Chapter 6: Reinsurance products - types

Question 1

Quota share

Answer 1

A proportional treaty reinsurance whereby the premiums and claims for all risks covered by the treaty are split in a fixed proportion.

Question 2

Commissions payable under a quota share agreement

Answer 2

The reinsurer pays return and override commission to the insurer.
Profit commission may also be payable.

Question 3

Return commission

Answer 3

The reinsurer will reimburse the direct writer with some percentage of the premium to help cover the acquisition expenses.

Question 4

Override Commission

Answer 4

Commission over and above the return commission, compensating the direct writer for attracting and administering the business.

Question 5

Ceding commission

Answer 5

The sum of return and override commission.

Question 6

Profit commission

Answer 6

Commission the reinsurer pays the direct writer as a reward for passing on good business.

Question 7

4 Advantages of quota share

Answer 7

• It spreads risk, increasing insurer’s capacity and encouraging reciprocal business
• Directly improves the solvency ratio (without losing market share)
• It is administratively simple
• may provide commission that helps with cashflow

Question 8

Solvency ratio

Answer 8

free assets divided by net written premiums.

Question 9

4 Disadvantages of quota share reinsurance

Answer 9

• Cedes the same proportion of low and high variance risks
• cedes the same proportion of risks, irrespective of size
• passes a share of any profit to the reinsurer
• it is unsuitable for unlimited covers

Question 10

Surplus reinsurance

Answer 10

A proportional treaty reinsurance, whereby the proportion of risk covered varies from risk to risk depending on the size and type of risk.

Question 11

Define “Estimated Maximum Loss (EML)”

Answer 11

The largest loss that is reasonably expected to arise from a single risk.

Question 12

Define Minimum retention

Answer 12

The minimum level of retention the reinsurer requires to prevent the insurer from having too little interest in the risk.
This requires the insurer to retain all risks that fall below the minimum retention.

Question 13

Define Number of lines of cover

Answer 13

This is specified in the contract and is used to calculate the maximum cover available from the reinsurer.
The maximum cover available is calculated as L multiplied by R, the Maximum retention

Question 14

What is the main difference between quota share and surplus reinsurance?

Answer 14

Whereas quota share has the same proportion of every risk ceded to the reinsurer, the proportion ceded will vary from risk to risk with surplus reinsurance.

Question 15

5 Advantages of surplus reinsurance

Answer 15

• Enables the insurer to choose within limits, the risk that it wants to retain. helps in avoiding accumulations and fine-tune its exposure
• Enables the insurer to write larger risks
• It is useful for those classes where a wide variation can occur in the size of risks
• It helps spread the risks
• The commission may help with cashflow

Question 16

3 Disadvantages of Surplus reinsurance

Answer 16

• It requires more complex administration
• It is unsuitable for unlimited covers (liability) and personal lines cover
• The terms may not be flexible enough to cover the largest risks

Question 17

Excess of loss reinsurance

Answer 17

With XL reinsurance, the reinsurer agrees to indemnify the cedant for the amount of any loss above a stated excess point. More usually, the reinsurer will give cover up to a stated upper limit, with the insurer purchasing further layers of XL cover – which stack on top of the primary layer – from different reinsurers.

The retention and limits may be indexed for inflation

The higher layer cover(s) come into operation only when the lower layer cover has been fully used (“burnt through”).

Question 18

3 Main types of excess of loss reinsurance

Answer 18

• Risk XL
• Aggregate XL
• Catastrophe XL

Question 19

Risk XL

Answer 19

Indemnifies an insurer for the amount of an individual loss in excess of the excess point - in return for a premium.

Question 20

Aggregate XL

Answer 20

Relates to cumulative losses, where the aggregation may be by event, by peril or by class.

Question 21

Catastrophe XL

Answer 21

A form of aggregate XL covering sever losses (within the hours clause) that result from a specified event.

Question 22

4 Advantages of Excess of loss

Answer 22

• Allows the insurer to accept risks that could lead to large claims
• Reduces the risk of insolvency from a large claim, an aggregation of claims or a catastrophe
• Reduces claim fluctuations (and smoothes results)
• helps to make more efficient use of capital

Question 23

Working layer

Answer 23

The first layer above the cedant’s excess point, where moderate to heavy loss activity is expected by the cedant and reinsurer.

Question 24

Indexed limits

Answer 24

Where inflation has a significant effect on the cost o claims, a stability clause may be applied to the excess point.
This is so that the reinsurer does not receive a higher proportion of the risks purely because of inflation.

Question 25

Commission on XL Re

Answer 25

Return commission and override commission are not normally relevant (since the reinsurer charges a premium to cover the risk, and commission would effectively just lower the premium)

Profit commission is possible (in the lower layers).

Question 26

Deductibles on XL

Answer 26

It is possible the reinsurer will cover only a proportion of the claims within the layer, by applying a deductible.

The reason for this type of arrangement is to give the direct writer more incentive to keep the claim settlements low.

Question 27

Define “Hours clause”

Answer 27

A clause within a catastrophe reinsurance treaty that specifies the limited period during which claims can be aggregated for the purpose of one claim on the reinsurance contract.

Question 28

Stop loss

Answer 28

A form of XL reinsurance that indemnifies the cedant against the amount by which its losses incurred during the specific period exceed either:

• a predetermined monetary amount or
• a percentage of the company’s subject premiums (loss ratio) for the specific period.

Question 29

2 Types of financial reinsurance funding arrangements

Answer 29

• Pre-funded arrangements

- Post-funded arrangements

Question 30

Pre-funded financial re arrangement

Answer 30

The insurer pays premiums into a fund held by the reinsurer (which earns interest), and claims are paid from the fund.

Question 31

Post-funded financial re arrangement

Answer 31

The reinsurer pays the losses and the insurer pays back the losses over time.

Question 32

4 Specific financial reinsurance products

Answer 32

• time and distance deals
• spread loss covers
• financial quota share
• industry loss warranties

Question 33

Time and distance policies

Answer 33

The insurer pays the reinsurer a premium and in return, the reinsurer pays an agreed schedule of claim payments;
This has the effect of discounting the reserves of the insurer for the time value of money.

Question 34

Spread loss covers

Answer 34

Spread loss covers involve the insurer paying annual or single premiums to the reinsurer for coverage of specified claims. These accumulate with interest (contractually agreed) in an experience account, the balance of which is settled at the end of the multi-year period.
These might be useful where the insurer is exposed to a potentially large risk that may occur from time to time, for example an earthquake. A spread loss cover would help to spread the effect of a possible big loss over several years.

Question 35

Financial quota share

Answer 35

This is quota share purchased in order to obtain reinsurance commissions for financing assistance.

Question 36

Industry loss warranties

Answer 36

These are a type of reinsurance that pay out based on industry losses rather than losses to individual insurers.

Question 37

Run-off reinsurance

Answer 37

The aim of run-off reinsurance is the transfer of reserve development risks.

It provides cover against the insurer’s earnings volatility arising from past activities. It may be sought in circumstances such as:

The ‘book’ is sold to the reinsurer who assumes all remaining premiums and all of the risk. The claims reserves are also transferred from the insurer to the reinsurer.

For example, there have been many run-off solutions applied to accounts with exposure to US asbestos-related claims, in view of the uncertainty (and deterioration) of that claims experience.

Question 38

6 Circumstances in which run-off solutions are commonly sought

Answer 38

• corporate restructuring
• mergers and acquisitions
• closing lines of business
• economic changes in the value of the liability
• regulatory, accounting or tax changements
• legal developments

Question 39

Adverse development cover

Answer 39

Involves the purchase of reinsurance cover for the ultimate settled amount of a block of business above a certain pre-agreed amount.
Reserves are maintained by the insurer.

Question 40

Loss portfolio transfers

Answer 40

LPTs are an arrangement whereby the liability for a specified book of business is passed in its entirety from one insurer to another. Policyholders will be informed of this ‘novation’ and the deal may need to be approved by a court. This enables the original insurer to concentrate on any remaining book of business.

Question 41

Define “novation”

Answer 41

The transfer of the rights and obligations under a contract from one party to another.

Question 42

2 Advantages of Loss portfolio transfers

Answer 42

• They can improve the credit rating of the original insurer.
• The new insurer will gain diversification if not already in this area and achieve a larger client database.

Question 43

4 Disadvantages of Loss portfolio transfers

Answer 43

• assets may need to be realised to pass across the value of the reserves to the accepting insurer (might be mismatching or tax gains / losses)
• If the new insurer defaults, this could damage the reputation of the original insurer
• The transfer may require the buy-in of reinsurers where there are existing reinsurance arrangements covering the portfolio.
• There will be an associated cost to the original insurer of the risk transfer, which will depend on the current risk appetite of the market.

Question 44

Reinsurance product types

Answer 44

Traditional:
1. Quota share (proportional)
2. Surplus reinsurance (proportional)
3. XOL (Non proportional) - Risk/individual XL, Agg XL, Cat XL
4. Stop Loss (Non proportional)
Non-traditional reinsurance products:
5. Finite risk (financial) reinsurance - prefunded and post funded - time and distance, spread loss covers, financial quota share, structured finance, industry loss warranties
6. Run-off reinsurance - adverse develoment cover and loss portfolio transfers
Alternates to reinsurance:
7. Capital Market products - committed/contingent capital, securitization - CAT bond, Insurance Linked Securities (ILS), weather derivatives

Question 45

If available, explain why stop loss reinsurance is normally arranged on a losses-occurring basis

Answer 45

Stop loss cover protects the direct writer against many claims arising over an accounting period. For a company using normal accident-year accounting the corresponding exposure period is the accident year. Hence a losses-occurring basis would be used (except when using a funded accounting basis, eg at Lloyd’s, when a policies-incepting basis would be used).

Question 46

(a) Explain why reinsurers are often not prepared to provide stop loss cover.
(b) If the reinsurer does provide stop loss cover, suggest what conditions they are likely to impose on the business covered.

Answer 46

(a) Reinsurers are often not prepared to provide stop loss cover because:
the reinsurer has only limited control over initial underwriting and claim payments made
 historically some stop losses have been loss making.

(b) Conditions the reinsurer may impose before providing stop loss cover are:
maintain some control over underwriting, premium rates and claims.
 impose a deductible so that the insurer retains a proportion of the risk

Question 47

Define financial risk reinsurance

Answer 47

This is a form of reinsurance (or insurance) involving less underwriting risk transfer and more investment or timing risk transfer from the cedant than is customary in reinsurance.

Question 48

Define Increased limit factors

Answer 48

These are factors which estimate the cost for a new limit as a multiple of the basic (original) limit.

Question 49

Define Reinstatements `

Answer 49

The restoration of full cover following a claim. [1⁄2]
Normally, the number of reinstatements, and the terms upon which they are made, will be agreed at the outset. Once agreed, they are automatic and obligatory on both parties.

Question 50

Explain Capital Market products - committed/contingent capital, securitization, weather derivatives

Answer 50

Committed capital or contingent capital is based on a contractual commitment to provide capital to an insurer after a specific adverse event occurs that causes financial distress. The insurer purchases an option to issue its securities at a predetermined price in the case that the defined situation occurs, on the understanding that the price would be much higher after such an event.

Purpose of securitisation
Securitisation has two main purposes: 
Risk management – to transfer insurance risk to the banking and capital markets. It is often used for managing risks associated with catastrophes, as the financial markets are large and capable of absorbing catastrophe risk. It involves turning a risk into a financial security, eg as in a catastrophe bond.

Capital management – to convert illiquid, inadmissible assets into liquid admissible assets, hence improving the balance sheet.
Almost any assets that generate a reasonably predictable income stream can in theory be used as the basis of a securitisation. Examples of illiquid assets that could be securitised are: –
–
future profits, eg on a block of in-force insurance policies mortgages (and other loans)

Question 51

INsurance Linked SEcurities

Answer 51

Insurance-linked securities (ILS) are an innovative way of increasing (re)insurance capacity.
From the launch of the first securitisation in the 1990s, the ILS market has grown and cemented its place as a complementary alternative to reinsurance, notably in the property catastrophe reinsurance market. It has developed into what is now a reasonably liquid catastrophe (cat) bond market. These catastrophe bonds allow (re)insurers to transfer high severity low probability catastrophic risks to the capital market and spread them among many investors: if the specified catastrophic risk is triggered, the bondholders typically forfeit the interest and principal on the bond to the (re)insurer. If there is no catastrophic event, or trigger event before the maturity date of the contract, investors receive back their principal investment at maturity on top of the interest payments they have received.