30 - Risk Transfer

Question 1

Give the possible mitigation responses to risk by an organisation.

Answer 1

1. Avoid
2. Reduce the risk
3. Reject the need for financial coverage
4. Retain in full
5. Transfer in full
6. Partly retain and partly transfer

Question 2

How can a financial provider avoid a risk

Answer 2

1. Not selling a policy at all or,

2. Setting exclusions in the contract

Question 3

What is an important point to get right when transfering risks?

Answer 3

A mutual understanding of both parties’ objectives with the transfer.

Question 4

Give the factors that influence the choice of mitigation approach used by a firm.

Answer 4

1. Impact on frequency and severity of risk, or the expected value.
2. Feasibility of the implementation - costs and expertise
3. Overall impact on profits
4. Secondary risks arising and how they might be dealt with
5. How likely the risk event is to happen
6. Risk appetite
7. The existing resources that the stakeholder has to meet the cost of the risk event should it happen
8. The amount required by another party to take on the risk
9. The willingness of another party to take on the risk

Question 5

How may a regulator be involved in risk transfer practices?

Answer 5

1. Limiting the amount of risk that may be accepted or transferred.
2. Limiting the reduction in regulatory capital obtained through risk transfer.

Question 6

Give the factors that influence the extent to which a firm will use risk transfer as a mitigation strategy.

Answer 6

1. Probability of the risk occurring
2. Risk appetite and existing resources to finance the risk event if it happens - internally and ability to withstand counterparty risk
3. Cost of the risk transfer - admin costs, but also reduction in profits
4. Willingness of a third party to accept the risk

Question 7

Which factors influence a third party’s willingness to accept a risk transfer?

Answer 7

1. Nature of the risk relative to the business other risks and internal expertise
2. The nature of the premium offered - size and form
3. Diversification benefits to be gained

Question 8

Explain the main cost and downside of reinsurance.

Answer 8

The premium will always be higher than the reinsurance pay-outs received by the insurer in the long term.
This is due to the reinsurer looking to include a profit in their premium, thus the pay-out will only be profitable to the insurer if claims experience was worse than expected. This, however, has other negative implications to the insurer and then the reinsurer will also adjust their premium so that they do not continually make a loss due to mis-pricing of the premium. Either from misunderstood risks or a lack of expertise in setting the premium.

Question 9

Give the main advantages of reinsurance

Answer 9

1. A reduction in claims volatility
2. Limiting large losses
3. Reduction in risk of insolvency
4. Increased capacity to write larger risks
5. Access to the expertise of the reinsuerer

Question 10

Give the ways in which reinsurance can reduce the volatility in claims.

Answer 10

1. Smoother profits
2. Reduced capital requirements
3. An increased capacity to write more business and so to achieve diversification.

Question 11

Describe how reinsurance can limit large losses arising from an insurer’s claims experience.

Answer 11

1. A single claim on a single risk
2. A single event
3. Cumulative events
4. Geographical and portfolio concentrations fo risks

Question 12

Describe the expertise that a reinsurer can offer on purchase of an agreement.

Answer 12

1. Admin
2. Actuarial advice
3. Insurance advice
4. Data and claims experience
5. Reduction of business and operational risks through contract design and risk management expertise.

Question 13

Give the type of reinsurance available.

Answer 13

Proportional: 
1. Quota share
2. Surplus
Excess of Loss:
1. Risk XL
2. Aggregate XL
3. Stop loss
4. Catastrophe

Question 14

Give the advantages of quota share reinsurance.

Answer 14

1. Simple to administer
2. Allows the spread of risk
3. Allows an insurer to write larger portfolios or risk
4. Can encourage reciprocal business.

Question 15

Give the disadvantages of quota share reinsurance.

Answer 15

1. The firm cedes the same proportion of low and high variance risk and small and large risks - inflexible
2. Does not cap the cost of very large claims.

Question 16

Describe the purpose of catastrophe excess of loss reinsurance.

Answer 16

To reduce the potential loss to the insurer du to any non-independence of the risks insured.

Question 17

Give the main disadvantages of excess of loss reinsurance.

Answer 17

1. The ceding provider will pay a premium to the reinsurer which, in the long run, will be greater than the expected recoveries under the treaty as it must include loadings for the reinsurer’s expense and profit.
2. From time to time, excess of loss premiums may be considerably greater than the pure risk premium for the cover due to poor past performances.
3. Does not cover groups of risks for the individual excess of loss

Question 18

Give examples of Alternative Risk Transfer.

Answer 18

1. Integrated risk covers
2. Securitisation
3. Post loss funding
4. Insurance derivatives
5. Swaps

Question 19

Give the main advantage of post loss funding

Answer 19

The commitment fee will be lower than the equivalent insurance cost so, before the loss happens the contract appears cheaper than conventional insurance

Question 20

Give the advantage and disadvantage of using insurance derivatives.

Answer 20

Pro:
Solutions are tailor made for the firm
Con:
There are extra dealing costs associated with specific solutions and they are not available freely.

Question 21

Give the main use of insurance swaps.

Answer 21

Use:

Organisations can swap matching but negatively or uncorrelated risks to achieve greater risk diversification

Question 22

Give the main reasons why providers take out ART contracts.

Answer 22

1. Provision of cover might not otherwise be available.
2. Stabilisation of results
3. Cheaper cover
4. Tax advantages
5. Greater security of payment
6. Management of solvency margins
7. More effective provision of risk management
8. As a source of capital - freeing up capital can be seen as equivalent to raising new capital.
9. Diversificatuon

Question 23

Give the advantages of integrated risk cover.

Answer 23

1. Insurers can avoid buying excessive cover for all risks
2. Smooths results
3. Can lock in attractive terms for several years.

Question 24

Give the disadvantages of integrated risk cover

Answer 24

1. Creates credit risk
2. Lack of availability
3. Tailor-made solutions are usually more expensive to negotiate maintain.
4. It may be difficult for a firm to get a good overview of their risk portfolio in order to know what type of integrated cover they need.

Question 25

Give the main advantages of securitisation.

Answer 25

1. There is less risk for capital markets from catastrophes as they have better mechanisms for dealing with them.
2. Can provide diversification to investors
3. Has similar pricing to traditional catastrophe reinsurance - benefit to insurer
4. Reduces credit risk - the insurer receives cash upfront

Question 26

Give the main concerns around securitisation.

Answer 26

1. A very risky investment as the return can be 0
2. Much more expensive than similar corporate bonds - con to investors
3. Not a liquid asset - due to low numbers of issuances
4. Asymmetries of information about insurance to investors
5. No expertise supplied to insurer as with reinsurance
6. May not be available for new types of business or areas of new expansion as reinsurance would be.

Question 27

Give the advantages that surplus reinsurance has over quota share.

Answer 27

1. More flexible - enables amount ceded to be tailored to the size and variability of individual risks
2. Suitable for reinsuring heterogeneous risks
3. More efficient way of ceding premium than quota share as only pay for precise cover required.
4. Able to fine-tune exposure
   (Main disadvantage is more complicated admin)

Question 28

Give the elements of a reinsurance treaty that require negotiation.

Answer 28

1. Type of reinsurance arrangement
2. The retention of the insurer
3. The amount of cover to be granted automatically by the reinsurer
4. The dates the treaty starts and ends
5. The classes of business covered or excluded
6. The perils covered or excluded
7. The territorial scope of the treaty
8. How and when the reinsurance premiums are to be paid.
9. Commission arrangements
10. How and when claims will be paid
11. Cancellation terms
12. Arbitration clauses
13. Any other data requirements of either party.

Question 29

How are the costs and benefits of a reinsurance arrangement assessed?

Answer 29

Costs:
1. The value of the premiums + present value of any expenses incurred to implement and manage reinsurance + cost of capital allowances to cover additional risks
Benefits:
1. A realistic estimate of the value of benefits that would be paid out under the agreement
2. Involves realistic assumptions about likely future experience - distribution of claim size and rates
3. Quantify non-financial benefits such as less volatility in claims through assessing capital requirements
4. Assess the indirect benefits such as expertise and data offered by the reinsurer with regards to the standard cost of securing these services individually.

Question 30

Outline how to asses the security of a reinsurer

Answer 30

1. Look at the financial security of the reinsurer
2. Consider the published accounts and statutory returns to evaluate: solvency position, types of assets held - matching, diversification, volatility, cash flows, marketability and liquidity - and borrowings.
3. Consider the legislative environment and the type of business that the reinsurer writes.
4. Consider the liabilities of the reinsurer
   - diversity by class, geography region and cedant
   - exposures to any risk accumulations and catastrophes
   - any particularly large, unusual or volatile risks covered
   - the size of the liabilities and future plans for development
   - whether the reinsurer itself has reinsurance
5. The reputation of the reinsurer:
   - market share
   - previous claims history
   - ability of the management
   - parent or associated companies and their financial strength
   - credit rating
   - views of others in the industry