Ch 30: Risk Transfer

Question 1

List 6 possible responses from which a stakeholder can choose when faced with a risk

Answer 1

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)

Question 2

How could each risk mitigation option be evaluated?

Answer 2

FIRM

• Feasibility and cost
• Impact on frequency / severity / expected value
• Resulting secondary risks
• Mitigation required in response to secondary risks

Question 3

What 5 factors affect whether a stakeholder retains or transfers risk?

Answer 3

1. The cost of passing it on
2. The willingness of another party to take it on
3. The likelihood of the risk event occurring
4. The capital the stakeholder has with which to absorb the risk event.
5. The stakeholder’s risk appetite

Question 4

Outline the main benefits and costs of reinsurance

Answer 4

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
• Reinsurance may not be available on terms saught

Question 5

Outline the reasons why a provider might purchase reinsurance.

Answer 5

1. A reduction in claims volatility and hence:
   - smoother profits
   - reduced capital requirements
   - an increased capacity to write more business and achieve diversification.
2. The limitation of large losses arising from:
   - a single claim on a singe risk
   - a singe event
   - cumulative events
   - geographical and portfolio concentration of risk

and hence:

• a reduced risk of insolvency
• increased capacity to write larger risks

3. Access to the expertise of the reinsurer.

Question 6

Outline the two contract variations on which reinsurance may be arranged.

Answer 6

1. 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.
2. 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.

Question 7

What are the key features of proportional reinsurance?

Answer 7

1. Claims are split between the cedant and the reinsurer in pre-defined proportions.
2. Does NOT CAP the claim paid by the cedant.
3. Is written by TREATY.
4. The two types are Quota Share and Surplus.
5. Under QS, the proportion claim split is the same for ALL risks.
6. Under Surplus, the proportion can vary by risk.
7. The reinsurer may also pay the cedant a reinsurance commission, which can be used to provide financial assisstance.

Question 8

What are the advantages and disadvantages of quota share reinsurance?

Answer 8

Advantages:
1. QS is useful for small, new or expanding cedants who want to diversify their risk, write more risks or who would like reciprocal business.

2. Administration is relatively simple, since it is written by treaty and a constant proportion is ceded for ALL risks.

Disadvantages:
1. It is INFLEXIBLE in that the same proportion of each risk is ceded, irrespective of the size or potential volatility.

2. A share of profits will also be passed to the reinsurer.
3. It does not cap large claims.

Question 9

For which type of business is a fixed retention level Surplus reinsurance used?

Answer 9

Used for high volume, relatively homogeneous classes of business, such as life insurance or personal lines general insurance.

Question 10

For which type of business is a variable retention level Surplus reinsurance used?

Answer 10

Used for heterogeneous classed of business, eg. commercial property and business interruption insurance

Question 11

What are the advantages and disadvantages of surplus reinsurance?

Answer 11

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 quote 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.

Question 12

What are the key features of non-proportional reinsurance?

Answer 12

1. 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.
2. There may be an upper limit on what the reinsurer is prepared to pay.
3. There may be different layers of excess of loss reinsurance, each with a different reinsurer.
4. 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)
5. The retention level / upper limit may be indexed over time for inflation.
6. The reinsurer determines the reinsurance premiun
7. XOL can cap the claims paid by the cedant.
8. XOL may or may not be written using a treaty.

Question 13

Define 4 different types of XOL reinsurance contracts

Answer 13

1. Risk XL covers losses from a single claim from one insured risk.
2. Aggregate XL covers the aggregate losses from several insured risks, sustained from a defined peril (or perils) over a defined period, usually one year.
3. Catastrophe XL is a form of aggregate XL reinsurance that pays out if a “catastrophe”, as defined in the reinsurance contract, occurs.
4. 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.

Question 14

State the 3 main uses of XOL reinsurance

Answer 14

1. Opportunity to write larger risks
2. Reduces risk of insolvency from a large single claim, a aggregation of claims or a catastrophic event.
3. Soothes profits by reducing claims fluctuations.

Question 15

In what situation would surplus reinsurance and risk XL reinsurance provide the same cover?

Answer 15

Where the risk event can only result in the payment of the full sum assured, there is no difference between risk XL and surplus.

Question 16

Give factors that influence the type of reinsurance products used.

Answer 16

1. Type of business - homogeneous (QS) or heterogeneous (Surplus)
2. The size and volatility of claims. Is the insurer worried about single risks (risk XL), accumulations (agg XL) or catastrophes (cat XL)
3. Does the insurer have lots of free assets or does it need financial assistance? (e.g. the commissions associated with proportional reinsurance)
4. Is the insurer a mutual (worried about financial assistance) or proprietary (worried about smoothed profits)?
5. Does the insurer need expertise in a new or unusual product or new territory?
6. Does the insurer want diversification through reciprocal arrangements (QS)?

Question 17

List 5 ART products

Answer 17

1. Integrated risk covers
2. Securitisation
3. Post loss funding
4. Insurance derivatives
5. Swaps

Question 18

Describe ‘integrated risk covers’

Answer 18

These are multi-year, multi-line reinsurance contracts between insurers and reinsurers.

They give premium savings due to:

• the cost of savings (of not having to negotiate reinsurance separately for each class of business)
• greater stability of results over time and across more diversified lines

They are used to:

• avoid buying excess cover
• smooth results
• lock into attractive terms

Question 19

Describe securitisation

Answer 19

This is the transfer of risk (often catastrophe risk) to the banking and capital markets.

The banking and capital markets are used because of their capacity and because insurance risks provide diversification to their more usual credit and market risks.

Securitisation may be packaged as a catastrophe bond. The repayments of interest and capital from the insurer to the banking and capital markets are contingent on the specified catastrophe NOT happening.

The yield on such bonds is likely to be HIGHER than similar rated corporate bonds.

Question 20

Describe post loss funding

Answer 20

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 funding will in the most past be borne after the event has happened). Thus, before the loss happens the contract appears cheaper than conventional insurance.

Question 21

Describe insurance derivatives

Answer 21

Insurance derivatives include catastrophe and weather options.

The strike price will be based on a certain value of a catastrophe or weather index. Whether or not the option is exercised will reflect by how much the value of the index is different to that on which the strike price is based.

Question 22

Describe swaps, including examples

Answer 22

Organizations with matching but negatively correlated or uncorrelated risks can swap packages of risk so that each organization has a greater risk diversification.

Examples:
- A reinsurer with exposure to Japanese earthquakes may swap some of this risk with a reinsurer with exposure to hurricane in Florida.

• Longevity swaps may exchange expected annuity payments (the ‘fixed leg’) with actual annuity payments (the ‘floating leg’)
• Energy companies (which have lower profits in warm weather) may swap temperature risk with household insurers (which suffer more claims in cold weather)

Question 23

List the 9 main reasons for using ART

Answer 23

DESCARTES

• Diversification
• Exploits risk as an opportunity
• Solvency improvement / source of capital
• Cheaper than reinsurance
• Available when reinsurance may not be
• Results smoothed / stabilized
• Tax advantages (possibly)
• Effective risk management tool
• Security of payments improved