University of Cologne Department of Risk Management and Insurance Risk Management in Insurance Value and risk based management with special consideration of Solvency II Salzburg University April / Thursday 20 th / 2017 Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University
University of Cologne Department of Risk Management and Insurance Risk Management and / in Insurance Part I Risk Management Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at the University of Salzburg
University of Cologne Department of Risk Management and Insurance 4. Risk Financing, special issue: Reinsurance and Alternative Risk Transfer Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University
Table of Contents 1. Functions of Reinsurance a. How reinsurance works b. Why do Insurers buy Reinsurance? 2. Types of Reinsurance a. Proportional Reinsurance b. Non-Proportional Reinsurance 3. Finite Reinsurance (Financial Reinsurance) a. The Purpose of Reinsurance b. Characteristics of Finite Reinsurance c. Forms of Finite Reinsurance 4. Alternative Risk Transfer a. What is Alternative Risk Transfer? b. Why ART developed? c. Types of Alternative Risk Transfer 4
References Carter, Robert L. / Leslie D. Lucas: Reinsurance Essentials, 1st Edition, Reactions, 2005. Culp, Christopher L.: Structured Finance and Insurance The ART of Managing Capital and Risk, 1st Edition, Wiley, 2006. Cummins, David J.: Handbook of International Insurance Between Global Dynamics and Local Contingencies, 1st Edition, Springer, 2007. Paine, Chris: Reinsurance, 1st Edition, Institute of Financial Services, 2004. Phifer, Ross: Reinsurance Fundamentals Treaty and Facultative, 1st Edition, Wiley, 1996. 5
University of Cologne Department of Risk Management and Insurance Reinsurance and Alternative Risk Transfer 1. Functions of Reinsurance a. How reinsurance works b. Why do Insurers buy Reinsurance? Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University
How reinsurance works Reinsurance is an insurance transaction between insurance companies Original Risk Coinsurers A B C D E Reinsurers 1 2 3 4 5 Retrocessionaires a b c 7
How reinsurance works This transaction has the following basic requirements: An insurable interest must exist (original insurance risk), Original Risk must already exist at the beginning of the reinsurance contract, although it may change during the period of the contract, Reinsurance must transfer some portion of the risk from cedent to reinsurer, Some rewards (premium, profit expectation) must be passed from the cedent to the reinsurer, Reinsurance relies upon the good faith of both the cedent and reinsurer, The agreement is one of indemnity payment in the case the original risk occurs, The reinsurer is liable only to the cedent but not to the cedent s customer. 8
Why do insurers buy reinsurance? 1. Capacity: perhaps the most obvious need, by passing part of potential claims liabilities to a reinsurer, an insurer can afford to accept larger individual (original) risks, 2. Extreme Events (catastrophe cover: natural desaster, man made hazard): Reinsurance is needed to limit the impact from a single catastrophic event to the primary insurer (portfolio homogeneity), 3. Profit Stabilization (working cover): Reinsurance allows an insurer (cedent) to smooth its results over time, 4. Financial interests: By smoothing claims costs an insurer reduces the risk of unacceptable large falls in profits, In so doing the insurer is able to finance the expansion of its business. 9
Why do insurers buy reinsurance? 5. Market Intelligence: Insurer may use reinsurance as a vehicle to gain access to the experience of a specialist in a particular field (region, line of business), Reinsurer provides his cedent with statistic data all over the market, 6. Advice Reinsurer do provide support for ceding companies (education, training), Reinsurer is motivated to help improve the profitability of its reinsureds (deeper knowledge about the original risk), 7. Margin Attractive commissions and leveraged margins motivate the purchase of reinsurance, But reinsurance is a long-term relationship, where the reinsurer may accept a loss in one year, with the understanding that the terms will permit reasonable profit over a reasonable period of time. 10
University of Cologne Department of Risk Management and Insurance Reinsurance and Alternative Risk Transfer 2. Types of Reinsurance a. Proportional Reinsurance b. Non-Proportional Reinsurance Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University
Types of reinsurance Proportional reinsurance The reinsurer receives an agreed proportion of the original premium, less commission, and pays the same proportion of all losses Non-proportional reinsurance In return for an agreed premium the reinsurer accepts liability for losses incurred by the reinsured in excess of an agreed amount, subject to an upper limit Quota share Surplus Excess of loss Stop Loss A fixed proportion of all risks accepted by the insurer are ceded to the reinsurer if within the terms of the treaty, subject to a cession limit Only amounts accepted by the insurer greater than its own retention are ceded to the reinsurer for risks falling within the treaty, subject to a cession limit The reinsurer is liable for the balance of losses exceeding the reinsured s deductible, subject to an upper limit The reinsurer is liable for the balance of aggregate losses for a year that exceeds an agreed amount, subject to an upper limit 12
Proportional reinsurance Proportional reinsurance is where the insurer (cedent) reinsures to the reinsurer a proportion of the risk in relation to the retention of the ceding company. The reinsurer receives the same proportion of the original premium as the amount of risk ceded. The reinsurer pays to the cedent a ceding commission, which is deducted by the cedent from the ceded premium payable to the reinsurer. The reinsurer pays claims in the same proportion as the ceded risk and premium. Both quota share and surplus treaties involve the proportionate sharing of the original premiums. 13
Quota Share Reinsurance The reinsurer accepts liability for the same share of every risk written by the ceding company that falls within the scope of the treaty The division of total loss between reinsurer and insurer in a quota share treaty can be illustrated as S = S i + S Ri, where S Ri = q*s with E(S Ri ) = q*e(s) and S i = (1 q)*s with E(S i ) = (1 q)*e(s). 14
Quota Share Reinsurance Example: Division of insurance, premium and losses between ceding company and reinsurer under a quota share treaty with a 25 percent retention (assumes only one loss) Primary Policy Amount of insurance Premium Loss Retention by ceding company Insurance Premium Loss Ceded to reinsurer Insurance Premium Loss in 1,000,000 10,000 500,000 250,000 2,500 125,000 750,000 7,500 375,000 15
Surplus Reinsurance Surplus is where the amount the cedent reinsures is surplus to its own retention. Ceding company's retention is a line which is called maximum (M) The amount surplus to the retention is reinsured as a multiple of M Sum insured (V) of primary policy The reinsurer accepts liability for a share only of risks accepted by the cedent above its own net retention limit: and S Ri = V - M V S with E(S Ri ) = V - M V E(S) S i = M S with E(Si ) = V M V E(S) 16
Surplus Reinsurance Example: Division of insurance, premium and losses between ceding company and reinsurer under a surplus treaty with a retention of 100,000 (assumes only one loss per policy) Primary Policy Number 1 2 3 Primary Policy Amount of insurance 1,000,000 100,000 10,000 Premium 10,000 1,000 100 Loss 500,000 50,000 5,000 Retention by ceding company Insurance 100,000 100,000 10,000 Premium 1,000 1,000 100 Loss 50,000 50,000 5,000 Ceded to reinsurer Insurance 900,000 0 0 Premium 9,000 0 0 Loss 450,000 0 0 17
Non-Proportional Reinsurance The amount of a risk reinsured is not in proportion to the retention of the reinsured. The insurer decides how much of the risk it wants to retain, and will keep all claims that fall within its retention which is called priority (P). The balance of any claim that exceeds the retention is recovered from the reinsurer up to the limit of the cover which is called layer (L). The reinsurer does not pay anything on losses equal to or less than the priority. If the claim exceeds both priority and layer the insurer bears the exceeded portion. 18
Non-Proportional Reinsurance (II) The division of total loss between reinsurer and insurer in a non-proportional treaty can be illustrated as: 0 für S<P S für S<P S Ri = S-P für P<S<P+L S i = P für P < S <P+L L für S>P+L S-L für S>P+L 19
Non-Proportional Reinsurance Layer Amount of Loss Priority Ocurred Loss Primary Insurer Reinsurer Source: Liebwein, Peter: Klassische und moderne Formen der Rückversicherung, 2nd Edition, VVW 2009. 20
University of Cologne Department of Risk Management and Insurance Reinsurance and Alternative Risk Transfer 3. Finite Reinsurance a. The Purpose of Reinsurance b. Characteristics of Finite Reinsurance c. Forms of Finite Reinsurance Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University
The Purpose of Reinsurance Protect insurers from underwriting losses Assist in the financing of insurance operations Provide an insurer with administrative and technical services Therefore reinsurance contracts can be divide into two groups: 1. contracts, with the primary aim to transfer underwriting risk 2. contracts, with the primary aim to achieve financial goals 22
Characteristics of Financial (Finite) Reinsurance There is no universally accepted definition of financial (finite) reinsurance. But, financial (finite) reinsurance aims to directly address the financial outcome of the insurance process. Financial (Finite) Reinsurance as a transaction in which financial considerations dominate the buyer's motivation. They seek to achieve financial goals as their primary purpose, rather than insurance underwriting targets. The transfer of insurance risk to the reinsurer is limited (finite reinsurance) or non-existent (financial reinsurance). 23
Types of risk in reinsurance Essential to an understanding and analysis of the nature and protection afforded by a financial reinsurance contract is the extent to which it provides cover against the following types of risk: Insurance Risks Underwriting risk, Reserve risk, Timing risk, Financial Risk Investment risk (market price / interest rate), Credit risk, Central issue therefore: How much insurance risk has to be transferred so that the contract is viewed as insurance contract? (accounting perspective / regulator s perspective) 24
Forms of Financial Reinsurance Retrospective aggregate loss covers These contracts allow an insurer to transfer to a reinsurer its liability for losses incurred on business written in previous years. They enable a company to finance outstanding and IBNR losses on a block of existing business for a premium less than the sum. That relieves the company of balance sheet strain and enables it to distribute profit earlier. Types of retrospective contracts: Time and Distance Loss Portfolio Transfer Adverse Development Cover 25
Forms of Financial Reinsurance Prospective aggregate loss covers These contracts cover future losses that may be incurred either on a specified class of insurance business The principal objective is to smooth the cedent's net loss experience over a time by absorbing adverse loss experience Types of prospective contracts: Financial Quota Share Funded Cover Spread Loss Treaty Blended Cover 26
University of Cologne Department of Risk Management and Insurance Reinsurance and Alternative Risk Transfer 4. Alternative Risk Transfer a. What is Alternative Risk Transfer? b. Why ART developed? c. Types of Alternative Risk Transfer Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University
What is Alternative Risk Transfer? ART products are contracts, structures or solutions provided by insurance companies that enable firms either to finance or to transfer some of the risks to which they are exposed in a nontraditional way, thereby functioning as synthetic debt or equity in a customer's capital structure 28
Why ART developed? ART solutions help to expand the set of possible insurable risk ART not only provides solutions for unique problems, it can also improve the situation of the risk bearer ART solutions have played an important role since then by improving insurers capacity to withstand catastrophic-risk losses Catastrophe exposures require a greater allocation of corporate capital than ever before... (Smith / Canelo / Di Dio 1997, in: Geneva Papers on Risk and Insurance) 29
Why ART developed? U.S. Capital Markets Capitalization (1997): ~ 20.000 bn. USD, with a daily standard deviation of ~ 150 bn.. USD U.S. Primary Insurance: Capital and Surplus, ~ 220 bn. USD U.S. Reinsurance: Capital and Surplus, ~ 20 bn. USD 30
Types of Alternative Risk Transfer Types of Alternative Risk Transfer Traditional Risk Carriers Novel Risk Carriers Financial Re Securitization Derivates Captives Cat-Bonds Futures CATEX Contingent Capital Options 31
Risk Securitization 1 2 3 Basic structure Primary insurance Reinsurance Securitization 1 premium policyholder insurance contract 4 5 Refunding Administration 2 reinsurance Premium insurer / cedent reinsurance contract Promotor / stockholder 5 commission management SPV 4 interest / repayment refunding debitor (money Schuldner market) 3 Insurance linked bond Issue price investor 32
Risk Securitization Insurance Linked Bond (insurance linked securities / cat bonds) Bond whose interest payments (coupon at risk) and / or principal payment (principal at risk) depends of claims experience of a given insurance risk and a defined period. The ability to securitize (catastrophe) risk unlocks the vast potential of the global capital markets. Investors in Insurance Linked Bonds (syn.: Insurance Linked Securities, CAT- Bonds) benefit not only from the relatively high yields offered on these securities, but also from the additional diversification that results from the fact that catastrophic risk is essentially uncorrelated with financial risk. Tapping into the capital markets allowed insurers to diversify their risk and expand the amount of insurance available in catastrophe-prone areas. The issuance of bonds is becoming an increasingly popular option for transferring noncatastrophe risks as well. 33
Insurance Derivatives In 1992 the Chicago Board of Trade (CBOT) introduced catastrophe future contracts (CATs) These contracts were intended to track broadly insured losses arising from natural catastrophes Because no underlying is readily identifiable for such contracts, the CBOT created an index that imparts values to the future contracts by the contracts` reference to the index level at settlement The index is based on losses reported quarterly to the independent Insurance Services Office (ISO), which collects information from about 100 insurers 34
Insurance Derivatives In 1995 the CBOT introduced catastrophe insurance options based on PCS indexes PCS options are cash-settled options with an underlying cash value determined by a new index PCS provides estimates of nine catastrophic loss indexes on a daily basis. These indexes are geographical and track PCS-estimated insured catastrophe losses nationally, by region and by state PCS index measures a loss, not a loss ratio PCS purchasers have a choice between two loss development periods: 6 or 12 months 35
Classification of ART Techniques (similar to the scheme of Doherty) Assets Liabilities E A L Occurrence of a risk Assets Liabilities E 1 A 1 L Effectiveness of ART Assets Liabilities E 2 Assets Liabilities E 1 -L 2 Assets Liabilities E 1 A 2 E 2 A 1 L A 1 L A 1 L A 2 36
Classification of Reinsurance/ART-Hedging-Techniques How to compensate the claim payment on the balance sheet? Asset Hedge: Compensation by asset growth: (e.g. reinsurance, finite risk, Insurance Derivatives) Liability Hedge: Compensation by decline in other liabilities, in particular interest payment, principal repayment (e.g. securitization). Capital management: Compensation by exogenous increase in equity capital (e.g. contingent capital, equity put options). 37