Ch 30: Risk Transfer

Question 1

List 6 possible responses from which a stakeholder can choose when faced with a risk

Answer 1

PIRATE

• Partially transfer (to another party)
• Ignore (reject then need for financial coverage as the risk is either trivial or largely diversified)
• Reduce (frequency and/or severity)
• Accept (retain all)
• Transfer (to another party)
• Evade (avoid the risk altogether)

Question 2

How could each risk mitigation option be evaluated?

Answer 2

FIRM

• Feasibility and cost
• Impact on frequency / severity / expected value
• Resulting secondary risks
• Mitigation required in response to secondary risks

Question 3

What 5 factors affect whether a stakeholder retains or transfers risk?

Answer 3

1. The cost of passing it on
2. The willingness of another party to take it on
3. The likelihood of the risk event occurring
4. The capital the stakeholder has with which to absorb the risk event.
5. The stakeholder’s risk appetite

Question 4

Outline the main benefits of reinsurance

3

Answer 4

1.A reduction in claims volatility and hence:
- smoother profits
- reduced capital requirements
- an increased capacity to write more business and achieve diversification.

2.The limitation of large losses arising from:
- a single claim on a singe risk
- a singe event
- cumulative events
- geographical and portfolio concentration of risk
and hence:
- a reduced risk of insolvency
- increased capacity to write larger risks

3.Access to the expertise of the reinsurer.
* Competitive terms for admin, services, advice
* Assist to launch products

Question 5

Outline the main costs of reinsurance

4

Answer 5

• Profit is passed from cedant to reinsurer
• Reinsurance premium is likely to exceed cost of benefits (in the long run) as it will contain loadings for expenses, profit and contingencies.
• Liability may not be fully matched by reinsurance
• Possible liquidity issues
• Reinsurer may default
• Reinsurance may not be available on terms saught

Question 6

Outline the two contract variations on which reinsurance may be arranged.

2

Answer 6

1.Facultative:
- Arranged on a case-by-case basis.
- This is typically done for particularly large risks, but the insurer is not obliged to cede these risks to the reinsurer, but neither is the reinsurer obliged to accept them.

2.Treaty
- A defined GROUP of policies is covered by the treaty.
- The reinsurer is OBLIGED to accept these risks, subject to conditions as set out in the treaty.

Question 7

What are the key features of proportional reinsurance?

4

Answer 7

• Reinsurer covers agreed proportion of each risk.
• Fixed proportion (Quota)
• Variable proportion (Surplus)
• Written by a TREATY and no cap on payout made by cedant

Reciprocal agreements between companies

Question 8

Quota Share reinsurance
Def+ Adv+Dis

2,2,3

Answer 8

• Fixed % of each risk is reinsured, outlined in the treaty
• Used to spread risk to write larger volumes of business. (reciprocal Re)

Advantages:
1. QS is useful for small, new or expanding cedants who want to diversify their risk, write more risks or who would like reciprocal business.
2. Administration is relatively simple, since it is written by treaty and a constant proportion is ceded for ALL risks.

Disadvantages:
1. It is INFLEXIBLE in that the same proportion of each risk is ceded, irrespective of the size or potential volatility.
2. A share of profits will also be passed to the reinsurer.
3. It does not cap large claims.

Question 9

Surplus reinsurance
Def+Adv+Dis

2,2,2

Answer 9

• Cedant has discretion in choosing amount of risk to retain
• Cedant chooses a retention limit rather than specifying % for each risk

Advantages:
- The proportion of each risk passed to the reinsurer can vary from risk to risk, allowing the cedant the opportunity to ‘fine-tune’ its exposure. It is therefore useful where risks are heterogeneous in nature.
- Surplus is useful for cedants who want to diversify their risk, write more risks or who would like to be able to write larger risks.

Disadvantages:
- Surplus treaties are more complex and expensive relative to quote share due to the extra administration in particular of assessing and recording each risk separately. Therefore, surplus is generally more appropriate for larger, more heterogeneous risks such as commercial property.
- It does not cap large claims.

Question 10

What are the key features of non-proportional reinsurance?

Answer 10

1. The cedant specifies a retention level. The cedant pays the claim amount up to the retention level; the reinsurer pays the claim amount over the retention level.
2. There may be an upper limit on what the reinsurer is prepared to pay.
3. There may be different layers of excess of loss reinsurance, each with a different reinsurer.
4. The cedant may be required to retain a proportion of risk within each layer, so as to retain an INTEREST in the risk. (insurable interest)
5. The retention level / upper limit may be indexed over time for inflation.
6. The reinsurer determines the reinsurance premiun
7. XOL can cap the claims paid by the cedant.
8. XOL may or may not be written using a treaty.

Question 11

Define 5 different types of XOL reinsurance contracts

5

Answer 11

1.XL: Liability above retention limit is ceded to reinsurer until upper limit is reached.
2.Risk XL: covers losses from a single claim from one insured risk.
3.Aggregate XL: covers the aggregate losses above excess point from several insured risks, sustained from a defined peril (or perils) over a defined period, usually one year. (extention of risk XL)
4.Catastrophe XL: is a form of aggregate XL reinsurance that pays out if a “catastrophe”, as defined in the reinsurance contract, occurs.
5.Stop loss: is a form of aggregate XL that provides cover based on aggregate losses, from all perils, arising on a company’s whole account (or major class of business) over a specified period, usually one year.

Question 12

State the main reasons for using reinsurance

Answer 12

• Smooth results
• Avoid large losses
• Diversification
• Limit exposure to risk ( concentration/single event)
• Increase capacity to accept risk
• Financial assistance
• Expertise

SAD LIFE

Question 13

In what situation would surplus reinsurance and risk XL reinsurance provide the same cover?

Answer 13

Where the risk event can only result in the payment of the full sum assured, there is no difference between risk XL and surplus.

Question 14

Give factors that influence the type of reinsurance products used.

Answer 14

1. Type of business - homogeneous (QS) or heterogeneous (Surplus)
2. The size and volatility of claims. Is the insurer worried about single risks (risk XL), accumulations (agg XL) or catastrophes (cat XL)
3. Does the insurer have lots of free assets or does it need financial assistance? (e.g. the commissions associated with proportional reinsurance)
4. Is the insurer a mutual (worried about financial assistance) or proprietary (worried about smoothed profits)?
5. Does the insurer need expertise in a new or unusual product or new territory?
6. Does the insurer want diversification through reciprocal arrangements (QS)?

Question 15

List 5 ART products

1,5

Answer 15

• Alternate methods of transferring risk, can be easier and cheaper than Re

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

Question 16

Describe ‘integrated risk covers’

3

Answer 16

• These are multi-year, multi-line reinsurance contracts between insurers and reinsurers.
• Use retention and upper limits at the aggregate level

They give premium savings due to:
- the cost of savings (of not having to negotiate reinsurance separately for each class of business)
- greater stability of results over time and across more diversified lines

They are used to:
- avoid buying excess cover
- smooth results
- lock into attractive terms

Question 17

Describe securitisation

4

Answer 17

• This is the transfer of risk (often catastrophe risk) to the banking and capital markets.
• Turns risk into a financial security (converts illiquid assets into tradeable instrument)
• Securitisation may be packaged as a catastrophe bond. The repayments of interest and capital from the insurer to the banking and capital markets are contingent on the specified catastrophe NOT happening.
• The yield on such bonds is likely to be HIGHER than similar rated corporate bonds.

Question 18

Describe post loss funding

3

Answer 18

• Allow capital to be raised to cover losses after the risk event occurs.
• Terms are agreed in advance and a commitment fee is paid (loan)
• The commitment fee will be lower than the equivalent insurance cost (because the cost of funding will in the most past be borne after the event has happened). Thus, before the loss happens the contract appears cheaper than conventional insurance.

Question 19

Describe insurance derivatives

3

Answer 19

• Insurance derivatives include catastrophe and weather options.
• OTC traded
• eg Risk of mild winter - reduce energy for heaters - Buy weater put option w/strike in terms of avg temperatures over term
• The strike price will be based on a certain value of a catastrophe or weather index.

Question 20

Describe swaps, including examples

4

Answer 20

• Organizations with matching but negatively correlated or uncorrelated risks can swap packages of risk so that each organization has a greater risk diversification.

Examples:
- A reinsurer with exposure to Japanese earthquakes may swap some of this risk with a reinsurer with exposure to hurricane in Florida.

• Longevity swaps may exchange expected annuity payments (the ‘fixed leg’) with actual annuity payments (the ‘floating leg’)
• Energy companies (which have lower profits in warm weather) may swap temperature risk with household insurers (which suffer more claims in cold weather)

Question 21

List the 9 main reasons for using ART

Answer 21

DESCARTES

• Diversification
• Exploits risk as an opportunity
• Solvency improvement / source of capital
• Cheaper than reinsurance
• Available when reinsurance may not be
• Results smoothed / stabilized
• Tax advantages (possibly)
• Effective risk management tool
• Security of payments improved