Chapter 30: Risk transfer Flashcards
(23 cards)
List 6 possible responses from which a stakeholder can choose when faced with a risk
- Avoid the risk altogether
- Reduce the risk, i.e. by either reducing the probability of occurrence or the consequences or both
- Reject the need for financial coverage of that risk because it is either trivial or largely diversified
- Retain all the risk
- Transfer all the risk
- Transfer part of the risk
How could each risk mitigation option be evaluated?
- The likely effect on frequency, consequences and expected value
- Any feasibility and cost of implementing the option
- Any “secondary risks” resulting from the option
- Further mitigating actions to respond to secondary risks
- The overall impact of each option on the distribution of NPV
What factors affect whether a stakeholder retains or transfers risk?
- How likely the stakeholder believes the risk event is to happen
- The stakeholder’s risk appetite
- The resources that the stakeholder has to finance 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
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
* Possible liquidity issues
* Reinsurer may default
* Reinsurer may not be available on terms saught
Outline the reasons why a provider might 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 cendant
- Is written by treaty
- The two 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 cedants 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 relative 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 major 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 a large single claim, a aggregation of claims or a catastrophic event
- Smoothes profits by reducing claim 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
What are the advantages and disadvantages of excess of loss reinsurance?
Advantages:
* Caps losses, hence allows the cedant to take on risks that could produce very large claims
* Protects the cedant against individual or aggregate large claims
* Helps stabilise profits from year to year
* Helps make more efficient use of capital by reducing the variance of the claim payments
Disadvantages:
* 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 expenses and profit
* From time to time, excess of loss premiums may be considerably greater than the pure risk premium for the cover (due to for example, poor experience over the last few years)
What is Alternative Risk Transfer (ART) and what products fall under this category?
Alternative Risk Transfer (ART) is an umbrella term for non-traditional methods by which organisations can transfer risk to third parties. Broadly, these producs combine traditional insurance and reinsurance protection with financial risk protection, often utilising the capital markets.
There are many types of ART contract, including:
* Integrated risk covers
* Securitisation
* Post loss funding
* Insurance derivatives
* Swaps
Discuss “Integrated risk covers”
These are typically arranged between insurers and reinsurers
Integrated risk covers are reinsurance arrangements that typically cover several lines of general insurance business for several years.
These 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 across more (uncorrelated) lines
Cost savings arise because there is no longer the need to negotiate several separate reinsurance arrangements and also because integrated risk covers are multi-year arrangements that do not need to be renegotiated every year.
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.
The 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 provider 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.
Discuss 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 involves turning a risk into a financial security, e.g. as in a catastrohpe bond.
In simple terms, the catastrohpe bond might work as follows:
1. An investor purchases a bond from the insurance company and therefore provides a sum of money to the insurer.
2. The repayment of capital is contingent on a specified event not happening
3. If the event does happen, the insurer uses the sum of money provided from the investor to cover the cost of claims arising from the earthquake. The investor may get part of their capital back depending on the severity of the claim.
4. If the event does not occur, the investor gets their interest and capital back in the normal way.
The rationale is that insurance catastrophe risk is not correlated with market (systematic) risk and so there is a benefit to investors.
Discuss post loss funding
Post loss funding is a way of raising capital to cover the losses from a risk after the risk event has happened.
Post loss funding 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.
The commitment fee will be lower than the equivalent insurance cost (because the cost of the funding will in the most part be borne after the event has happened). Thus, before the loss happens the contract appears cheaper than conventional insurance
Discuss 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.
Discuss 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, the swapping uncorrelated risks would provide some risk diversification.
For example:
1. A reinsurer with exposure to Japanese earthquakes may swap some of this risk with a reinsurer with exposure to hurricanes in Florida
2. With increasing volumes of annuities as the post-war “baby boom” generation in developed countries ages, longevity swaps are becoming popular.
3. 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 two organisations can however swap their risks.
List the 8 main reasons for using ART
- Provision of cover that might otherwise be unavailable
- Stabilisation of results
- Cheaper cover
- Tax advantages
- Greater security of payment
- Management of solvency margins
- More effective provision of risk management
- As a source of capital
