Ch 30: Reinsurance 2

Question 1

List various reasons why insurer’s may use reinsurance (12)

Answer 1

Reinsurance mainly allows cedant to transfer risks from its balance sheet to reinsuerer’s balance sheet and acheive the following goals

1. increase (raise)
   1. capital (where permitted)
   2. profits or risk adjusted return on capital
2. reduce
   
   1. insurance parameter risk that claims might differ to expected
   2. claim payout flactuation by reducing cedant’s claim cost variance
   3. costs (cost reduction)
   4. new business strain
   5. overall capital requirements
3. limit
   
   1. amount paid on any particular claim
   2. total claims payout
4. receive technical assistance
5. seperate out different risks from a product
6. manage aggregation of risks

Question 2

What is insurance parameter risk, and what form of reinsurance best transfers this this type of risk? (2)

How might reinsurance assist with reducing parameter risk?

Answer 2

Broadly speaking, insurance parameter risk (also known as pricing risk) is,

• the risk that level of claims differ compared to what is expected
• may be caused by incorrect pricing, underwriting failures, fraudulent activities, etc
• best reinsurance for transfer this risk is through quota share reinsurance
  
  • individual surplus reinsurance wouldn’t be useful for this, as significant portion of pols’ claims may fall below insurer’s retention limit
  • under quota share reinsurance, the reinsurer would regulalry review insurer’s premium rates/controls and give expertise to assist with setting assumptions and carving actual experience which better represents assumptions

Question 3

Describe 2 factors which lead to variance of claim amounts being high relative to the mean, and what forms of reinsurance can be used for each factor? (9)

Answer 3

One of the key benefits of resinsurance is its ability to help reduce risk by reducing the variance of its claim costs.

Claims costs may have high variance relative to the mean if

• there are a small number of contracts, with very high levels of cover ie concentration of risk
  
  • forms of reinsurance that help with this:
    
    • either original terms reinsurance (coinsurance), or
    • risk premium reinsurance, usually on an individual surplus basis
• lives insured not independant risks
  
  • ​forms of reinsurance that could help are
    
    • excess of loss reinsurance
      
      • catastrophe reinsurance
      • stop loss reinsurance

Question 4

Why would flactuations in claim costs be undesirable for an insurer? (6)

Answer 4

Flactuations in claim costs are bad for an insurer for a number of reasons

• may make life company insolvent
  
  • big risk for small companies, this have an strong need for reinsurance.
  • for larger companies mortality fluctuations won’t plausibly threaten solvency
• may reduce excess of value of company’s assets over its liabilities below the level desired by the company
• may reduce rate of return on free assets below level desired by company in some years
• may cause fluctuations in shareholder dividends

Question 5

Explain how reinsurance mirhg be used to reduce new business strain? (2)

What is the benefits or reducing new business strain? (1)

Answer 5

Provided it’s permitted under relevant supervisory regime, the cedant could use reinsurance to reduce financial risk associated with new business, either by:

• increasing its available capital, or
• reducing its financing requirement

Reducing new business strain has the benefit that

• more new business can be written for the same amount of capital

Question 6

Which types of reinsurance would be used for the purpose of reducing new business strain? (6)

Answer 6

Types of reinsurance which might help reduce new business strain include

• original terms coinsurance usually on quota share basis
  
  • usually pass some liability to reins, so insurer can hold lesss reserves
  • hence, reducing new business strain by around same proportion
  • more significantly, large initial reinsurance comm contributes to insurer’s assets at time of sale, effectively discounting future profits that would’ve been tied up in the large reinsurance premiums
• risk premium reinsurance usually on quota basis
• financial reinsurance (if effective under regulatory regime)
  
  • ​improve balance sheet of insurer immediately, thereby increasing available capital

Question 7

Why is invididual surplus reinsurance less useful than quota share reinsurance for reducing new business strain? (2)

Answer 7

Individual surplus reinsurance would be less useful than quota share for reducing new business strain because

• new business strain is a funtion of many constituents (init comm, init expenses, prem income, initi supervisory reserves, etc) relating to new business sold, whether made up of many small individual pols, or fewer individual larger pols
• using individual surplus reinsurance for financing would generate capital support that would be a function of new business mix by size (which is irrelevant to total amnt of strain)

Question 8

Explain the circumstances in which an insurer may benefit from the technical assistance a reinsurer can provide (4)

What form of reinsurance best allows insurer to benefit from technical assistance from the reinsurer? (1)

Answer 8

Reinsurance can provide the following technical assistance to the insurer

1. Reinsurer may have considerable degree of expertise on underwriting, product design, pricing and systems design
2. This is particularly important when cedant starts a new line of business, as it can receive tehcnical assistance from reinsurer until it has built up its own expertise
3. Likewise for recently established insurance company.
4. Reinsurer can give support for existing lines in areas such as underwriting, eg treatment of unusual cases.

Best form of reinsurance to benefit insurer regarding technical assistance is

• original terms reinsurance (with high quota share reinsured)

Question 9

Dicuss how reinsurance may help insurer’s in terms of cost reduction (6)

Answer 9

Cost reduction benefit of reinsurance derives from reinsurer perhaps being able to price risk at lower cost than insurer due to

• different capital requirements it faces
• diversitication benefits of due to reinsurer having greater spread of risks than any individual cedant in terms of
  
  • number lives covered, geographical region, original sales channel, etc
  • reduce reinsurer’s random flactuation risk relative to any insurer
  • …and quantity of data should help reduce parameter risk
  • hence reinsurer won’t need to build in such large risk margins into reinsurance prems, potentially making it more profitable for cedant to cede this business than retain risk on it
• tax differences across regions/regimes, across certain types of business
• different assessments of risks

Question 10

What key questions should an insurer ask itself regarding the use of reinsurance? (3)

Answer 10

Before deciding on the use of reinsurance, an insurer should ask itself the following questions:

1. whether or not to use reinsurance
2. which types of reinsurance to use
3. how much reinsurance to use

Question 11

We’ve touched on the questions an insurer should ask itself regarding the use of reinsurance.

List considerations that an insurer will take into account in deciding on the answers to these questions (5)

What kind of risks does the use of reinsurance introduce? (2)

Answer 11

Key considerations for insurer when answering above questions about reinsurance

1. reasons for acquiring reinsurance
2. type of business being reinsurance
3. cost of reinsurance
4. retention limits - ie maximum amount of risk retained by cedant on any individual risk
5. legal conditions applying types of reinsurance available and way in which amoutn reinsured is specified

In addition, the use of reinsurance introduces the following important risks:

1. Legal risk: ir reinsurance treaty incomplete
2. Counterparty risk: risk that reinsurer defaults in event of claim

Question 12

Reinsurance considerations: cost of reinsurance

What factors influence the cost of reinsurance? (1)

What key considerations should be factored into a decision about reinsurance regarding the cost thereof? (6)

Answer 12

The cost of reinsurance is influenced by the following factors

• the reinsurer intends to make profit as well as meet its cost of capital and expenses when writing reinsurance, which will reduce the expected absolute level of profit for the cedant

Most importantly, the cedant needs to consider

• The return/risk adjusted return on capital
  
  • risk reduction from reinsurance may leverage up return or risk adjusted RoC
  • given insurer holds less capital, RoC will increase (leverage up return)
  • implying lower RDR for future profit stream, making them more valuable to shareholders (increasing the risk adjusted RoC)
• The balance between risk and return
  
  • balance must be struck between increased cost of reinsurance against increased risk of loss from adverse experience if less reinsurance used

Question 13

What different types of insurance are there (4) and what are the different ways in which the amount reinsured might be specified (2)?

Answer 13

For reinsurance we have the following types

• original terms, risk premium, excess of loss, financial reinsurance

And the way that the amount reinsured might be specified is

• individual surplus, quota share

Question 14

What factors will influence the

• type of reinsurance acquired
• the way in which the amount reinsured is specified

(total 5 key points)

Answer 14

Factors influencing type of insurance taken + way in which amount reinsured is specified

• insurer’s reason for use of reinsurance
• costs of reinsurance
  
  • eg recently, unrestricted form of catastrophe cover became extremely expensive and terms increasingly restrictive, as reinsurers have become better at modelling extent of tail risk from extreme events
• type of business sold by insurer
  
  • term assurance:
  • with profits:
  • individual immediate annuity
  • group business
  • unit linked
• legal conditions applying
• forms of reinsurance cover actually available in market

Question 15

When considering what type of reinsurance to purchase, the type of reinsurance acquired is an important factor.

One factor which influences this, is the type of business the cedant/insurer writes.

List what types of contracts the cedant might write, and what reinsurance would be best suited for each (15)

Answer 15

Factors influencing type of insurance taken + way in which amount reinsured is specified: type of business sold by insurer

1. term assurance:
   
   1. original terms or risk prem reins, with differences in reins prem
   2. original terms: level prem, set at outset, with initial waiting period where no/low reinsurance premiums paid
   3. risk premium: recurring single premium based on current age, rates may be guaranteed for few years
   • 2. with profits:
        1. original term reins may be difficult, as reins would be obligated to follow cedan’t bonus rates
        2. reinsuring guaranteed elements/options attaching becoming popular in market
   • 3. individual immediate annuity
        1. normally no reinsurance, unless very large case
        2. consider impact on mortality profits of unexpectedly light mortality of annuitants
        3. reinsurers can also provide advice on impaired life annuities or smoker/non-smoker rates
   • 4. group business:
        1. catastrophe cover important (for risk accumulation)
   • 5. unit linked:
        1. normally risk premium reinsurance

Question 16

Definition of a retention limit

Answer 16

The maximum amount of risk retained by the cedant on any individual risk.

Question 17

Once a suitable form of reinsurance has been chosen, the cedant needs to decide on how much risk it will retain (ie retention limit)

What factors shold the insurer/cedant consider when determining its retention limit? (9)

Answer 17

Factors to consider when setting retention limits

1. the average benefit level and the expected distribution of the benefit
2. insurer’s/cedant’s insurance risk appetite
3. level of company’s free assets and the importance attached to stability of its free asset ratio
4. terms on which reinsurance can be obtained and dependence of such terms on retention limit
5. company’s familiarity with underwriting the type of business involved
6. effect on company’s regulatory capital requirements of increasing or reducing retention limit
7. existence of profit-sharing arrangement in the reinsurance treaty
8. the company’s retention on its other products
9. the nature of any future increases in sums assured

Question 18

State 3 ways in which a cedant can use stochastic simulation to determine its retention limit (11)

(1,1)

(2,4)

(3,2)

Answer 18

• Stochastic simulation - reinsurance only
  
  1. Determine retention limit such that probability of loss/insolvency (ruin probability) kept below certain level
     or
     
     2. Aim for a P(loss in any one quarter or year) does not exceed a proportion of the earnings of the business, if that is how the cedant determines its risk appetite.
• Stochastic simulation - reinsurance and fluctuation reserve
• Use stochastic simulation to determine a retention level that minimises the total of
  
  1. cost of financing an appropriate mortality fluctuation reserve, and
  2. cost of obtaining reinsurance
     As retention limit increases, (1) will increase and (2) will decrease
• Financial economics approach
  
  1. ​Based on the theory of efficient investment frontiers, and looks at reinsurance as an asset class that allows the company to optimise its risk and reward trade off.
  2. Allows identification of asset portfolios including reinsurance, which cannot be bettered in terms of either reducing risk for no reduction in return, or increasing return for no increase in risk.

Question 19

State the methods for the Stochastic simulation - reinsurance only retention limits.

Answer 19

• Stochastic simulation - reinsurance only
  This can be done by using a stochastic model for projecting claim rates and a model of the business, so that claims can be projected forward together with the value of the company’s assets and liabilities. By using simulation, a retention level can then be determined such that the company stays solvent, or earnings stay above a certain level, for 995, say, out of 1,000 runs.

Model the following stochastically:
1. # of deaths, but more NB variance of deaths for each grouping - depends on mean mortality rate and random fluctuations variance for each group.
2. Expected mean mortality (subject to parameter error).

Question 20

When an insurer is deciding on reinsurance, describe how factors relating to counterparty risk may arise (2)

How might an insurer reduce its counterparty risk? (1)

Answer 20

Counterparty risk arises as follows

• Cedant retains liability to the policyholder for the benefits even if the reinsurer becomes insolvent and can not meet claim payments as they become due. Amount of exposure known as credit risk.
• The greater the counterpaty risk, the less valuable the value of reinsurance

An insurer may reduce its counterparty risk by:

• reinsuring with multiple reinsurers, thereby diversifying its risk

Question 21

How might a supervisory authority help insurers to manage counterparty risk (4)

Answer 21

To manage insurers’ counterparty risk from reinsurance, supervisory authorities in certain countries may

• require reinsurer to collaterise/deposit back its share of the total reserve under a reinsurance contract with a cedant
• generally only applicable to coinsurance where level reinsurance premiums paid, since reinsurer would have to set up reserve from past prems received as with any other long term prem insurance contract
• for normal risk premium contracts, reinsurance prems operate as recurring single prems, so insurer hold all of policy reserve anyways; no need for deposit back
• may be used even if not supervisory requirement, giving cedant benefit of reinsurance, while maintaining reserve for whole contract

Question 22

When it comes to counterparty risk for reinsurance contracts, what are the benefits of direct deposits for

(a) insurer (1) and
(b) reinsurer (2)?

Answer 22

Benefits of deposits back

• For insurer/cedant/direct write
  
  • more profitable, allows for maximum funds (reserve) available to invest, hence can earn investment profits
• For reinsurer
  
  • e.g. on with profits business an original terms arrangement would normally leave reinsurer with significant investment risk, because it would have to match the insurer’s bonus rates on maturity, but by depositing back reserves it will avoid investment risk.
  • avoid problems of investing in unfamiliar market.

Question 23

When an insurer considers the use of reinsurance, what legal risks may arise that it should take note of? (6)

Answer 23

• reinsurance is governed by a treaty between ceding company and the reinsurer
• regading reinsurance treaties
  
  • usually many clauses to be negotiated to cover numerous contingencies and risks, each one potentially impacting price of the reinsurance.
  • due to operational risks involved and the impact of disputes where contracts have not been finalised, regulators are increasingly focused on ensuring that reinsurance treaties are complete and signed.
• regading treaties being watertight
  
  • also in direct interest of insurer to ensure treaties are legally watertight, in order to avoid problems including the risk that reinsurance recoveries would not be recoverable from the reinsurer to the extent expected.

Question 24

Reinsurance examples: large established mutual, with profits (5)

Answer 24

1. may not purchase reinsurance
   
   • healthy free assets and writes mainly with profits business,
   • it will be able to absorb a fairly high level of mortality risk and will probably be able to finance new business from its own resources.
2. risk premium reinsurance
3. some catastrophe cover

Question 25

Reinsurance examples: new unit-linked company, limited capital (18)

Answer 25

1. New business strain reduction is key focus
   
   • enabling company to grow faster and reach critical mass without the financial limitations imposed by emplying just its own capital resources
2. Quota share with low retention
   
   • Individual surplus, to reduce any mortality or morbidity risk whilst the portfolio is small.
3. Risk premium reinsurance
   
   • allows build up of retained premium income quickly.
   • unit linked business wouldn’t normally use original terms reinsurance since
     
     • reinsurer would need to match the unit liability under the reinsured part of the contracts and
     • if the link is to the ceding company’s internal fund it would not be able to do this directly.
     • deposit backs may be used to get around this.
     • can be arranged very much like mortality charge arrangement in place for policyholders.
   • Little point in reinsuring using original terms since liabilities and assets should match.
4. Financing commision arrangement
   
   • combined with risk premium reinsurance…
   • …in order to help reduce new business strain…
   • …if such an arrangement effectively reduces capital requirements under local regulations.
5. Catastrophe reinsurance
   
   • Market capacity has reduced and price has increased though.

Question 26

Reinsurance examples: large proprietary, expanding rapidly, declining free assets (8)

Answer 26

1. Reducing financing requirement
   
   • consider other options for raising capital and compare the pros and cons with the use of reinsurance
2. Reduce capital employed
   
   • Creating leverage, and so increasing the company’s own return on capital.
3. Financial reinsurance
   
   • if effective under the relevant regulatory regime, it could opt for financing reinsurance agreement based on its large in force portfolio.
4. Risk premium reinsurance
   
   • with financing commission, with the retention limit set such that the company obtains its required reduction in new business strain, but without giving away too much profit to the reinsurer.
5. Catastrophe cover
   
   • in view of its reducing free assets.
   • may also raise capital, should compare pros and cons with use of reinsurance.
6. Stop loss reinsurance
   
   • cedant cannot manage on its own, so allowing manufacture of product lines, e.g. if cedant had a large concentration of risk in a certain geographical location then the cedant could reinsure this and still be able to write business.

Question 27

Reinsurance examples: company writing large amount of group life business (6)

Answer 27

1. Adverse flactuations in mortality experience
   
   • catastrophe risk
2. Individual surplus arrangement
   
   1. with fairly high retention on a risk premium basis, if company is large
3. Quota share basis
4. Experience refund agreements

Question 28

Reinsurance examples: new company, low sum assured term assurance (4)

Answer 28

1. quota share original terms, with low retention percentage
2. profit share agreement
3. stop loss
4. catastrophe risk