Chapter 44: Risk management tools (1) Flashcards
Main benefits of reinsurance
Reduction in claims VOLATILITY and hence:
- smoother profits
- reduced capital requirements
- and increased capacity to write more business and achieve diversification
the LIMITATION of LARGE LOSSES arising from:
- a 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 EXPERTISE of the reinsurer
2 Main types of reinsurance
- proportional
- non-proportional
Proportional reinsurance
The reinsurer covers an agreed proportion of each risk.
This proportion may:
- be constant for all risks covered (ie QUOTA SHARE REINSURANCE)
- vary by risk covered (ie SURPLUS REINSURANCE)
3 Main uses of Quota share
Quota share is widely used by ceding providers to:
- spread risk
- write larger portfolios of risk
- encourage reciprocal business
Disadvantages of quota share (3)
- it cedes the same proportion of low variance and high variance risks
- it cedes the same proportion of each risk, irrespective of size
- it passes a share of any profit to the reinsurer
Surplus treaty
Specifies a retention limit 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.
Excess of loss 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 reinsurance, the excess will revert back to the ceding company.
4 different forms of non-proportional (excess of loss, XL) reinsurance:
- risk XL
- aggregate XL (including stop loss)
- catastrophe XL
- stop loss
Risk XL
relates to individual losses.
It affects only one insured risk at any one time.
Aggregate XL
covers the AGGREGATE of losses,
… above an EXCESS point
…. subject to an UPPER LIMIT,
sustained from DEFINED PERIL (or perils)
… over a DEFINED PERIOD, usually one year.
Stop loss
A form of aggregate XL that provides cover based on TOTAL CLAIMS, from ALL PERILS on a ceding company’s WHOLE ACCOUNT.
Catastrophe XL
pays out if a “catastrophe”, as defined in the reinsurance contract, occurs.
There is no standard definition of what constitutes a catastrophe.
3 Main uses of excess of loss reinsurance
- to permit a ceding provider to accept risks that could lead to larger claims
- to stabilise the technical results of the ceding provider by reducing claims fluctuations
- to reduce the risk of insolvency from large losses
- to make more efficient use of capital by reducing the variance of the claim payments (and thus the capital requirement)
Alternative risk transfer
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.
5 Examples of alternative risk transfer contracts
- integrated risk covers
- securitisation (catastrophe bonds)
- post loss funding
- insurance derivatives
- swapts
8 Reasons why providers take out ART (alternative risk transfer) 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.
How is technical assistance (from a reinsurer) in itself a means of risk management?
- it reduces business risk
- it can reduce operational risk by transferring certain activities to the reinsurer
Business risk
The risk of pricing being based on inappropriate assumptions
define “cede”
“pass on” or “give away”
as in “cede some risk to a reinsurer”
define “treaty”
Covers a group of policies - reinsurance that the reinsurer is obliged to accept from the insurer, subject to conditions (set out in the treaty).
define “direct writer”
An insurer with a direct contract with the policyholders (as opposed to a reinsurer, who has a contract with the direct writer).
Also called the primary insurer or “cedant”
Quota share
Under quota share reinsurance, a fixed proportion of each and every risk is reinsured.
Securitisation
Involves turning a risk into a financial security.
I.e. The TRANSFER of insurance risk to the banking and CAPITAL MARKETS.
Among other things, it is used for managing risks associated with catastrophes, as the financial markets are large and capable of absorbing catastrophe risk
The process of securitisation
- An investor purchases a bond from the insurance company and therefore provides a sum of money to the insurer
- the repayment of capital (and possibly interest) is contingent on a specified event NOT happening
- If the event does happen, the insurer uses the sum of money provided from the investor (in purchasing the bond) to cover the cost of claims arising from the earthquake. The investor may get part of his capital (and interest) back depending on the severity of the claim.
- If the event does not occur, the investor gets his interest and capital back in the normal way.
