3) Principles and Practice of Reinsurance

1. The reinsurance needs of direct insurers

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(3) PRINCIPLES AND PRACTICE__________________________________________________

3.PRINCIPLES AND PRACTICE OF REINSURANCE


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1.  The reinsurance needs of direct insurers

2.  Forms and methods of placing reinsurance

3.  Reinsurance practices and problems


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1.  The reinsurance needs of direct insurers


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1. Why do Insurers purchase reinsurance?


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•  The need to protect solvency


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2. What determines any deviation in outcomes from R0 to Rn?


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Deviation of outcomes from line R0Rn will depend upon: 1.  Accurancy of Premium calculation.

Estimate of loss expectancy may differ from the true loss expectancy because: a) Sampling error (function of sample size) b) Failure to identify or allow for changing risk conditions

2. The fluctuation of actual outcomes around the mean. (function of

sample size) Reserves can be substantially reduced because of a random occurrence of •  LARGE INDIVIDUAL losses or •  ACCUMULATION of losses


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Fluctuation of actual outcomes


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3. The occurence of fluctuations in the basic probabilities.

Distribution of yearly outcomes on an unchanging portfolio


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3. The occurence of fluctuations in the basic probabilities.

Insurer´s overall operating result

Figure3.4


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3. The occurence of fluctuations in the basic probabilities. The insurer´s need of reinsurance in order to reduce it´s probability of

ruin, will vary according to: The SIZE OF ITS PORTFOLIO

•  sample size ->The larger the portfolio, the smaller will tend to be the variability of outcomes

AND THE TYPE OF BUSINESS UNDERWRITTEN •  The variation in the size of the individual units exposed to loss

•  The degree of interdependece between loss exposures


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Therefore , in examining an insrurer‘s need of reinsurance protection the facts to be considere are:

1.  The premiums (no protection against under-pricing)

2.  Characteristics of the class of buisness insured and the composition of the company´s portfolio.

An other aspect is not only the probability of the aggregate claims in any one year exceeding some predetermined tolerable amount, but also the degree of variability in possible outcomes

2. Forms and methods of placing reinsurance

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Forms and types of reinsurance

Proportional Reinsurance.

Non-proportional Reinsurance.

Quota Share Surplus Stop loss, or loss ratio

Risk basis Occurence basis

Excess of loss


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Proportional Reinsurance.

Quota Share Surplus

QUOTA SHARE: A fixed proportion accepted by the primary insurer and ceded to the reinsurer is the same for all risks (in premium, costs, and claims)

SURPLUS: The ceding company reinsures only the balance of those risks beyond it´s own retention (line).


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Forms and types of reinsurances Diffrerences between the reinsurer´s loss experience on the total portfolio of business ceded and the primary insruer´s net retained account migth be the cause of:

1.  A badly balanced account leaving the reinsurance portfolio heavely exposed to random fluctuations in loss experience from year to year.

2.  Although a reasonable spread of risks may be ceded, the reinsurer´s portion may be prove to be subject to either larger random fluctuations in losses or to a poorer experience than the retained part.

3.  The primary insurer may cede a larger proportion of the poorer risks it has written.


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TODAY…. Because of the heavy underwriting losses incurred during the 1980

´s, reinsurers pay more attention to the types of risks they accept. They also place lower limits on treaty capacity (table of limits and lines to provide) involving ceding companies more in their losses experience.

The Increase in the number and severity of claims following natural disasters has changed practice in regards to natural perils und property treaties. Therefore proportional reinsurers are no longer prepared to accept potentially unlimited liability for accumulations of natural perils losses, and at the extrem they even may totally exclude cover for natural prils, thats why the insurer requires a CAT XL

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Stop loss, or loss ratio


Excess of loss


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Excess of loss

Excess of loss: Usually placed in layers.For Example, 3 separate XL risks basis:

Retain -> up to 1000 € •  XL layer-> Cover: 4000€ xs 1000€ •  XL layer-> Cover: 5000€ xs 5000€ •  XL layer-> Cover: 10000€ xs unlimited

Stop loss, or loss ratio



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Stop loss, or loss ratio Excess of loss

Stop loss: (or excess of loss ratio) protects a company against ist aggregate annual net loss experience on a particular underwriting account exceeding some tolerable figure. For Example, a stop loss may cover 40% of the net losses incurred during a year in excess of 70%,

Occurence basis Risk basis


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Forms and types of reinsurances We have following conditions:

1.  Retention of 1 Mio €, reinsured with a XL risks basis 900.000€ xs 100.000€.

2.  Surplus : Capacity of 4 lines of each 1 Mio€

How would be the splitting a claim of 1 Mio € form a risk risk with a sum insured of 4 Mio €?


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Methods of placing reinsurance The facultative

•  was the first method to be used.

•  Each risk offered individually to reinsurers, who are free to accept what share they decide or to reject.

•  Mainly used for proportional reinsurances

Open cover (or facultative obligatory)

•  A reinsurer agrees to accept obligatory a share of any business confoming to predetemined conditions regarding class of insurance, type of riks, country , etc. offered by a ceding company; or A broker (brokers open cover)

•  No obligation to offer any buisiness

•  Mainly used for surplus


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Methods of placing reinsurance Treaty

•  Subject to terms and conditions agreed between the parties and set out in the treaty.

•  There is an obligation on the reinsured to cede and the reinsurer to accept risks of a class falling within the limitations of the treaty.

Pool

•  Take various forms but often a quota share or surplus reinsurance arrangement between participating member.

•  According to the rules agreed, insurance accepted by members are ceded to the pool which in turn arranges retocessions to members.

•  The pool may retain some part of each risk for ist own account

•  Its used for proportional reinsurance, The pool may protect itself by purchasing non-proportional reinsurance from outside reinsurers.

3. Reinsurance practices and problems

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Inflation Problems of conducting reinsurance business on international scale considerably increased since the end of the 1960‘s.

–  DOMESTIC RATES OF INFLATION during the 1970‘s and 1980‘s

–  INTERNATIONAL MONETARY FOND‘S SYSTEM of fixed parties between currencies was abandoned

And then in the 1990‘s –  LOW LEVELS of INFLATION in the major western economies and

capital and funds did flow relatively unhindered across international markets.


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Inflation influences both Insurers and Reinsurers.

–  Rising administrative expenses

–  A tendency for INCREASES IN PREMIUM RATES to lag BEHIND THE RISE of property, liability and mos non-life CLAIMS

Even though interest rates grow, the increase in investment earnings is usually insufficient to offset fully the higher claimscosts.

-> Operating profits fall , -> FREE RESERVES can‘t increase in step with the premiums and -> the solvency margin fall too, -> affecting the financial stability and underwriting capacity.


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Reinsurers are generally more exposed for 2 reasons:

–  The average of settlement delays tend to be longer on reinsured

losses. Generally under both SURPLUS and NON-PROPORTIONAL , reinsurers are involved in the larger losses, and larger losses tend to be longer to settle than small claims.

2.  Under EXCESS OF LOSS, inflation may a) take more claims above the lower excess limit, and b) for losses within the excess of loss reinsurance band, the reinsurer will bear the full impact of inflation.


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Floating exchange rates

The effect of movements in exchange rates on the respective financial positions of a

ceding company and ist reinsurer(s) will depend upon: 1.  The provisions regarding the currency(ies) in which accounts are to be

rendered and settled. 2.  The abilitiy of the reinsurer to match liabilities with assets in the same

currency(ies). Problems:

1.  Time lags between the recept of premiums and payment of the claims 2.  Localisation of technical reserves or capital market conditions are unfavourable. 3.  The degree of variability in claims costs 4.  Freedom to move funds at will and to retain foreign currencies is restricted.

Documents

3) Principles and Practice of Reinsurance