Chapter 30: Risk transfer Flashcards
(22 cards)
List 6 possible responses from which a stakeholder can choose when faced with a risk.
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)
How could each risk mitigation option be evaluated?
FIRM
* Feasibility and cost of implementation
* Impact on frequency / severity / expected value
* Resulting secondary risks
* Mitigation required in response to secondary risks.
What are 5 factors that affect whether a stakeholder retains or transfers risk?
- The cost of passing it on
- The willingness of another party to take it on
- The likelihood of the risk event occurring
- The capital the stakeholder has with which to absorb the risk event.
- The stakeholder’s risk appetite.
Outline the main benefits and costs of reinsurance
Benefits:
* Reduction in / removal of risk
* Reinsurer may offer competitive terms for admin, actuarial services and advice
Costs:
* 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
* Possibly liquidity issues
* Reinsurer may default
* Reinsurance may not be available on terms saught.
Outline the reasons why a provider may purchase reinsurance
- A reduction in claims volatility and hence:
- smoother profits
- reduced capital requirements
- an increased capacity to write more business and achieve diversification - The limitation of large losses arising from:
- a single claim on a single risk
- a single event
- cumulative events
- geographical and portfolio concentration of risk
and hence:
- a reduced risk of insolvency
- increased capacity to write larger risks.
- Access to the expertise of the reinsurer.
Outline the 2 contract variations on which reinsurance may be arranged
- 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 - 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
What are the key features of proportional reinsurance?
- Claims are split between the cedant and the reinsurer in pre-defined proportions
- Does not cap the claim paid by the cedant
- Is written by treaty
- The 2 types are Quota share and surplus
- Under QS, the proportion claim split is the same for all risks
- Under surplus, the proportion can vary by risk.
- The reinsurer may also pay the cedant a reinsurance commission, which can be used to provide financial assistance.
What are the advantages and disadvantages of quota share reinsurance?
Advantages:
* QS is useful for small, new or expanding cendants who want to diversify their risk, write more risks or who would like reciprocal business
* Administration is relatively simple, since it is written by treaty and a constant proportion is ceded for all risks
Disadvantages:
* It is inflexible in that the same proportion of each risk is ceded, irrespective of the size or potential volatility.
* A share of profits will also be passed to the reinsurer
* It does not cap large claims.
For which type of business is a fixed retention level surplus reinsurance used?
Used for high volume, relatively homogeneous classes of business, such as life insurance or personal lines general insurance
For which type of business is a variable retention level surplus reinsurance used?
Used for heterogeneous classes of business, e.g. commercial property and business interruption insurance
What are the advantages and disadvantages of surplus reinsurance?
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 related to quota 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
What are the key features of non-proportional reinsurance?
- 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.
- There may be an upper limit on what the reinsurer is prepared to pay
- There may be different layers of excess of loss reinsurance, each with a different reinsurer.
- 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)
- The retention level / upper limit may be indexed over time for inflation
- The reinsurer determines the reinsurance premium
- XOL can cap the claims paid by the cedant
- XOL may or may not be written using a treaty.
Define 4 different types of XOL reinsurance contracts
- Risk XL covers losses from a single claim from one insured risk
- Aggregate XL covers the aggregate losses from several insured risks, sustained from a defined peril (or perils) over a defined period, usually one year.
- Catastrophe XL is a form of aggregate XL reinsurance that pays out if a “catastrophe”, as defined in the reinsurance contract, occurs.
- 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 majore class of business) over a specified period, usually one year.
State the 3 main uses of XOL reinsurance
- Opportunity to write larger risks
- Reduces risk of insolvency from large single claim, a aggregation of claims or a catastrophic event.
- Smoothes profits by reducing claims fluctuations
In what situation would surplus reinsurance and risk XL reinsurance provide the same cover?
Where the risk event can only result in the payment of the full sum assured, there is no difference between risk XL and surplus.
List 5 ART products
- Integrated risk covers
- Securitisation
- Post loss funding
- Insurance derivatives
- Swaps
Describe ‘integrated risk covers’
These are typically arranged between insurers and reinsurers.
They are often written as multi-year, multi-line covers and will give premium savings due to cost savings and to greater stability of results over longer time periods and acrosss more (uncorrelated) lines.
They are used to:
* Avoid buying excessive cover
* Smooth results
* Lock into attractive terms
They can be used as a substitute for debt or equity in the investment portfolio of the original insurer.
Possible disadvantages include:
* credit risk in relation to the cover provider
* lack of availability
* expenses arising from the tailor-made aspect of the deal, as the cover provided would need full insight into the dealings of the insurer seeking cover.
* difficulty in structuring the provider’s risk management programme in a holistic, multi-line way - as typically separate risk managers would be used for separate risk types.
Describe securitisation
This is the transfer of insurance risk to the banking and capital markets. Among other things it is used for managing risks associated with catastrophes, as the financial markets are large and capable of absorbing catastrophe risk.
Securitisation therefore involves turning a risk into a financial security.
The rationale is that insurance catastrophe risk is not correlated with market (systematic) risk and so there is a benefit to investors.
To date, the pricing of such contracts has been similar to that for traditional catastrophe reinsurance and much more expensive than similarly rated corporate bonds.
Describe post loss funding
Post loss funding is a way of raising capital to cover the losses from a risk after the risk event happened. Very often when a catastrophe occurs, it can be difficult for the insurance company to subsequently raise capital. In particular, not only will it be difficult to raise capital but any such capital will often have to be raised on unfavourable terms.
Post loss funding therefore guarantees that, in exchange for a commitment fee, funding will be provided on the occurrence of a specific loss. The funding is often a loan on pre-arranged terms or equity.
Describe insurance derivatives
In the energy, utility and large-scale agriculture sectors there is a real risk of being adversely affected by natural disasters or bad weather, and therefore these derivatives have become increasingly used. Use of these instruments within the insurance sector has been modest to date, but they offer a lot of potential in many other sectors such as building companies, tourist attractions, shops, restaurants, which can all be adversely affected by the weather.
The majority of the market for such derivatives is over-the-counter although exchange-traded contracts also exist.
Describe swaps, including examples
Organisations with matching, but negatively correlated risks can swap packages of risk so that each organisation has a greater risk diversification.
If organisations can’t find negatively correlated risks to swap, then swapping uncorrelated risks would provide some risk diversification.
Example 1: A reinsurer with exposure in Japanese earthquakes may swap some of this risk with a reinsurer with exposure to hurricanes in Florida.
Example 2: With increasing volumes of annuities as the post-war ‘baby boom’ generation in developed countries ages, longevity swaps are becoming popular. The arrangement may be set up in the form of a traditional swap, with the ‘fixed leg’ being based on expected annuity payments and the ‘floating leg’ being the actual annuity payments
Example 3: Swaps can also be set up between non-insurance organisations with opposite risks. For example, energy companies dislike warm weather as consumers use less of their product. Conversely, household insurers dislike cold weather as it leads to insurance claims. The 2 organisations can, however, swap their risks.
List the 8 main reasons for using ART
- Provision of cover that might otherwise be unavailable
- Stabilistaion of results
- Cheaper cover
- Tax advantages
- Greater security of payments
- Management of solvency margins
- More effective provision of risk management
- As a source of capital
