Reinsurance

1
Reinsurance

• The Role, Importance, Functions of Reinsurance

2
What is Reinsurance?

• A transaction between insurance companies to
  distribute loss between them
• In return for a consideration (premium) an
  insurer transfers some of its loss exposure to a
  reinsurer
• Reinsurer agrees to indemnify the insurer for
  losses falling within the agreement

3
Readings

• An introduction to reinsurance
• Reinsurance a systemic risk?
• Both are Sigma Swiss Re. articles in the readings
  package

4
What is Reinsurance?

• Reinsurance agreement is a separate contract
  between insurer and reinsurer
• A response to losses arising under the original
  contract between insurer and policyholder

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Reinsurance Defined

• The transfer of part of risk that an insurer
  assumes via legal contract to a second insurance
  carrier
• That carrier (the reinsurer) has no direct
  contractual relationship with the insured

6
Reinsurance Markets

• Insurance companies (top 4 companies have 39 of
  volume)
• Professional reinsurance companies
• Exchanges
• Reinsurance pools
• Captive insurance companies

7
Why the need?

• Increasing industrialization produced
  concentrations of value
• Demand for insurance grew
• Insurers needed to transfer their growing risk
• Demand for reinsurance cover grew

8
Licensed vs. Unlicensed

• Licensed reinsurers are under supervision of both
  federal and provincial regulations
• Benefits of regulation
• Unlicensed reinsurers are not regulated
• Not necessarily unsatisfactory

9
Licensed vs. Unlicensed

• Reasons for providing unlicensed reinsurance
• Substantial investment required to become
  licensed
• Reasons for buying unlicensed reinsurance
• Specialized reinsurance
• Availability of greater limits

10
Functions of Reinsurance

• Four key functions, serving as important keys to
  the role of reinsurance are
• Financing
• Stabilization
• Capacity
• Resource protection

11
Balanced Unbalanced Portfolios

• Balanced - Consisting of many similar and
  equivalent risks, which collectively balance
  losses
• Unbalanced one-off exposures nuclear or
  aviation coverage
• Huge loss exposure

12
Concerns with Financial Stability

• Exposure of reinsurers in credit capital
  markets is cause for concern
• Reinsurance lacks transparency and creates a
  possible source of systemic risk
• Result zero cover bankrupt primary insurers
  bankrupt lenders

13
Defining Systemic Risk

• The danger that an event will trigger a loss of
  economic value and/or confidence in the financial
  system
• Will have significant adverse effects of the real
  economy
• Bank run poorer countries
• Bank run cannot occur with reinsurers

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Financing

• For business growth and progress, both short and
  long-term
• Reinsurance can be used to improve the
• Ratio of assets to liabilities ratio
• Ratio of net premiums written to capital and
  surplus
• Indirectly is the equivalent of providing
  additional financing

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Financing cont

• Solvency regulations are vital in Canada
• Assets to Liabilities ratio (must equal each
  other plus a margin calculated by regulators)
• Unearned Premium Reserve and O/S Loss Reserve
  funds protection for insured
• Minimum Asset Test

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Financing cont

• Example
• An insurer has unearned premiums reserves of
  50,000,000 and outstanding loss reserves of
  55,000,000.
• An additional amount of margin required by the
  regulators for the MAT is 15 of liabilities

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Financing cont

• Therefore,
• Unearned Prem. 50,000,000
• Loss reserve 55,000,000
• Total Liabilities 105,000,000
• 15 Margin required 15,750,000
• Liability Margin 120,750,000
• Total Assets 115,000,000
• Deficit (5,750,000)

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Financing cont

• Insurer needs to raise additional capital to the
  tune of 5,750,000!
• Alternatively, insurer arranges a Quota Share
  reinsurance transaction to cede 30 of its
  business in return for a premium of 25 of
  unearned premiums

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Financing cont

• Quota Share Transaction
• 30 of Unearned Premium 15,000,000
• Less 25 Reins. Commission
• 3,750,000
• Balance 11,250,000
• 30 of Loss Reserve 16,500,000
• Payment to reinsurer 27,750,000

20
Financing cont

• Net Premiums Written to Capital Surplus Ratio
• Generally, net premiums should not exceed the
  amount of capital and surplus by more than a
  certain factor acceptable to regulators (3X)
• Quota Share Treaty can reduce (cede) volume to a
  reinsurer to lower this ratio

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Financing cont

• Advantages
• Readily available
• Filing with securities authorities is not
  required
• No dilution of shareholders equity
• Simple to administer
• Negotiable terms for repatriation on a flexible
  basis
• Provides time to study long-term needs

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Financing cont

• Disadvantages
• A volume of business is given away
• Cost to the insurer is generally high

23
Stabilization

• Corporate planning needs stability
• Management wants predictable results
• Fluctuations add uncertainty and make steady
  progress a difficult task
• Reinsurance is an important tool for stabilizing
  an insurers results

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Stabilizing Crises

• Claims from 9/11 were 40 billion
• Reinsurance sectors withstood without any major
  defaults in payments etc.
• Proved the system works
• Proved the capacity was not at risk

25
Reinsurance to Stabilize

• Working Excess of Loss Treaty
• When insurer expects claims activity
• Loads work/claims on reinsurer (expected)
• aka Spread Loss Cover
• Surplus Treaty
• smoothes a portfolio removes peaks

26
Reinsuring to Stabilize

• Facultative
• Peaks can be removed on an individual basis
• Catastrophe Excess of Loss Treaty
• Disasters
• Protects against infrequent but potentially
  harmful claims
• Stop Loss Treaty
• Designed to limit insurers loss to a specific
  of GWP

27
Capacity

• Most insurers are required to insure amounts
  larger than their own resources can provide
• To attract business (big clients/premiums)
• To compete with the big dogs for competitive
  reasons
• To cater to the needs of its agents

28
Capacity cont

• Surplus Treaty
• Provides capacity in multiples of the insurers
  net
• Facultative
• Easy way to add substantial extra capacity
• May be costly, though

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Capacity cont

• Quota Share
• increases retention via a multiplier effect on
  surplus treaty
• Per Risk Excess of Loss Treaty
• Casualty classes
• Enables insurer to write larger amounts

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Resource Protection

• Protection is sought for resources such as
• Capital and surplus
• ELR - results
• Investments
• Protects vs. disaster/catastrophe
• Choice higher retention, less costly
• Insurers purchase a great deal of reinsurance
  protection spread of risk

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Methods of Reinsurance

• Proportional (Pro-Rata)
• A of the risk is transferred to the reinsurer
• Reinsurer receives the same of the original
  premium and each loss incurred
• Process of transferring the risk is termed,
  ceding
• Amount of risk ceded is the cession

32
Methods of Reinsurance

• Non-Proportional Reinsurance
• Retention is agreed upon in specific terms
• Insurer pays all losses up to a predetermined
  amount (priority excess point, attachment point,
  deductible, retention)
• Insurer covers majority of small claims
• Aka Excess of loss or XL reinsurance

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Methods of Reinsurance

• Non-Proportional Reinsurance cont
• Premium charged will be part of the original
  insurance premium but not proportional to the
  amount of loss the reinsurer might be called upon
  to pay

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Non-Proportional An Example

• Assume a reinsurer agrees to pay the part of a
  loss which exceeds the retention of 500,000 up
  to an amount of a further 1,000,000
• Total loss 300,000
• Insurer pays 300,000, reinsurer pays 0
• Total loss 750,000
• Insurer pays 500,000, reinsurer pays 250,000
• Total loss 1,350,000
• Insurer pays 500,000, reinsurer pays 850,000

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Types of Reinsurance

• Facultative
• Placed on an individual risk/policy basis
• Each party has absolute free-choice in arranging
  the reinsurance
• Can be either proportionate or excess of loss
  basis
• Normally a small proportion of the total
  reinsurance of any insurer
• Usually involves large risks

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Facultative cont

• Costly due to negotiation of one-off risk
• Non-prop can be placed in multiple layers (into
  excess layers on top of the insurers retention)
• Can be placed with one or more insurers (similar
  to standard subscription policies)
• Info to be provided underwriting, processing,
  accounting, claims etc.

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Facultative cont

• In Property classes
• Both on a pro rata and excess of loss basis
  (mainly used for large complex risks)
• Reduces risks for large individual risks
• In Liability classes
• Almost exclusively used on an excess of loss
  basis (e.g. what if? pharmaceuticals exposure)

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Facultative Reinsurance cont

• Proportional reinsurance terms can be
  negotiated (proportion to be accepted and
  commission rate)
• Non-Prop. reinsurance reinsurer quotes the
  price for reinsurance (catastrophes)
• Pro rate costs overhead
• Adjusting costs
• Layering
• More than one reinsurer involved

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Types of Reinsurance

• Treaty
• Entire line (portfolio) is covered by agreement
• Neither can pick and choose risks
• Insurer doesnt have freedom to decide whether to
  place reinsurance or which reinsurer to use
• Reinsurer obligated to accept the reinsurance
  with no option to decline

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Types of Reinsurance

• Treaty cont
• Less costly
• Both proportional and non-prop.
• Underwritten via company, management, and results

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Types of Reinsurance

• Proportional Treaties
• Quota Share simplest single fixed
• Insurer and reinsurer agree that the cessions
  will always be a single fixed of each risk
  included in the portfolio of business reinsured
• Embraces all business written by an insurer
  therefore it is all-inclusive and rigid
• Insurer must cede every risk

42
Proportional Reinsurance cont

• May be restricted to a specific class, a
  specified territory, or a designated broker-force
• Annual negotiations to determine rates
• Simpler payments and administration
• Surplus negotiated one risk at a time
• Retention line

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Surplus Treaties

• Percentage ceded of each risk is not fixed
• Insurer makes decision about the percentage to be
  ceded one risk at a time
• Capacity is expressed as lines of insurers
  retention
• Minimum retention specified for insurer

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Surplus Treaties

• Parameters which can allow the insurer to vary
  the cession amount
• Maximum number of lines
• Maximum dollar capacity
• Minimum dollar retention
• Second Surplus additional capacity
• First Surplus issued before the Second

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Surplus Treaties

• Similar in costing to facultative
• There are several advantages to insurers
• More spread of risk
• Insurer retains more quality (or
  desirable)business

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Treaties

• Facultative Obligatory treaty insurer is free
  to decide what to reinsure but once its decided
  theyre obligated to accept the treaty
• A half half solution
• Facultative for insurer obligatory for reinsurer
• Similar to surplus treaty
• Reduces facultative expenses

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Surplus Treaties cont

• Balance via ratio of premiums to maximum capacity
• Less balanced
• Net account cover separate calculation
• Gross account cover all-in-one formula
• Administration is cheaper quicker
• Analysis is straightforward
• Unaffected by quota share changes

48
Non-Proportional Treaties

• Per Risk Excess of Loss
• Mainly for Property risks
• Limits loss to insurers retention of risk
• Cover applies to each physical risk separately
• i.e. windstorm damages number of houses in
  community. Total amount exceeds retention, but
  each loss is less than the retention. Reinsurer
  pays nothing. In a Per Risk XL treaty, the
  damage to a single risk must exceed retention
  before reinsurer becomes involved

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Non-Proportional Treaties

• Per Risk Excess of Loss
• Can be used separately or with other treaties
• Advantages
• Easier administration
• Comparable experience
• Changes to gross account cover are unaffected to
  changes to the Quota Share

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Non-Proportional Treaties

• Per Event Excess of Loss Treaty
• All losses from the same event are aggregated and
  reinsurer will get involved if the aggregate
  exceeds retention
• Used in both Property Liability classes

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Non-Proportional Treaties

• Per Event XL Treaty
• Catastrophe Excess of Loss Treaty
• Accumulation of small losses
• Ultimate net loss
• Casualty Excess of Loss Treaty
• Working Layer Treaty claims activity expected
• Buffer or Shock Layer Treaty retention beyond
  normal expected loss
• Clash Layer Treaty retention exceeds single
  policy limit

52
Non-Proportional Treaties

• Stop Loss Treaty
• Protects annual result of a class of business
• Retention usually expressed in terms of insurers
  loss ratio