Reinsurance

1
Reinsurance Risk Transfer

• RMI 4700
• Insurance Operations
• Robert Klein

10-12-09
2
Reinsurance Transactions
Reinsurance is a contractual agreement under
which the primary insurer transfers some or all
of its loss exposures to a reinsurer.
?
Primary Insurer
Reinsurer
Retrocessionaire
3
Functions of Reinsurance

• Stabilization of loss experience
• i.e., hedging
• Large-line capacity
• full retention of large exposures not feasible
• Financing
• keep leverage reasonable, offset SAP penalty
• surplus aid and financial reinsurance
• Catastrophe protection
• Underwriting assistance
• Withdrawal
• portfolio transfers

4
Stabilization of Loss Experience
5
Relationships Insolvencies

• Typically, there is no contractual relationship
  between primary insured and reinsurer.
• recourse only through receiver of insolvent
  insurer
• Exception cut-through endorsements
• Offsets
• Typically, a reinsurer can offset any receivables
  from insolvent insurer against reinsurers
  obligation to insolvent insurer.
• Primary insurer still obliged to insured even if
  reinsurer fails to meet obligations.

6
Types of Reinsurance

• Facultative Reinsurance
• Primary insurer and reinsurer negotiate a
  specific agreement for a particular
  risk/exposure.
• Best suited for unique, large exposures.
• High transaction costs.
• Treaty Reinsurance
• Reinsurer is obligated to accept all business
  that falls within the terms of the treaty.
• Lower transactions costs but greater potential
  for adverse selection.
• Best suited for numerous, smaller exposures that
  are more similar.

7
Types of Reinsurance
8
Quota Share Treaties

• Primary insurer cedes a fixed, predetermined of
  premium losses on every risk it insurers within
  class(es) subject to treaty.

• Simple to rate administer.
• Does not stabilize underwriting results.

150,000 Policy

• Can help reduce reported expenses.
• Can cede profitable business.

75
100,000 Policy
75
50,000 Policy
25
75
25
25
9
Surplus Share Treaties

• Minimum limit of retention stated in of
  premiums losses ceded varies by policy.
• Avoids cessions on small policies.
• Better at providing large-line capacity.
• More costly to administer.
• Used on property risks, rarely liability.

Example 25,000 retention 250,000 limit
150,000 Policy
83
100,000 Policy
75
17
25
10
Excess of Loss or Nonproportional

• Per Risk or Per Policy
• Designed to protect against large losses, exclude
  small losses.
• Less premium submitted to reinsurer.
• Helps to stabilize loss experience.

Example Per Risk

• Per Occurrence
• Works well for catastrophes, clash cover.
• Can trigger even if there are a large number of
  small claims from one occurrence, e.g., storm.
• Definition of occurrence important.
• Reinsurer typically pays 90-95 of reinsured
  losses ? counters moral hazard.

Policy C
60,000 Loss
35,000

• Aggregate Excess

Policy A 8,000 Loss
Policy B 10,000 Loss
25,000
11
Functions Summarized
12
Facultative Reinsurance

• Reinsurer underwrites each loss exposure
  individually as submitted with detailed
  information.
• Primary insurers frequently obtain reinsurance
  commitment (on terms) before they quote a price
  to the primary insured.
• Advantages of Facultative Reinsurance
• Addresses exclusions and limits in reinsurance
  treaties.
• Used to protect reinsurance treaties.
• Obtain second opinion of reinsurer.

13
Types of Facultative Reinsurance

• Pro Rata
• Functions similarly to surplus share treaty.
• Excess
• Operates like per risk/policy excess treaty.
• Used primarily for liability/work comp, more
  recently for property.

1,000,000
Surplus Share Reinsurers 50
Facultative Reinsurance 40
Primary Co. Ret. 10
Pro Rata Example
100,000
500,000
400,000
14
Layering Reinsurance Example
The Safe Insurance Company (SIC) writes
homeowners insurance in Florida. It specializes
in large, expensive homes. Assume that the amount
of insurance on each home is 1,000,000.
Summary of SICs Exposures

• SIC has the following reinsurance program in
  place for its homeowners business in Florida
• A surplus share reinsurance treaty with Reinsurer
  A in which SIC retains the first 250,000 of
  losses on each home and Reinsurer A assumes any
  losses exceeding 250,000 up to a limit of
  1,000,000 on each home.
• A per occurrence excess-of-loss reinsurance
  treaty with Reinsurer B with a 100 million
  retention by SIC and a limit of 400 million.

15
Layering Reinsurance Example cont.
A severe hurricane strikes Broward, Dade County
and Palm Beach counties, causing insured losses
equal to 40 of total insured exposures in each
county. Assume that 40 of the homes insured by
SIC are totally destroyed but there are no losses
on the other homes insured by SIC. The table
below indicates the amount of losses suffered by
SIC on a direct (before reinsurance) basis.
16
Layering Reinsurance Example cont.

• How much will Reinsurer A pay to SIC according to
  its reinsurance contract?
• How much will Reinsurer B pay to SIC according to
  its reinsurance contract?
• What will be the amount of losses that SIC will
  retain after it is paid by its reinsurers?

17
Reinsurance Through Pools

• Organization of insurers banded together to
  underwrite reinsurance jointly.
• Motivations
• economies of scale
• increase capacity of small insurers
• government requirements

18
Reinsurance Planning Administration

• Factors Determining Reinsurance Needs
• Setting Retentions
• Setting Reinsurance Limits
• Cost of Reinsurance

19
Factors Determining Reinsurance Needs
20
Setting Retentions

• Depends on purpose and type of reinsurance.
• Pro rata treaties for surplus relief will depend
  on premiums ceded ceding commission.
• Retention in excess of loss treaties for
  stabilizing experience depends on the size of
  loss insurer can absorb without undue effects on
  surplus or loss ratio.
• Most states limit maximum possible loss on any
  one exposure to 10 of surplus.
• Retain that which is stable and predictable and
  cede that which is not stable and predictable.
• Treaties should be integrated.

21
Setting Reinsurance Limits

• Ideally, should cover most of the loss
  exposures of the primary insurer.
• Insurer may have target Prob. Max Loss (PML)
• Balancing protection against its cost.
• Higher layers require higher risk premiums.

22
Reinsurance Pricing

• Pro Rata Treaties
• Pro rata shares of losses premiums equal.
• Ceding commission to primary insurer will vary
  effectively determines price of reinsurance.
• Retrospective commission arrangements can be used
  to share profits and risk.
• Per Risk or Per Policy Excess Treaties
• burning-cost method
• Catastrophe
• Modeled expected loss p

23
Reinsurance Market

• Suppliers include both domestic U.S. reinsurers
  and non-U.S. reinsurers roughly split the U.S.
  market for reinsurance.
• Some firms solely provide reinsurance others
  provide both primary and reinsurance.
• Reinsurance market subject to cycles
  fluctuations in supply or capacity and
  underwriting/pricing.
• Historically, long-term relationships between
  primary insurers and reinsurers provided
  stability.
• As relationships have eroded, market has become
  more volatile.

24
Cat ROL Reinsurance Price Index
Rate on Line premium paid as of exposure
25
Global Reinsurance Capitalization
Source Guy Carpenter
26
Regulation of Reinsurance

• U.S. reinsurers alien licensed insurers
  regulated like primary insurers for solvency
• Terms of reinsurance contracts not regulated
  directly.
• State regulators regulate reinsurance through
  granting of accounting credit.
• Credit can depend on contract reinsurer.
• Unauthorized reinsurers must post collateral
  for ceding insurer to get credit.
• Conflicts between U.S. and non-U.S. insurers over
  regulation.

27
Government Reinsurance

• Examples
• Terrorism Risk
• Crop Insurance
• State Cat Reinsurance (Florida)
• Proposals for Federal Cat Reinsurance
• Issues
• Is there a gap in supply of private reinsurance?
• Desire to have government subsidize cost of
  insurance/reinsurance.