23' Reinsurance

1
23. Reinsurance

• Dr. Jan-Juy Lin
• Dept. of Risk Management and Insurance
• ETP course, CNCCU

2
Introduction

• Worldwide risk sharing
• Reinsurance demand
• Reinsurance fundamentals and operations
• Reinsurance markets
• Reinsurance regulation

3

• Worldwide Risk Sharing Through Reinsurance

4
Fundamentals

• Insurance vs. reinsurance vs. retrocession
• Retention vs. cession
• The amount of risk retained / transferred
• Privity of contract vs. cut-through provision
• The insureds cant / can seek recoveries from the
  reinsurers while the insurer fail to meet its
  obligation

5
Fundamentals

• Reciprocal agreement
• Each insurer transfers a portion of its risks to
  another insurer and vice versa
• Direct insurers purchase reinsurance for
• Hedge volatilities
• Minimize potential loss
• Secure greater underwriting capacity

6
Worldwide Risk Sharing (Figure 23.1)
7
Worldwide Risk Sharing (Figure 23.1)
8
Rationales for Reinsurance Demand

• Ownership structure
• Many insurers are neither diversified nor widely
  held. For them, reinsurance allows
  diversification of their loss exposures beyond
  their internal pool.
• Cost of financial distress
• Insurers may purchase reinsurance to reduce
  attendant costs by purchasing reinsurance.
  Insurers have incentive to reduce their default
  risk with the reinsurance.

9
Rationales for Reinsurance Demand

• Capital market imperfections
• Potential investors dislike insurers facing large
  potential losses. Reinsurance may reduce the
  investment disincentive.
• Real service efficiency
• Reinsurers with broad exposures bases may have
  real efficiencies in risk diversification
  associated with low probability events.

10
Rationales for Reinsurance Demand

• Reduction of tax liability
• The direct insurers reduce expected tax liability
  by purchasing reinsurance and reducing the
  taxable income. (e.g. transferring earning and
  minimizing taxes for a group, e.g. higher tax
  domiciles to lower ones)
• Volatility control
• Effective use of reinsurance also can provide an
  insurer with more predictable cash flows and less
  earnings volatility.

11
Rationales for Reinsurance Demand

• Regulatory constraints
• Regulation limits insurers financial leverage
• An insurer can reduce its leverage by purchasing
  reinsurance
• The higher the leverage, the greater the demand
  for reinsurance.
• Ceding commission to increase underwriting
  capacity.

12

• Reinsurance Fundamentals

13
Types of Reinsurers

• Professional reinsurers
• An insurance company that specializes in writing
  reinsurance
• Reinsurance departments (of insurance companies)
• Insurance laws generally permit direct insurers
  to sell reinsurance

14
Types of Reinsurers

• Pools
• An arrangement where member firms jointly accept
  risks in a line of business.
• Lloyds associations
• Lloyds of London, Lloyds of Asia, Lloyds of
  Japan

15
Reinsurance Distributions

• Direct writing reinsurer
• Reinsurers sell directly to primary insurers
• Reinsurance brokerage (broking) firm
• Primary insurers wish to place business with one
  or more reinsurers
• Slip will be provided by the intermediary on
  behalf of the client insurer.

16
Reinsurance Distributions

• Lead (leading underwriter)
• When the placement involves several reinsurers,
  the intermediary usually identifies a lead
  reinsurer.
• Brokers cover
• Brokers are given in-principle approval to accept
  certain risks on behalf of their reinsurers.

17
Types and Nature of Reinsurance Contracts

• Facultative vs. treaty reinsurance
• Facultative the insurer negotiates a separate
  reinsurance agreement for each policy that it
  wishes to reinsure.
• Treaty it automatically applies to the entire
  portfolio of risks covered by treaty unless
  specifically excluded.

18
Types and Nature of Reinsurance Contracts

• Proportional (pro-rata) vs. non-proportional
  (excess-of-loss or XL) reinsurance
• Proportional the reinsurer takes a stated share
  of each risk that the insurer writes and shares
  in the premium and losses in that same
  proportion.
• Financial reinsurance

19
Classification of Reinsurance Contracts (Figure
23.2)
20
Forms of Reinsurance (Figure 23.3)
21
Forms of Reinsurance (Figure 23.3)
22
Proportional Reinsurance Quota Share (Table
23.1)
23
Proportional Reinsurance Surplus (Table 23.2)
24
Illustrative Proportional Treaty (Figure 23.4)
25
Proportional reinsurance

• Quota share reinsurance

Reinsurer assumes an agreed-upon, fixed quota
(percentage) of all the insurance policies
written by a direct insurer within the particular
branch or branches defined in the treaty. This
quota determines how liability, premiums and
losses are distributed between the direct insurer
and the reinsurer.
26
Quota share reinsurance
27
Quota share reinsurance
28
Proportional reinsurance

• Surplus reinsurance

The direct insurer himself retains all risks up
to a certain amount of liability (his retention).
This retention may be defined differently for
each type (class) of risk. The reinsurer will
accept the surplus the amount that exceeds the
direct insurers retention. This limit is usually
defined as a certain multiple of the direct
insurers retention, known as lines (see example
below).
29
Example 1
Example 1 The cedents original liability from
his share in a given risk amounts to 3 million
the premium is 1.50 (of the sum insured) and
the loss is 1.5 million. The risk is shared by
the cedent and the reinsurer as follows
30
Example 2
31
Example 3
32
Surplus reinsurance
33
Non-proportional (Excess-of-Loss) Reinsurance

• Facultative XL (per risk) cover the losses of
  an individual risk or policy over the cedants
  loss retention
• Risk (working) XL the reinsurer indemnify the
  insurer for any losses, subject to the
  reinsurance in excess of the insurers retention
  for each risk falling under the treaty.
• Common account XL protects the combined
  exposure of the insurer and its quota share.

34
Non-proportional (Excess-of-Loss) Reinsurance

• Per occurrence (cat.) XL protects the cedant
  against an accumulation of losses from a single
  disaster
• Hours clause ex. A 72-hour clause
• Stop loss XL the reinsurer indemnifies the
  insurer once the insurers loss ratio in a line
  of business exceeds a percentage
• Aggregate XL indemnifies the insurer once the
  insurer incurs losses of a stipulated amount

35
Non-proportional (Excess-of-Loss) Reinsurance

• Umbrella XL indemnifies the insurer in case it
  experiences a run of losses in 2 or more lines of
  business in the same class
• Whole account XL indemnifies the insurer for a
  run of losses in the aggregate from all lines in
  which it operates.
• Reinstatement provision allows the insurer
  to restore the reinsurance limit to the original
  level after collecting part or all of the
  original limit

36
Excess-of-loss Reinsurance (Figure 23.5)
37
Non-proportional reinsurance excess of loss (XL)
reinsurance

• Deductible, cover limit
• - No matter what the sum insured, the direct
  insurer carries for his own account all losses
  incurred in the line of business named in the
  treaty up to a certain limit known as the
• deductible.
• WXL/R and CatXL covers
• - Excess of loss insurance can be broadly
  divided into covers per risk (WXL/R) and covers
  per catastrophic event (CatXL).

38
Loss event 3
39
(No Transcript)
40
Reinsurance Program Design

• Factors to consider in designing a program
• Risk and loss portfolios over several years
• Types of reinsurance contracts
• Apportionment of risks or losses by layer
• Availability of reinsurers specializing in each
  type of reinsurance and their ancillary services

41
Reinsurance Program Design

• Factors to consider in designing a program
• Prevailing conditions in the reinsurance market
  and in the economy
• Profitability (including the size of ceding and
  other commissions from reinsurers)
• The insurers own capacity to retain losses

42
Reinsurance Program Design

• Commissions
• Reinsurers often compensate cedants for a share
  of their expenses.
• Types
• Ceding commissions ex. Based on a fixed or
  sliding-scale percent
• Profit commissions ex. Based on the reinsurers
  operating experience for the cedants book of
  business
• Not all reinsurance contracts offer commissions

43
Financial Reinsurance

• Risks involved
• Underwriting (pricing) risk
• Losses and expenses under the contract will be
  greater than expected.
• Timing risk
• If losses are paid more quickly than expected,
  the reinsurer loses cash flow with a resulting
  loss of investment income.
• Investment risk
• The actual investment performance will be poorer
  than expected.

44
Financial Reinsurance

• Financial reinsurance explicitly considers the
  investment and timing risks and may provide
  little or no pricing risk transfer.
• Retrospective financial reinsurance
• Covers the insurers past loss, which has already
  occurred but not yet been reported pr settled.
• Time and distance contracts
• Increase surplus through the immediate
  recognition of the future investment income on
  the loss reserves of the insurer.

45
Financial Reinsurance

• Loss portfolio transfer (LPT)
• Involves an insurer ceding all of its liabilities
  on a portfolio of policies to a reinsurer.
• Run-off business LPT is used when an insurer
  wants to liquidate its liabilities as a condition
  for a merger or acquisition

46
Financial Reinsurance

• Prospective financial reinsurance
• The primary focus of financial reinsurance in
  todays market
• The transfer of risk on current and future
  exposures to another party, not necessarily a
  reinsurer.

47
Prospective Financial Reinsurance

• Length of coverage period
• Flexible in length and scope
• For a long term to smooth year-to-year loss
  result
• Finite term of contract (non-renewability)
• Renewal of the coverage means writing a new
  contract

48
Prospective Financial Reinsurance

• Explicit profit sharing agreement
• If loss experience is favorable, a profit sharing
  refund is made to the cedant.
• Limit on coverage
• The aggregate limit is commonly for the entire
  contract period.
• FR assumes mainly timing risk and investment
  risk, and limit underwriting risk by imposing per
  loss and aggregate limits.

49
Prospective Financial Reinsurance (Insight 23.1)
50

• Reinsurance Markets

51
Reinsurance Premiums Globally (2005) (Figure 23.6)
Source Datamonitor (2005)
52
Cession Rate by Region (1998) (Table 23.3)
53
Largest Reinsurers (2005) PART 1 (Table 23.4)
54
Largest Reinsurers (2005) PART 2 (Table 23.4)
55
Reinsurance in Emerging Markets

• Reinsurance is crucial, as domestic companies
  tend to have low levels of capitalization and
  keep low retentions (and a correspondingly high
  demand for reinsurance).
• Insuring industrial infrastructure necessitates
  technical expertise.
• Historically, large global reinsurers have
  provided risks assessment and underwriting
  services

56
Reinsurance in Emerging Markets

• Most insurers in developing countries have
  proportional treaties as the basis of their
  reinsurance programs.
• Fronting is common in developing countries.

57
Reinsurance in Emerging Markets

• Compulsory placement of reinsurance as a means of
  the local governments attempt to
• Diversify the pools of risks from individual
  insurers to the national reinsurer
• Permit more favorable terms and prices when the
  national reinsurer retrocedes risks
  internationally
• The global trend is to abandon such practices, as
  compulsory cessions usually harm markets relying
  on them.

58
Compulsory Reinsurance Cessions (Table 23.5)
59

• Reinsurance Regulation

60
Reinsurance Regulation

• In general, reinsurance subject to less stringent
  regulation than is direct insurance
• Even so, of critical concern because of its
  importance to the stability and growth of
  insurance markets
• Further, the market internationally dominated by
  a relatively small number of very large
  reinsurers
• Current initiatives largely the domain of
  advanced economies and intergovernmental
  organizations

61
Reinsurance Regulation

• The IAIS Standard on Supervision of Reinsurers
  (2003)
• Principle One. Regulation and supervision of
  reinsurers technical provisions (loss
  reserving), investments and liquidity, capital
  requirements and policies and procedures to
  ensure effective corporate governance should
  reflect the characteristics of its business and
  be supplemented by systems for exchanging
  information among supervisors.

62
Reinsurance Regulation

• Principle Two. Except as stated in Principle One,
  regulation and supervision of the legal forms,
  licensing and the possibility of withdrawing the
  license, fit-and-proper testing, changes in
  control, group relations, supervision of the
  entire business, on-site inspections, sanctions,
  internal controls and audit, and accounting rules
  applicable to reinsurers should be the same as
  those for primary insurers.

63
Reinsurance Regulation

• The E.U. Reinsurance Directive (2005)
• Supervisory power
• The directive lays down supervisory powers, but
  financial supervision of the reinsurer remains
  the sole responsibility of its home state.
• Single licensing
• All reinsurers must be authorized in their home
  states.
• Solvency provision
• Require companies to maintain a minimum guarantee
  fund of not less than 3 million.

64
Regulatory Developments in Reinsurance (Table
23.6)
65

• Discussion Questions

66
Discussion Question 1

• What advantages and disadvantages would an
  insurance company expect from ceding its risks
• (a) facultatively or
• (b) using a treaty?

67
Discussion Question 2

• Describe how premiums and losses are shared in
• (a) surplus treaty reinsurance and
• (b) working XL reinsurance.

68
Discussion Question 3

• What effect would you expect from continuing
  consolidation in the reinsurance market?
• Discuss its impact on competition, capacity and
  reinsurance market security.

69
Discussion Question 4

• An author cited in this chapter wrote
  reinsurance can be viewed as both a leverage and
  a risk management mechanism. Explain.

70
Discussion Question 5

• What are the reasons that some governments offer
  for subjecting domestic nonlife insurance
  companies to compulsory cessions to a national or
  regional reinsurance company?
• In those countries, why do you believe the
  cession commonly applies to treaty reinsurance
  only?

71
Discussion Question 6

• In view of the trends in the reinsurance market,
  what is their likely impact on reinsurance
  distribution systems.

72
Discussion Question 7

• Why are the worlds largest reinsurance firms
  located in Europe?