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					                23. Reinsurance




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

 Worldwide risk sharing

 Reinsurance demand

 Reinsurance fundamentals and operations

 Reinsurance markets

 Reinsurance regulation

                                           2
Worldwide Risk Sharing
 Through Reinsurance
Fundamentals

 Insurance vs. reinsurance vs. retrocession

 Retention vs. cession
   The amount of risk retained / transferred

 Privity of contract vs. cut-through provision
    The insureds can’t / can seek recoveries from
    the reinsurers while the insurer fail to meet its
    obligation


                                                        4
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



                                                      5
Worldwide Risk Sharing (Figure 23.1)

           Insured      Insured            Insured       Insured                   Insured       Insured            Insured       Insured




                                   Primary                                                                    Primary
                                   Insurer                                                                    Insurer
                                  (Canada)                                                                    (China)




   Reinsurer/            Reinsurer              Reinsurer             Reinsurer                  Reinsurer                    Reinsurer
Retrocessionaire          (U.S)                (Germany)               (Japan)                  (Singapore)                   (Mexico)
    (France)




                     Retrocessionaire            Retrocessionaire           Retrocessionaire           Retrocessionaire             Retrocessionaire
                          (Italy)                  (Bermuda)                     (U.S.)                    (Korea)                       (Brazil)




                                                                                                                                                  6
Worldwide Risk Sharing (Figure 23.1)




                                       7
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.

                                                     8
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.


                                                       9
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.

                                                       10
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.

                                                    11
Reinsurance Fundamentals
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




                                                   13
Types of Reinsurers

 Pools
   An arrangement where member firms jointly
   accept risks in a line of business.

 Lloyd’s associations
    Lloyd’s of London, Lloyd’s of Asia, Lloyd’s of
    Japan




                                                     14
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.



                                                   15
Reinsurance Distributions

Lead (leading underwriter)
    When the placement involves several reinsurers,
   the intermediary usually identifies a lead
   reinsurer.

Broker’s cover
   Brokers are given in-principle approval to accept
   certain risks on behalf of their reinsurers.



                                                   16
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.




                                                      17
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




                                                    18
Classification of Reinsurance Contracts   (Figure 23.2)




                                                     19
Forms of Reinsurance (Figure 23.3)

                                                     Proportional (Pro-rata)
                            Sharing the amount of insurance, premium and loss on a proportional basis

                                                          • Quota Share
                                                             • Surplus
                                                      • Facultative-Obligatory
   Forms of Reinsurance




                                              Excess-of-loss (Non-proportional)
                          Reinsurance coverage only when loss exceeds the retained loss at lower layer(s)

                                                       • Facultative Excess
                                                     • Risk (working) Excess
                                                   • Catastrophic (Cat) Excess
                                                           • Stop Loss
                                                        • Umbrella Excess
                                                              .....



                                                            Financial

                                              • Retrospective Financial Reinsurance
                                               • Prospective Financial Reinsurance




  Source: Kwon (1999)
                                                                                                            20
Forms of Reinsurance (Figure 23.3)




                                     21
Proportional Reinsurance – Quota Share (Table 23.1)




                                                  22
Proportional Reinsurance – Surplus (Table 23.2)




                                                  23
Illustrative Proportional Treaty (Figure 23.4)




                                                 24
         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.
                                                          25
Quota share reinsurance




                          26
Quota share reinsurance




                          27
      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 insurer’s retention.
This limit is usually defined as a certain multiple of
the direct insurer’s retention, known as lines (see
example below).
                                                      28
                            Example 1
Example 1:
The cedent’s 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:




                                                                          29
Example 2




            30
Example 3




            31
Surplus reinsurance




                      32
Non-proportional (Excess-of-Loss) Reinsurance

 Facultative XL (per risk) – cover the losses of an
 individual risk or policy over the cedant’s loss
 retention

 Risk (working) XL – the reinsurer indemnify the
 insurer for any losses, subject to the reinsurance in
 excess of the insurer’s retention for each risk falling
 under the treaty.

 Common account XL – protects the combined
 exposure of the insurer and its quota share.

                                                       33
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 insurer’s loss ratio in a line of business
 exceeds a percentage

 Aggregate XL – indemnifies the insurer once the
 insurer incurs losses of a stipulated amount

                                                   34
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

                                                       35
Excess-of-loss Reinsurance (Figure 23.5)




                                           36
    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
                                                   37
Loss event 3




               38
39
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




                                                     40
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 insurer’s own capacity to retain losses




                                                      41
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
      reinsurer’s operating experience for the
      cedant’s book of business
   Not all reinsurance contracts offer commissions

                                                42
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.
                                                   43
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 insurer’s 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.
                                                    44
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




                                                         45
Financial Reinsurance

 Prospective financial reinsurance
   The primary focus of financial reinsurance in
   today’s market

    The transfer of risk on current and future
    exposures to another party, not necessarily a
    reinsurer.




                                                    46
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




                                                   47
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.

                                                       48
Prospective Financial Reinsurance (Insight 23.1)




                                                   49
Reinsurance Markets
Reinsurance Premiums Globally (2005) (Figure 23.6)

                                   Rest of the
                                     World
             Asia                    5.1%
            10.3%




                                                  North
                                                 America
                                                  50.4%
     Europe
     34.2%




      Source: Datamonitor (2005)


                                                           51
Cession Rate by Region (1998) (Table 23.3)




                                             52
Largest Reinsurers (2005) PART 1 (Table 23.4)




                                                53
Largest Reinsurers (2005) PART 2 (Table 23.4)




                                                54
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



                                                     55
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.




                                               56
Reinsurance in Emerging Markets

 Compulsory placement of reinsurance as a means
 of the local government’s 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.


                                                     57
Compulsory Reinsurance Cessions (Table 23.5)




                                               58
Reinsurance Regulation
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

                                                      60
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.


                                                         61
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.



                                                      62
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.

                                                  63
Regulatory Developments in Reinsurance   (Table 23.6)




                                                  64
Discussion Questions
Discussion Question 1

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




                                          66
Discussion Question 2

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




                                        67
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.




                                           68
Discussion Question 4

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




                                         69
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?



                                              70
Discussion Question 6

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




                                            71
Discussion Question 7

 Why are the world’s largest reinsurance firms
 located in Europe?




                                             72

				
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