Fall 2008 Version Professor Dan C. Jones FINA 4355

Risk Management and Insurance: Perspectives in a Global Economy 23. Reinsurance Professor Dan C. Jones FINA 4355

3 Correction – Figure 23 One in each category of this column has to be non-proportional!

4 Study Points Worldwide risk sharing Reinsurance demand Reinsurance fundamentals and operations Reinsurance markets Reinsurance regulation

Worldwide Risk Sharing Through Reinsurance

6 Fundamentals Insurance vs. reinsurance vs. retrocession Retention vs. cession Privity of contract vs. cut-through provision Reciprocal agreement Refer also to Chapter 1 for the basic concepts.

7 Worldwide Risk Sharing (Figure 23.1) Insured  Primary Insurer (Canada) Insured  Primary Insurer (China) Reinsurer (U.S) Reinsurer (Germany) Reinsurer (Japan) Reinsurer/ Retrocessionaire (France) Retrocessionaire (Italy) Retrocessionaire (Bermuda) Reinsurer (Singapore) Reinsurer (Mexico) Retrocessionaire (U.S.) Retrocessionaire (Korea) Retrocessionaire (Brazil) Another version of the same figure in the next slide.

8 Worldwide Risk Sharing (Figure 23.1)

9 Rationales for Reinsurance Demand Ownership structure Cost of financial distress Capital market imperfections Real service efficiency Reduction of tax liability Volatility control Regulatory constraints Refer to “Insurance Demand” in Chapters 2 and 19.

Reinsurance Fundamentals

11 Types of Reinsurers Professional reinsurers Reinsurance departments (of insurance companies) Pools Lloyd’s associations

12 Reinsurance Distributions Direct writing reinsurer Reinsurance brokerage firm Slip Lead (leading underwriter) Broker’s cover

13 Types and Nature of Reinsurance Contracts Facultative vs. treaty reinsurance Facultative-obligatory (fac-oblig) reinsurance Proportional (pro-rata) vs. non-proportional (excess-of-loss or XL) reinsurance Financial reinsurance

14 Classification of Reinsurance Contracts (Figure 23.2) Facultative The contract is on individual risk basis; that is, there is no pre- existing reinsurance contract. The insurer decides whether to cover a risk alone, or cede part of it to a reinsurer. When offered, the reinsurer may accept it, decline it or counteroffer the insurer. Treaty The contract commonly is annual on a line of business and territory basis. The insurer and the reinsurer are bound to a contract that dictates what risks are to be shared and how they are shared. Therefore, the insurer must transfer all risks subject to the agreement and the reinsurer must accept all ceded risks. Facultative-Obligatory (Fac-Oblig) Commonly used as the top layer of a treaty reinsurance program, this type of contract gives the insurer an option to retain a risk fully or cede part of it to the reinsurer. When ceded (a facultative element), the reinsurer must assume the risk (an obligatory element). Reinsurance Contract Proportional Non-proportional Proportional Non-proportional Source: Kwon (1999) Another version in the next slide.

15 Classification of Reinsurance Contracts (Figure 23.2)

16 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 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 Forms of Reinsurance Source: Kwon (1999) Another version in the next slide.

17 Forms of Reinsurance (Figure 23.3)

18 Proportional Reinsurance – Quota Share (Table 23.1)

19 Proportional Reinsurance – Surplus (Table 23.2)

20 Illustrative Proportional Treaty (Figure 23.4)

21 Non-proportional (Excess-of-Loss) Reinsurance Facultative XL Risk (working) XL Common account XL Per occurrence XL Hours clause Stop loss XL Aggregate XL Umbrella XL Whole account XL Reinstatement provision (page 608)

22 Excess-of-loss Reinsurance (Figure 23.5)

23 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 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

24 Reinsurance Program Design Commissions Types Ceding commissions Profit commissions Not all reinsurance contracts offer commissions You may use the example in pages to describe the relief from ceding commissions. Ceding commissions differ from reinsurance brokerage fees.

25 Financial Reinsurance Risks involved Underwriting (pricing) risk Timing risk Investment risk Financial reinsurance explicitly considers the investment and timing risks and may provide little or no pricing risk transfer.

26 Financial Reinsurance Retrospective financial reinsurance Time and distance contracts Loss portfolio transfer Run-off business Prospective financial reinsurance The primary focus of financial reinsurance in today’s market

27 Prospective Financial Reinsurance Length of coverage period Finite term of contract (non-renewability) Explicit profit sharing agreement Limit on coverage

28 Prospective Financial Reinsurance (Insight 23.1)

Reinsurance Markets

30 Reinsurance Premiums Globally (2005) (Figure 23.6) Source: Datamonitor (2005)

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

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

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

34 Top 10 Global Reinsurers (2006)

35 Top 10 Global Reinsurance Brokers (2006)

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

37 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.

38 Compulsory Reinsurance Cessions (Table 23.5)

Reinsurance Regulation

40 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 Table 23.6

41 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. 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.

42 Reinsurance Regulation The E.U. Reinsurance Directive The E.U. Reinsurance Directive (2005) Supervisory power Single licensing Solvency provision

43 Regulatory Developments in Reinsurance (Table 23.6)

44 Reinsurance Issues (new for discussion) Meaning and application of reinsurance Alternative risk transfers, especially insurance-linked securitizations Taxatio issues

Discussion Questions

46 Discussion Question 1 What advantages and disadvantages would an insurance company expect from ceding its risks (a) facultatively or (b) using a treaty?

47 Discussion Question 2 Describe how premiums and losses are shared in (a) surplus treaty reinsurance and (b) working XL reinsurance.

48 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.

49 Discussion Question 4 An author cited in this chapter wrote “reinsurance can be viewed as both a leverage and a risk management mechanism.” Explain.

50 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?

51 Discussion Question 6 In view of the trends in the reinsurance market, what is their likely impact on reinsurance distribution systems.

52 Discussion Question 7 Why are the world’s largest reinsurance firms located in Europe?