Chapter 44: Risk Management Tools I

Question 1

2 Main types of reinsurance

Answer 1

• proportional

- non-proportional

Question 2

Key features of proportional reinsurance

Answer 2

• all claims from a particular risk are split in the same proportions between the cedant and the reinsurer
• does not cap the claim paid by the cedant
• written under a treaty

2 Types:

• quota share
• surplus

Question 3

What is the difference between quota share and surplus?

Answer 3

Under quota share all claims under all risks are split in the same proportions.

Under surplus, the proportions will vary by risks. But once decided, all claims from a particular risk will be split in the same proportions.

Question 4

How are the proportions under surplus reinsurance calculated?

Answer 4

Under surplus, the proportions will normally be calculated by using a retention limit and an estimated maximum loss.

The limits may vary by risk (as is typical of commercial covers), or may be fixed for all risks (as is typical for domestic covers and life insurance).

Question 5

Key features of non-proportional reinsurance

Answer 5

Under non-proportional reinsurance (or excess of loss), the cedant specifies a retention limit.

The cedant pays the claim amount up to the retention limit and the reinsurer pays the claim amount over the retention limit.

There may be an upper limit on what the reinsurer is prepared to pay.
There may also be different layers of excess of loss reinsurance - each layer possibly covered by a different reinsurer.
The limits may be indexed over time for inflation.
Excess of loss can cap the claims paid by the cedant.

Question 6

4 Main types of excess of loss reinsurance

Answer 6

• risk/individual excess of loss
• aggregate excess of loss
• catastrophe excess of loss
• stop loss

Question 7

Risk / individual excess of loss

Answer 7

Relates to an individual loss from a single claim from 1 insured risk at any one time.

Question 8

Aggregate excess of loss

Answer 8

Covers the aggregate of losses from multiple claims sustained from a single event or from defined perils over a defined period (usually one year).

Question 9

Key difference between catastrophe and aggregate excess of loss

Answer 9

Catastrophe excess of loss acts at a much higher level.
Also, the time period for aggregating losses is normally shorter for catastrophe cover.
E.g. 72 hours.

Question 10

Reinstatement clause

Answer 10

Under excess of loss reinsurance, if claims breach the layer, it may be able to reinstate cover by paying a reinstatement premium.

Question 11

Stop loss arrangement

Answer 11

Covers aggregate losses from multiple claims all perils over a defined period for a provider’s whole account (between agreed limits).

The limits are usually expressed as loss ratios.

Question 12

What are the main uses of quota share

Answer 12

useful for small, new or expanding cedants who want to

• • diversify their risk,
• • write more risk or
• • who would like reciprocal business

Quota share may provide financial assistance through reinsurance commissions
– large providers may use quota share because the commission rates look attractive

Question 13

What are the problems with quota share?

Answer 13

Inflexibility, as the same proportion of all risks are ceded - irrespective of size, or potential volatility.
A share of profits will also be passed to the reinsurer.

Question 14

Advantages and disadvantages of surplus reinsurance.

Answer 14

Under surplus reinsurance, the proportion of the risk passed to the reinsurer is different for each risk - allowing the cedant the opportunity to FINE TUNE its experience.

However, surplus treaties are more complex and expensive than quota share arrangements, due to the extra administration of assessing each risk separately. Therefore surplus is more appropriate for larger, more heterogeneous risks such as commercial property.

Question 15

Main uses of excess of loss

Answer 15

Excess of loss gives the cedant the opportunity to write larger risks.
This is because excess of loss reduces the risk of insolvency from
- a catastrophe
- a large single claim
- an aggregation of claims

It can also be used to smooth results.

Question 16

What factors might influence the choice of reinsurance arrangements?

Answer 16

• the type of business
• are the risks homogeneous or heterogeneous
• how big and volatile will they be?
• is the insurer worried about single risks, accumulations of risk, or catastrophes?
• does the insurer have lots of free assets?
• is the insurer a mutual or proprietary?
• does the insurer need financial assistance?
• does the insurer need EXPERTISE in a new or unusual product, or an unusual territory?
• does the insurer want DIVERSIFICATION through reciprocal arrangements?

Question 17

Disadvantages of using reinsurance

Answer 17

• reinsurance may not be available
• may not exactly match the liabilities of the provider, leading to either:
• – retention of unwanted risk, or
• – excessive cost
• The cost of reinsurance will include a contribution to the reinsurer’s expenses and profits.
• The reinsurer may default.
• In passing on downside risk, the cedant is also passing on upside risk.

Question 18

5 Alternative risk transfer products

Answer 18

• integrated risk covers
• securitisation
• post-loss funding
• insurance derivatives
• swops

Question 19

What are the main advantages of ART?

Answer 19

D - Diversification
E - Exploiting risk as an opportunity
S - Solvency management
C - Cheaper cover possibly
A - Available cover, when reinsurance isn't
R - Results smoother
T - Tax advantages
E - Effective risk management
S - Security is greater