Intensive Actuarial Training for Bulgaria January 2007 Lecture 11 – Reinsurance By Michael Sze, PhD, FSA, CFA

Reinsurance Contract Ceding company: primary insurer Reinsurer: offers insurance of insurance companies Each contract is unique: reflects the needs of the ceding company Covers proportional or excess loss based on predetermined retention level Domestic or foreign reinsurance companies

Reasons for Purchasing Reinsurance Limit liabilities on specific risks Stabilize loss experience Protect against catastrophes Increase capacities Additional services provided by reinsurer

Limiting Liabilities Retention limit refers to individual policies Limit risk exposure to amount that the primary insurer can absorb Allow primary insurer to offer coverage considerably higher than what they can provide Of crucial importance: allow smaller insurers to compete with large companies

Stabilization Characteristics of P & C risk –Many small claim, a few large ones –In catastrophe, aggregate claim is more than what smaller insurer can absorb By ceding the excess loss, the profit or loss of the primary insurer is more stable

Catastrophe Protection Two protections against catastrophic loss Catastrophic loss from one single event –Fire of a large manufacturing factory Catastrophic loss from aggregation of many smaller claims –Earth quake –hurricane

Increased Capacity New business needs capital causing surplus drain: commission, administrative expenses,taxes All expenses happens before profit develops Proportional reinsurance shares part of the underwriting expenses: reduces surplus drain Credit for reinsurance: accounting issue –Reduces risk and loss reserve Ceding commission from reinsurer –For expenses paid by ceding company

Additional Services Provided by Reinsurer Guidance in underwriting, claim reserves, claim handling, investment, and general management Important note: reinsurance does not change the nature of the risk of the policy

Two Categories of Reinsurance Contracts Treaty reinsurance: covers all risks written by the ceding insurer, with exceptions: –Long haul truckings, ammunition manufacturing Reinsurer needs to carefully review ceding company –Underwriting philosophy, underwriting practice, –claim management procedure, claim experience, and –management background and expertise

Facultative Reinsurance Covers specific risks Catastrophic risks Unusual risks Used to supplement treaty arrangements on the specific exclusions Different layers of reinusurance

Characteristics of Reinsurance Risks Long tail –Loss may take long time to develop –Claims not reported to reinsurer until the primary retention is exceeded –Inflation and legal verdict increases cost –IBRN (incurred but not reported) claims are difficult to estimate Law of large number may not work –Correlation between different claims –Much judgment call