Risk Transfer Flashcards
When faced with a risk, each stakeholder needs to decide whether to
• avoid the risk altogether
• reduce the risk (probability, severity, both)
• reject the need for financial coverage, e.g. if risk is trivial or largely diversified
• retained in full
• transfer in full
• partly retain and partly transfer
The choice of mitigation approach will depend on
• the likely effect of the approach on the frequency and severity of the risk
• feasibility of implementation
• cost and impact on profit
• secondary risks arising and how they might be dealt with
• how likely the risk event is to happen
• risk appetite
• the existing resources that the stakeholder has to meet the cost of the risk event should it happen
• the amount required by another party to take on the risk
• the willingness of another party to take on the risk
The extent of risk transfer will depend on
• probability of the risk occurring
• risk appetite and existing resources to finance the risk event if it happens
• cost of transferring the risk
• willingness of a third party to accept the risk
Reinsurance - benefits and costs
The benefits of reinsurance have to be weighted up against the cost. The reinsurance premium will include loadings for profits and contingencies
Benefits of reinsurance include:
• a reduction in claims volatility and hence:
- smoother profits
- reduced capital requirements
- an increased capacity to write more business and achieve diversification
• limitation of large losses arising from:
- a single claim in a single risk
- a single event
- cumulative event
- geographical and portfolio concentrations of risk
and hence:
- reduced risk of insolvency
- increased capacity to write larger risks
• access to the expertise of the reinsurer
Proportional reinsurance
Proportion covered by the reinsurer may:
• be constant for all risks covered - quota share
• vary by risk covered - surplus
Both firms have to be administered automatically, and therefore require a treaty
Quota share is simple to administer
Surplus reinsurance treaty specifies a retention limit and a maximum level of cover available from the reinsurer
The retention limit may be fixed for all risks or variable at the discretion of the cedant
Non-proportional reinsurance
Risk excess of loss (XL) - relates to individual losses and affects only one insured risk at one time
Aggregate XL - covers the aggregate of losses, above an excess point and 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 in a ceding company’s whole account (or a major class of business)
Catastrophe XL - pays out if a ‘catastrophe’, as defined in the reinsurance contract, occurs (there is no standard definition of what constitutes a catastrophe)
Main uses of excess of loss reinsurance
• to permit a ceding provider to accept risks that could lead to large claims
• to stabilize the results of the ceding provider by reducing claims fluctuations
• to reduce the risk of insolvency from large losses
Alternative risk transfer (ART)
ART is 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.
Examples of ART contracts include:
• integrated risk covers - arranged by insurers and reinsurers that typically covers several lines (or classes) of general insurance business for several years - “reinsurance package” where the reinsurer covers different lines of business in one policy
• securitization - turns risk into a financial security, e.g. a catastrophe bond
• post loss funding - secures the terms of raising capital in advance if a loss (e.g. a catastrophe) occurs, typically provided by a bank. A commitment fee is needed to guarantee the funding
Commitment fee is lower than insurance so this way appears to be cheaper
• insurance derivatives - the derivatives set up with the underlying catastrophe or weather options. Majority are over the counter. Can help cover risks that are not covered by the insurance market
• swaps - organizations with matching but negatively correlated risks can swap packages to increase the level of diversification of both parties. They can be set up between non-insurance parties with opposite risks. They can also swap uncorrelated risk to increase diversification
Reasons why providers take out ART contracts include
• provision of cover that might otherwise be unavailable
• stabilization of results
• cheaper covers
• tax advantages
• greater security of payment
• management of solvency margins
• more effective provision of risk management
• as a source of capital
