Chapter II: Insurance & Reinsurance

Question 1

What are the four criteria for the insurability of risks ?

Answer 1

1) Randomness
The time and location of an insured event are unpredictable.
Event occurence must be independent of the will of the insured.

2) Assessability
It is possible to describe the claimable events by frequency and severity.
Both magnitudes can be estimated and quantified with reasonable confidence bands.

3) Mutuality
There should be large number of similar exposure units in one risk class.
Hence risk can be pooled to reduce the volatility around the expected loss.

4) Economic viability
Achievable price must cover expected claims costs and administration costs of the insurer.
The insurer’s shareholders demand an adequate return on capital.

Question 2

How does insurance work ?

Answer 2

An insurer takes on risks from individuals or companies.
The insured pays a premium and receives indemnification (non-life) or benefits (life),
The insurer pools the risks and hedges with reinsurance or other risk management tools.

Question 3

How does indemnity insurance work ?

Answer 3

Indemnity insurance requires the occurrence of a loss.
Contracts are characterized by a claim transformation rule and deductible.
Typical for nonlife business lines.

Question 4

How is determined the indemnification ?

Answer 4

1st step: apply the transformation rule to the claim

2nd step: apply deductible to calculate the actual indemnification

Question 5

What are the different approaches for the premium calculation ?

Answer 5

• Actuarial approach: principles that determine ^ based on the insurer’s risk aversion
• Financial approach: based on capital market theory and option pricing theory
• Utility-based approach: take into account the customer’s willingness to pay

=> Actuarial pricing much more common in practice since applicable to individual contracts and on the portfolio level

Question 6

What are the main critics about the actuarial princing principles ?

Answer 6

• Depend on the risk aversion but how should be determined in practice ?
• The price of insurance is dependent on the choice of risk measure
• Investment risk on the asset side of the insurer’s balance sheet is not considered
• Risk definition not in line with insights of capital market theory

Question 7

What are pooling effects ?

Answer 7

They arise when insurance contracts are combined into portfolios.
Type I: constant capacity
Type II: increasing capacity

Question 8

How does reinsurance work ?

Answer 8

The reinsurer takes on part of the risk that a primary insurer has written.
The primary insurer transferring the risk pays a premium.
The original policyholder is not involved in the transaction.

Question 9

What is a retrocession ?

Answer 9

It is a reinsurance agreement between reinsurers

Question 10

What benefits to reinsurer offer to the primary insurers and to the real economy ?

Answer 10

-Primary insurer:
Risk transfer, Capital Relief, Advisory and Information

-Worl Economy:
Global diversification of Risk, Provision of Capital, Innovation and Progress

Question 11

Explain briefly the global reinsurance market

Answer 11

There are about 200 companies. It is a centralized industry with a strong capital based (230 bn premium volume and 524 bn equity capital)

Question 12

What are the pros and cons of the quota share insurance ?

Answer 12

• Pros : Simplest form of proportional reinsurance and ideal for homogeneous portfolios with many similarly sized risks
• Cons: Ineffective against large risks and extreme loss scenarios

Question 13

How does the surplus share insurance work ?

Answer 13

For each policy, the part of SI above a specified amount is reinsured. The maximum exposure kept by the primary insurer is called retention R.

Question 14

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

Answer 14

In contrast to the fixed q in a quota share reinsurance, the ratios by which premiums and claims are shared vary according to the sum insured

Question 15

What is the reinsurance commission ?

Answer 15

Reinsurer usually pays back a part of the original premiums ceded. It is simply a compensation for the primary insurer’s acquisition/administrations costs that the the reinsurer don’t face. RC = phi(ri) - RP

Question 16

Pros and cons of the excess of loss reinsurance per risk ?

Answer 16

• Pros: Effective protection against large single losses (e.g destruction of expensive buildings)
• Cons: Ineffective against high-frequency/low severity risks or loss accumulation across policies.

Question 17

Pros and Cons of excess of loss contracts ?

Answer 17

-Pros:
Protection against extreme single and accumulated losses
Insurer retains a higher proportion of the original premium since smaller losses are not covered
Lower administration costs for both parties since loss proportions do not need to be calculated for each risk.

-Cons:
Smaller losses below the retention(deductible) are not reinsured
Reinsurer prices risk: need to provide data for complete portfolio
Lack of loss sharing above the absolute deductible may lead to relaxation of underwriting and claims handling by the insurer.