Reinsurance and capital market

• To protect the company's solvency position
• To smooth profits
• It may be compulsory
• Spread risks better especially for the companies with less exposure to risk. Amount of reinsurance will depend on the life insurance company’s attitude to risk and their ability to withstand adverse experience
• To gain experience of a new class of business. They may have provided underwriting, claims, administration and pricing expertise. The reinsurer may have helped price and design similar underwriting sets for other insurers. Relevent if the company will have not had experience in pricing this product nor experience data. (Quota share is suitable in this case)
• Reinsurance rates may be perceived to be good value
• Help with staff training

Possible problems

• The ability to make a recovery will depend on the solvency position of the reinsurer. Underwriting risk is turned into credit risk.
• Reinsurance of the desired type (e.g. stop loss) may not it may be availability. and/or there may be doubts about the value for money of reinsurance.
• The insurance company wants to minimise reinsurance use as it costs money i.e. the reinsurer want to make a profit
• The company may inadequately appreciate the scale of the risks and purchase inadequate reinsurance or the wrong kind of reinsurance.

• Technical ability e.g. on underwriting and pricing
• Resource e.g. can they “loan” staff to the insurance compan
• Capacity and willingness to accept the business.E.g. If a reinsurer already has high exposure to a particular market they may not offer such good terms, if at all.
• Counterparty risk
• The reinsurer’s published accounts and statutory returns would be a good source to measure the counterparty risk.
• The insurer should look at the reinsurer’s:
  • Solvency position, i.e. the level of free assets
  • Types of assets held – match for liabilities, cashflow, volatility, diversification, marketability and liquidity
  • Borrowings – level of gearing, income and asset cover.
• The legislative environment in which the reinsurer operates will also affect solvency.
• The type of business that the reinsurer writes will affect the security of the reinsurer.
• With regard to the reinsurer’s liabilities, the insurer should look at:
  • The diversity by class, geographical region and cedant
  • Exposure to any risk accumulations/catastrophes
  • Any particularly large, unusual or volatile risks covered by the reinsurer
  • The size of the liabilities and future plans for development/expansion
  • Whether the reinsurer itself has reinsurance
• The insurer should examine the reputation of the reinsurer, for example:
  • Its market share
  • Its previous claims history
  • The ability of the management
  • Whether the reinsurer has a parent company or is associated with other companies and how financially strong these are
  • Its credit rating
  • The views of others in the industry: other insurers, analysts, the regulator etc.

Stochastic modelling techniques are often used to determine an appropriate retention limit. Future claims on a particular tranche of business are projected using a stochastic model for the number of claims. Then, the optimal retention level can be chosen so as to keep the probability of insolvency (or some other risk measure) below some probability of insolvency (or some other risk measure) below some specified level (based on the current level of the free assets).

• the lower the free assets, the greater the need for reinsurance
• the greater the uncertainty in the future mortality experience, the greater the need for reinsurance
• lack of relevant past data or poor quality data (e.g. new product or market, changes in underwriting or T&C of policy).

Particularly relevant for small business/new markets

• Reinsurance can reduce regulatory reserves
  • With reinsurance the direct insurer can pass the liability of extreme events over to the reinsurer. As long as teh reinsurer's solvency position is high enough, the direct insurer no longer has to reserve for these events and the regulatory capital requirement will fall.
• Reinsurance can reduce capital strain
  • paying the various forms of commission available in treaties such as quota share. The burden of initial costs is shared by both the direct insurer and the reinsurer
  • Through the use of financial reinsurance the timings of cash-flows can be altered.
• The level of reinsurance is therefore dependent on the level of capital
  • The more capital a company has therefore the less reinsurance they will usually use so that they can retain more expected profit.

Analyze the reasons behind the claim loss / the need of expertise. Rather than treaty reinsurance is may be possible to faculatively reinsure very large policies.

• Quota share: this shares bad experience with the reinsurer reducing reserve and capital requirements, enabling diversification through selling more policies limiting any geographic concentrations.
  
  • It is applicable to new product (don't know claim experience, cannot decide the limit / excess).
  • Commission to reduce the initial capital strain.
  • With quota share we are able to take on larger risks
  • Allowing reciprocal business, thus diversify the risks
  • Gain knowledge from the reinsurer
  • Simple to administer, thus reduce the cost
• Surplus
  • can reduce the risk of individual large claims. As it is more flexible, as the insurance company can choose the level of risk they wany to retain, therefore The insurer is able to balance risk and retain to a greater extent.
  • Commission to reduce the initial capital strain.
  • Allow the direct insurer to write larger risks
• Individual excess of loss
  • protect the insurer from large individual claims, thus allowing it to write risks with large sum assured / maximum possible loss. The company is thus able to protect its solvency position.
• Aggregate excess of loss
  • reduce the risk of concentration as a result of a single event or a peril.
  • can lead to lower reserves being required hence increase in level of free assets thus promoting greater investment freedom
• Stop loss reinsurance
  • using it when you are charging small premiums but have a high expectation of claims. e.g. you are worried about your loss ratio.
  • insurer's claim experience is poorer.
  • High claim management expense.
  • In practice, it is only used when
    • There is a close relationship between the insurer and the reinsurer i.e. part of the insurance group
    • Where there is very little influence over claims

Stabilization of profits

Why ART is used

• 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

• Discounted covers
  • Discounted covers are usually a form of financial reinsurance used where regulations require that reserves for the direct insurer have to be calculated on a non-discounted basis.
• Integrated risk covers
  • Reinsurance products that are a combination of typical reinsurance products.
  • The idea of using integrated risk covers is that it can lower expenses as we have fewer contracts, and it should also reduce premium costs because we reduce the level of reinsurance as it becomes more targeted.
  • Expenses: the complexity means the initial cost is high
  • Concentrated credit risk: If the reinsurer goes insolvent then a large amount of cover is lost.
  • Agreed terms
  • Lack of supply
  • Terminology
  • Regulators
• Securitisation
  • An indemnity bond
    At its most basic, if no catastrophe occurs during the duration of the bond the investor will receive a large return.
  • Advantages
    • For investors the idea is that they were able to get a higher return than investing in a corporate bond of similar risk.
    • The returns on catastrophe bonds should be independent of market return and hence the investor should be able to diversify their portfolio.
    • The returns on catastrophe bonds can be viewed as having no credit risk.
  • Disadvantages
    • The bond investor would have little idea on how to price a catastrophe bond for a particular company, as they would have to investigate the exposure that the insurance company has which would not be their expertise.
      Relying on the insurance company to provide information would therefore be a source of moral hazard as the insurance company will want to look low risk to reduce the "premium" paid.
• Post loss funding
  • With post funding the insurance company enters into an agreement with some financial institution that if a precribed catastrophe does occur that the institution will buy bonds and/or equities at a given price.
• Insurance derivatives
  • The derivatives with the index of average temperature or wind speed.
  • Alternatively it could be an investor trying to create a diversified portfolio of investment.
• Swaps
  • Swap some of the exposure to diversify the portfolio.