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.
The rationale of insurance securitisation
insurance catastrophe risk is not correlated with market (systematic) risk and so there is a benefit to investors.
The banking and capital markets are used because of CAPACITY ISSUES and because the risks involved are ones with which the banking and capital markets are more comfortable.
It diversifies the “usual” risks of BOTH parties.
Post loss funding
(aka contingent capital)
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.
Why might post-loss funding be cheaper than conventional insurance?
The commitment fee will be lower than the equivalent insurance cost (becuase the cost of the funding will in the most part be borne after the event has happened).
Swaps
Organisations with matching, but negatively correlated risks can swap packages of risk so that each organisation has a greater risk diversification,
i.e. swaps can be set up between non-insurance organisations with opposite risks.
Reciprocal quota share
Involves one company reinsuring part of its business to another, in exchange for accepting part of its reinsurer’s business.
In this way, both companies achieve a wider spread of risk and greater diversification.
Aim of catastrophe reinsurance
To reduce the potential loss, to the ceding company, due to any non-independence of the risk insured.
The cover is usually only available on a yearly basis and has to be renegotiated each year.
Key advantage of quota share reinsurance
- ADMINISTRATION SIMPLICITY
- DIVERSIFICATION, since the insurer can write more business for the same amount of capital
5 areas in which an insurance company might seek assistance from a reinsurer
- product design
- pricing
- guidance in setting underwriting policies and claims controls
- wording of policy documents
- establishment of suitable administration systems
How might a reinsurer be able to aid in pricing?
The reinsurer will be able to provide past claims experience data to assist in setting pricing assumptions.
The reinsurer may even determine appropriate premium rates on the insurer’s behalf.
3 Advantages of surplus reinsurance
Allows the cedant to fine-tune its experience.
- allows the cedant to ACCEPT LARGE RISKS that would otherwise be too big
- SPREADS RISK
- FLEXIBLE - the ceding provider does not have to cede the same proportion of every risk.
Main disadvantage of surplus reinsurance
MORE COMPLEX ADMINISTRATION
compared to quota share, as there is a need to assess and record separately for each risk the amount to be ceded.
3 Steps to how surplus reinsurance works
- Cedant chooses a RETENTION LIMIT for each risk.
- The retention limit, together with the estimated maximum loss, is used to work out THE PERCENTAGE RETAINED by the direct writer of each risk.
- Each claim is split ENTIRELY IN THOSE PERCENTAGES, regardless of size, in the same way as quota share.
Surplus:
Percentage retained of the risk by the direct writer (calc.)
% retained =
retention limit / EML
2 Disadvantages of Excess of Loss Reinsurance
- The cedant will pay a premium to the reinsurer, which (in the long run) will be greater than the expected recoveries under the treaty as it includes loadings for reinsurer expenses and profit.
- From time to time, excess of loss premiums may be considerably greater than the pure risk premium for the cover. (underwriting cycle: and reinsurers have to reistablish solvency positions)
Integrated risk covers
Reinsurance arrangements that typically cover
… SEVERAL LINES (or classes) of general insurance business
… for SEVERAL YEARS.
It is common for such arrangements to include cover of financial risks (credit and market), which traditional reinsurance does not.
How do Integrated risk covers provide cost savings?
Cost savings arise because there is
- no longer the need to negotiate several separate reinsurance arrangements
and also because integrated risk covers are multi-year arrangements that
- do not need to be renegotiated each year.
How do Integrated risk covers achieve greater stability of results
The greater stability of results arises due to the diversification by:
- type of risk insured
- time
3 Uses for integrated risk covers
They are used to:
- avoid buying excessive cover
- smooth results
- lock into attractive terms
They can be used as a substitute for debt or equity in the investment portfolio of the original insurer, since they reduce the need for capital.
4 Disadvantages of integrated risk covers
- credit risk from the cover provider
- lack of availability
- expenses arising from the tailor-made aspect of the deal
- difficulty in structuring the provider’s risk management programme in a holistic, multi-line way.
