Introduction to reinsurance and the economics of the insurance industry Flashcards
What are the advantages of QS for a reinsured? Name three
Can reduce its overall risk exposure
Enhance financial stability
Increase its underwriting capacity.
What are the advantages of QS for a reinsurer? Name two
Generates premium income
Diversifies its risk portfolio from multiple insurers
What are the advantages of surplus programmes for a reinsured? Name four
- Protects them from financial impact of high risk exposures.
- Maintain control over underwriting decisions.
- Profits from smaller risks.
- Can tailor their risk retention to their financial appetite.
What are the advantages of surplus programme for a reinsurer? Name two
- Diversify its risk portfolio by risk assumption from multiple insurers
- Can charge higher premiums due to high risk profile and increase underwriting/accounting administration.
Definition of XL per risk
Protects the ceding insurer from relatively few large, unexpected losses that can substantially impact the ceding insurer’s financial stability. Premiums are based on expert predictions of underwriting model and are not predetermined by an arranged percentage. This is aimed at covering individual loss per risk basis.
What are the advantages of XL per risk for the reinsured? Name two
- Retains control over underwriting decisions for smaller risks and profits.
- Shielded by the reinsurer from large losses.
What are the advantages of XL per risk for the reinsurer? Name two
- Assumes the risk of potentially sig losses in exchange for premiums.
- No participation on minor losses.
Definition of XL per event
Specifically designed to manage large aggregate losses arising from a single event, such as natural disasters, major accidents.
What are the advantages of an XL per event programme for a reinsured? Name three
- Mitigates financial impact of aggregated losses from a single event
- Optimise capitol
- Expand underwriting capacity
What are the advantages of an XL per event programme for a reinsurer? Name three
- Leverage its expertise
- Diversify risk portfolio.
- Earn premium.
Definition of stop loss reinsurance
Used to protect the ceding insurer from aggregate loss per unit of time, that exceed a certain amount of its premiums usually throughout the year.
What are the advantages of a stop loss programme for a reinsured? Name two
- Protect from financial instability by excessive losses at all classes of business
- Protect or may increase the solvency ratio
How is the stop loss point usually defined?
As a percentage of the premiums
What are the three main types of reinsurance?
FAC
Treaty
Hybrid
Define Facultative reinsurance
Covers a single risk. Primary insurer can decided which risks to offer to the reinsurer and the reinsurer is free to either accept or decline. No obligation on each side.
What is treaty insurance also known as and why?
Also known as obligatory reinsurance or automatic reinsurance.
Because all policies covered by the treaty must be offered to the reinsurer and the reinsurer has to accept.
Benefits of treaty in general
Automatically provides cover for the reinsured without having to wait to negotiate a FAC contract first. Therefore, it is quick and cost effective, a preferred type of reinsurance for standard risks.
It also benefits the insurer, who automatically receives the right to participate in all the businesses covered by the treaty.
How does the reinsurer control the treaty?
They specify certain types of risks that it will not include within the treaty.
These are then dealt with via FAC.
What risks does FAC usually deal with? Name three
- Peak risks - policies with TSI that exceeds a specified amount in treaty
- Difficult/unusual risks - difficult risks refer to hazardous ones such as chemical, pharma, mining companies. Unusual risks might be large roller coasters in amusement parks, submarine etc.
- Voluntarily excluded risks - insurer may choose to exclude certain risks from treaty. Afraid that risk may produce a large loss and negatively impact the results of treaty.
Name two forms of hybrid insurance
- Facultative- obligatory reinsurance: the primary insurer can decide which risks to offer to the reinsurer. the reinsurer has to accept them.
- Obligatory-facultative reinsurance: the primary insurer must offer all risks covered by the treaty. The reinsurer can choose whether to accept them.
Definition of QS
The reinsurer agrees to take on a fixed percentage of all the risks within a specific category from the ceding insurer. In return, the reinsurer will also receive the same percentage of premiums.
Definition of surplus
The ceding insurer decides on a retention limit, and any amount of risk above this limit up to a certain maximum is ceded to the reinsurer. Useful to insurers who want underwrite policies that exceed their individual risk thresholds.
What is a cut through agreement?
An agreement between insurer and the reinsurer, which enables the insured to seek payment directly from the reinsurer. However, this poses risks for the reinsurer because it may pay the insured what it owes, but still have a legal obligation to pay the insurer - known as double payment. This could be enforced by a liquidator if the insurer becomes insolvent.
Name three key points that make a contract valid
- An offer and acceptance of that offer.
- Valuable consideration - one party must give consideration for the product or service being negotiated in the contract. e.g premium
- Certainty of terms - covers all essential elements in a written form that provides evident as to T&C agreed by parties
Privity of contract for insured, insurer, reinsurer
If insurer fails to pay a claim, insured cannot claim from the reinsurer. If the reinsurer defaults, the insurer cannot use to avoid paying a claim to the insured.
What is the ‘follow the fortunes’ principle?
The principle obliges the reinsurer to follow the cedant’s insurance fortunes resulting from the underlying insurance policies. Principle is in place as original and reinsurance policies are separate contracts. It binds the reinsurer to the interpretations and modifications of the original policy. However, there are exceptions e.g the reinsurer is not bound to cover losses that fall outside reinsurance contract.
Six steps of primary insurer handling claims
- Recording, inspecting loss reported
- Clarifying and assessing validity
- Defence/rejection of invalid claims
- Establish the amount of claims reported, including calculating the portion covered in the original policy
- Settlement or payment of the claim to the rightful claimants by the primary insurer
- Carrying out loss recovery measures.
Explain the ‘follow the settlement’ principle
States that the cedant is solely responsible for handling claims and that the reinsurer must ‘follow’ the settlements made by the cedant. Avoids reinsurer reinvestigating loss. However, the reinsurer is not obligated to pay ex-gratia payments to the insurer. e.g despite not being covered, insurer indemnifies the policyholder.
What is included in a FAC submission? (Name five)
- Information about underlying insured.
- Description of location and nature of risk
- T&C of original insurance policy
- Historical loss
- Type and amount of reinsurance required
What is included in a treaty agreement?
- Details of portfolio e.g number of policies, policies split by activity, average sums insured, claims exp and claims outstanding
- Internal underwriting guidelines
- Policy wordings
- Strategy of company such as growth plans, geographical distribution
- Type and amount of reinsurance required
Name 5 key areas covered in a treaty agreement
- Scope of cover
- Reinsurance cover and price
- Claims settlement process
- Accounting and payments
- Legal jurisdiction and dispute resolution
What is considered in scope of cover for a treaty agreement? Name four
Material scope (what)
Geographical scope (where)
Temporal scope (when)
Exclusion (what is not)
What does material scope of cover define? (Name two)
Line of business to be covered
Perils included
What is a multi-line reinsurance treaty?
A treaty combining the liabilities from several classes or lines of insurance.
How do you define geographical scope of mobile risks?
- Where the policy holder is domiciled (e.g in the case of motor physical damage, hull in marine or aviation and personal insurance)
- Where the insurance is concluded (e.g marine cargo insurance).
What are the two elements to the temporal scope of cover?
- Contract period (but some treaties have no end date but contain a cancellation clause. Proportional is usually written on this basis)
- Period of cover
What are the three methods for period of cover?
1.Underwriting year basis - covers all policies written within the treaty period
2. Year of occurrence/accident year basis - covers all claim events that occur during the treaty period.
3. Accounting year basis - covers all claims paid by the reinsured during the treaty period
What is the common approach for period of cover?
Accident year basis - fire, liability
Underwriting year - marine, life, credit, aviation and engineering
Accounting year - not common but used for fire sometimes
What are the two types of exclusions
- Standard exclusion - found in all reinsurance treaties and are generally not negotiable.
- Specific exclusion -negotiable and are intended to keep undesirable classes of insurance, risk, and perils out of treaty.
Give examples of standard exclusions
Exclusion of indirect business - reinsurance business written by a primary insurer (because technically they are a competitor)
Exclusion of specific perils - war, SRCC, terrorism, nuclear.
What is a claims cooperation clause?
It states that the insurer will work in partnership with the reinsurer in settling claims, particularly helpful if the insurer has limited claims experience. The clause requires the cedant to consult with the reinsurer on the claim settlement after giving notice. Cooperation may range from the reinsurer offering advice or opinions, which may or may not be followed, to the reinsurer approving certain claim actions in connection with claims handling. Dependent on the particular language used in the clause.
In what cases could ca claims cooperation clause apply?
A typical clause does not impose an obligation on the reinsurer but rather gives it to the right to cooperate. The clause can be applied to all losses, or only to larger losses, if the latter than consultation is not required for each and every case.
What is a claims control clause?
A stronger version of the claims cooperation clause. At minimum, the reinsurer is granted the right to approve some or all settlement actions of the cedent. The reinsurer may also be given the option of directing the investigation and claims process through negotiation with TPs or dictating the tactical approach. It needs to be carefully drafted as it can cause legal issues. E.g it makes the reinsurer vulnerable to the allegation that it is functioning as a primary insurer, giving rise to cut-through problems or bad faith actions.
In what cases could a claims control clause be applied?
It should only be used in clearly defined cases, such as high exposure business with a potential for large claims. Example: industrial property, business with mass tort litigation exposure and certain types of engineering business.
What information is included in a statement account and when is it provided.
Insurer sends to the reinsurer, usually on a quarterly basis for proportional and annually for non-proportional contracts.
Information required relates to:
Reinsurance premiums
Reinsurance claims recoveries
What is included in reinsurance claims recoveries? Name three
- The total amount of loss payable by the reinsurer
- Any amounts already paid
- Any outstanding payments
Provided in a claims bordeau
What info is included in reinsurance premiums section in statement of accounts?
In proportional - reinsured needs to provide details of the original gross insurance premiums for the period and the reinsurer’s share.
In non proportional reinsurance, the amount of reinsurance premium payable is usually not finalised until the end of the treaty year but is due at the start of the year. So reinsurance deposit of 80%-90% is usually specified, paid in half or quarterly instalments. And any outstanding balance is paid at the end of the year.
What is a cash loss clause and what treaty do we see this in?
Forms an integral part of every proportional treaty. The clause states that even if the current accounting period is not yet about to be closed, the reinsured can ask the reinsurer to pay its share at short notice. Usually due to cash flow reasons (eg within 10 working days).
When are claim payments owed by the reinsurer paid?
Paid within a specified period following the end of the accounting period.
When are claim payments owed by the reinsurer paid in non-proportional reinsurance?
Where losses covered by this treaty arise, the insurer must report them to the reinsurance individually without delay. The reinsurer must be kept informed of the development of every loss event that might affect it, right up to final settlement.
An insurance company’s profit comes from two sources
Underwriting
Investing
What is the formula for a typical insurer’s P&L account
Primary
- Expected claims
- Expenses
——————————-
= UW profit
+ Investment return
——————————-
= Profit
Name an approach that forecasts normal losses
Loss distribution profile - shows the possible losses that could under different scenarios
What’s the formula for risk loss ratio (RLR)?
RLR= size of loss / sums insured
What are the three drivers that helps produce a loss distribution profile?
- Loss frequency - measures the % of total policies written that suffer a loss
- Sums insured - of policies suffering a loss, which shows whether the claims relate to policies with a high or low sums insured
- Risk loss ratio
What is the formula for construction a normal loss distribution?
number of policies x frequency x average sums insured x loss ratio percentage
Then takes average of gross claims figure in each of the diff scenarios. e.g 162mUSD/27 (scenarios) = 6m USD
What is a loss distribution tree?
It’s a model used in insurance to prototype and understand the distribution of potential losses. Helps assess and manage risk.
Name two causes that leads to higher claims than expected?
- Error - insurer underestimates expected frequency, average sums insured or expected loss ratio, therefore setting too low a premium. May not have sufficient historical information due to entering new market or new product line.
- Change - same as above and underestimates, however this is due to a wrong claims estimate because the insurer did not fully understand the risk at the time of writing the business. The risk of change refers to changes that occur after the business was written that will affect the claims outcome.
Name an example for risk of change and risk of error
Risk of change: Insurer writes motor policies and estimated claims correct based on info about likely losses it had at the time. However, gov relaxes speed limit, leading to increase in accidents.
Risk of error: Insurer was slow to identify change in claims exp, even after new laws had been introduced and accidents increased. It continued to write policies using previous claims forecasts.
What are the two sources of capital?
Equity + Debt
What is subordinated debt?
Some regulators do not allow debt to be treated as capital for regulatory purposes. If they do, it’s restricted and known as sub debt. This debt can only be repaid with prior approval from the regulator.
Most regulators do not considered capital to be equity + debt, but rather what?
Regulatory capital = equity + subordinated debt
what is the solvency ratio formula?
Solvency ratio = available capital / required capital
What is cost of equity (COE) and what is the formula?
It’s the return required by shareholders.
Cost of equity = risk free rate + equity risk premium
What is cost of debt (COD) and what is the formula?
It’s the return required by lenders.
Cost of debt = Risk free rate + credit spread
Formula for the average Cost of Capital (CoC)
CoC = (% of capital made up of debt x cost of debt) + (% of capital made up of equity x cost of equity)
Name two factors that determine how much capital an insurer needs
- Minimum amount set by the regulator
- Any extra amount the company holds to ensure that, even if it makes a loss, it will still meet the minimum amount set by the regulator
A bad claims year is commonly defined as one that only has a XX% chance of being exceed. What’s the %?
0.5% chance
It can also be thought of as a year where losses will only be exceeded once every 200 years
or
as the loss results from claims at a 99.5% confidence level
If solvency ratio is 100%, what does this mean?
The insurer has just enough capital to cover losses at 99.5% confidence level.
What solvency ratio do insurers usually target?
Commonly 150%-200%
What is risk premium?
The premium required to be able to pay the expected claims
Formula for total expected claims
Number of policies x frequency x sums insured x risk loss ratio
Risk premium per policy formula
Total expected claims / number of policies
or if expressed in percentage
risk prem per policy / sums insured per policy
Formula for technical price
expected claims (risk prem) + expense loading + cost of capital
What is cost of capital (CoC)?
The return investors require on the capital they invest
What is the formula for Return on Capital (ROC)?
ROC = Profit / Available capital
If a company increases its solvency ratio, what will happen to the Return on Capital (ROC)?
It will fall, however it will be more likely to be able to pay claims.
What does capital intensity ratio (CIR) measure?
It measures whether an insurer is managing its risk effectively to minimise the amount of capital that it requires in relation to the business that it writes. It’s a measure of capital efficiency.
A lower capital intensity ratio will result in a higher economic value.
If the Capital Intensity Ratio (CIR) is 110%, what does that mean? What if it’s 90%?
This means that for every USD100 of prem it writes, it needs to raise USD110 of capital to support the risk.
If the ratio is 90%, to generate USD100, it only needs to provide USD90 capital.
For Return on Capital (ROC), a higher return on capital will result in a XYZ
It will result in a higher economic value
Return on required capital (RORC) - A higher return on required capital will result in a XYZ
It will result in a higher economic value.
What is an UW margin?
It shows how much underwriting profit an insurance company makes compared with the premiums it writes.
If the UW margin is 10%, what does it mean?
It means that for every USD100 of premium written, it is making a USD10 profit.
A higher underwriting margin will result in a higher economic value.
What is a combined ratio?
It gives the same information as the UW margin but is expressed differently.
Combined ratio - A lower combined ratio will result in a XYZ
It will result in a higher UW profit for any given premium level.
Combined ratio + UW margin is what?
Always 100%
What is expense ratio?
It shows how much of the premiums are needed to cover the insurer’s expenses e.g salaries, rent, IT costs etc
A lower expense ratio will result in a XYZ
It will result in a higher economic value
What is a loss ratio?
It shows how much of the premiums are needed to cover the insurer’s claims
If the loss ratio is 60%, what does that mean?
It shows that for every USD100 of premiums written, it is paying USD60 in claims.
What are the four fundamental drives of economic value?
Return on capital
1. UW margin - profitability
2. Capital intensity ratio - capital efficiency
3. Solvency ratio - capital adequacy
Cost of capital
In order to cover CAT losses, how much capital does an insurer need to cover?
1 in 200 year event
What is return on required capital (RORC)?
What can this be also known as?
It’s a ratio that compares the amount of profit that a company makes with the capital that the regulator requires it to hold to support the risk.
RORC=profit/required capital
It also can be seen as risk-adjusted return.
What does a high ROC indicate for an insurance company?
A. The company’s capital requirements are too high.
B. The company has a low profit margin.
C. The company is undercapitalised.
D. The company is efficiently using its capital to generate profit.
D
The RORC is a better measure of economic value than ROC because it takes into account the capital required to undertake the insurance risks.
True or False?
True
A low Combined Ratio indicates that an insurance company is spending less on claims and expenses compared to its premium earnings, which typically means higher profitability.
True or False
True
The Expense ratio is the ratio of X to X. It is a measure of an insurance company’s operational efficiency.
Expenses
Premiums
