g., data, pricing, underwriting, design, admin for new, unusual risks and new territories

Question 11

Problems with reinsurance

Answer 11

• Reinsurance has a cost associated with it
• Insurers add an expense and profit loading to their premiums reinsurers do exactly the same
• So the value of the benefits paid is less than the premium paid
• Administration cost in paying reinsurer
• Cede profit to a reinsurer
• Additional risk
• Reinsurer default
• Liquidity risk
• Not always appropriate, e.g., with profit not straight forward how much reinsurance to buy

Question 12

Discuss the reasons for reinsurance for a small company

Answer 12

A small company would need reinsurance for a number of reasons

• Worried about volatility in claims experience
• need reinsurance to limit exposure to risks and avoid large losses
• This would smooth results

It would also want to increase its capacity to accept risk which will, in turn, lead to diversification

Might lack data and other experts which could be sourced from reinsurance

Lack of capital so has a need for financial assistance

Verdict: Lots of reinsurance with low retention limits

Question 13

Discuss the reasons for reinsurance for a company with a large number of free assets

Answer 13

Has less need for reinsurance as they can use their free assets to cover losses

Less worried about claim volatility and capital adequacy and less likely to want reinsurance, especially financial assistance and writing more and bigger risks

Question 14

Discuss the reasons for reinsurance for a company selling group term assurance

Answer 14

Exposed to aggregations of risks

Verdict: Aggregate XL or Stop Loss

Question 15

Discuss the reasons for reinsurance for a company selling non-reviewable premiums or charges

Answer 15

Exposed to the risk that premiums and charges are set at the wrong level, as they cannot be changed as experience is different than expected

Such a company would want to limit its exposure to such risks

Has a greater need for reinsurance than once that sells reviewable premiums and charges

Question 16

Discuss the reasons for reinsurance for a company selling commercial property insurance

Answer 16

Has to have a capacity to accept large risks. it would then prefer to protect itself against large losses from these large risks.

Can also be exposed to geographical accumulation of risks, and would prefer to reduce exposure to this they of risk.

Verdict: Surplus XL, Aggregate XL and catastrophe XL

Question 17

Discuss the reasons for reinsurance for a new contract

Answer 17

The insurer lacks data and expertise

New contracts incur development costs and have a new business strain component. Financial assistance might be important which helps smooth results

Diversification is an important consideration in new contracts

Question 18

Discuss the reasons for reinsurance for a proprietary company

Answer 18

Smooth results

Question 19

Discuss the reasons for reinsurance for a mutual company

Answer 19

Financial assistance since cannot raise equity or debt finance

Question 20

What type of reinsurance is most appropriate for each risk or scenario: Homogeneous risks

Answer 20

Quota share insurance, since a single proportion will be acceptable for all risks

Question 21

What type of reinsurance is most appropriate for each risk or scenario: Variable risks

Answer 21

Surplus reinsurance as the percentage retained can be varied for each risk

Question 22

What type of reinsurance is most appropriate for each risk or scenario: Protect the whole account

Answer 22

Stop Loss

Question 23

What type of reinsurance is most appropriate for each risk or scenario: New contract

Answer 23

Quota share

Question 24

What type of reinsurance is most appropriate for each risk or scenario: Personal lines

Answer 24

Fairly homogeneous risks, so quota share might be appropriate

Question 25

What type of reinsurance is most appropriate for each risk or scenario: Exposed to catastrophic risks

Answer 25

Catastrophe reinsurance

Question 26

What type of reinsurance is most appropriate for each risk or scenario: Solvency issues

Answer 26

Financial reinsurance

Question 27

What type of reinsurance is most appropriate for each risk or scenario: Small local insurer

Answer 27

Diversification is a priority, so quota share might be appropriate Can also swap with another local insurer in another part of the country Aggregate XL to reduce geographical exposure to risks

Question 28

What type of reinsurance is most appropriate for each risk or scenario: Achieving diversification

Answer 28

Quota share, although it is arguable all types of reinsurance will achieve some form of diversification

Question 29

What type of reinsurance is most appropriate for each risk or scenario: No upper limit on claim size

Answer 29

Individual XL

Question 30

Reasons to use ART DESCARTES

Answer 30

D - Diversification (allowing to cover more or larger risks) E - Exploit risk as an opportunity S - Source of capital (improves solvency position) C - Cheaper than reinsurance A - Available when traditional reinsurance is not R - Result smoothed (especially important for proprietary companies) T - Tax advantages E - Efficient risk management tool S - Security of payments improved

Question 31

Name 5 ART products

Answer 31

1. Integrated risk cover 2. Securitisation 3. Post-loss funding 4. Insurance derivative 5. Swaps

Question 32

Discuss what integrated risk cover is (Definition/Advantages (6)/Disadvantages (3))

Answer 32

Definition * Reinsurance that covers many classes of business, over many years Advantages + Lower cost as one reinsurance arrangement is needed to cover many risks and does not need to renegotiate each year + Tailored to the insurer's needs, so avoids buying excessive cover + Smoothing results over many years + Predictable premium over many years + Insurer is passing on an already diversified business, the premium can be lower + Principles consistent with an enterprise-wide risk management framework (risks are being considered holistically rather than separately) Disadvantages - Credit risk, as the insurer cannot diversify by reinsurer - Inflexible, as insurers cannot pick and choose which risks to reinsure - Can be expensive if not a lot of willing reinsurers to provide such cover

Question 33

Discuss what securitisation is (Definition/why an insurer will securitise risks (3)/why banking and capital market take up such a product (3))

Answer 33

Definition * Transfer of insurance risk to banking and capital markets. Useful as those markets can absorb large risks, e.g., using of catastrophe bond Why does the reinsurer securitise risks * May be available when reinsurance is not (saturated market / unwilling to reinsure those risks) * May be cheaper than traditional reinsurance * Effective way to transfer risks to those most willing to take it on Why banking and capital market take up such a product * Diversify their portfolios * Capital markets have a greater capacity to accept risks than the reinsurance market * Can perceive return as adequate compensation for risk on the bond

Question 34

How does a catastrophe bond work?

Answer 34

1. Investors purchase a bond from an insurer and therefore provide a sum of money to the insurer 2. Repayment of capital is contingent on a specific event not happening, e.g., an earthquake higher than 6.5 on the Richter scale 3. Doesn't occur investor gets interest + capital back

Question 35

Discuss what post-loss is (Definition/how does equity funding work in practice)

Answer 35

Definition: * An agreement that enables an insurer to raise finance (loans or equity) after a catastrophe on terms secured in advance through a commitment fee Equity funding * Issue of new (issuing new equity capital on pre-agreed terms) or existing equity (put option on the insurer's own shares)

Question 36

Discuss what insurance derivates are (Definition/4 stakeholders interested in weather derivatives)

Answer 36

Definition * Parties can use insurance derivatives to hedge against particular risks, commonly adverse weather conditions (based on temperature, rainfall, snowfall) and catastrophes * E.g., buying cold weather derivatives, get R1000 for each degree below zero for each day it falls below zero 4 Stakeholders interested in weather derivatives 1. Energy industry (warm weather will reduce sales) 2. Energy consumers (cold weather will increase heating costs) 3. Hot drinks producers (warm weather reduce sales) 4. Construction companies (wet weather may lead to delays) 5. Ski resorts (Light/ no snowfall will reduce revenues 6. Agricultural industry (Extreme temperature/rainfall will lead to crop losses) 7. Local government (Heavy snow will lead to costs (in clearing it) 8. Insurers (motor, household (Extreme low temperatures/ poor weather will lead to high claims

Question 37

Discuss what swaps are (Definition/ example of lines of insurance business that face negatively correlated risks/ one non-insurance organisation that faces negatively correlated risks

Answer 37

Definition: * Parties swap packages of risk to achieve greater diversification * Ideally parties would face negatively correlated risks, however, in practice, uncorrelated risks may be the best that can be achieved * Swaps can be between insurers on lines of business and non-insurance organisations Insurance * Annuity business (longevity risk) and term assurance (mortality risk) Non-Insurance *Energy company (too much warm weather) and ice cream company (too much cold weather)