Reinsurance and Cross-Border Issues August 2007 Reinsurance Training - Brazil Bryan Fuller - NAIC Senior Reinsurance Manager
Outline • Purpose and role • Financial impact • Monitoring and security • Insurer failures • Contracts and supervision • Broader context and references
Five Functions of Reinsurance • 1. Capacity / Spreading Risk • Ability to write more premium while maximizing • principle of insurance. • 2. Loss Control / Catastrophe Protection • Minimize financial impact from losses. • 3. Financing • Providing financial resources for growth. • 4. Stabilization • Minimize variations in financial results. • 5. Services • Facilitate operations of insurance companies.
Capacity • Refers to an insurer’s ability to provide a high limit of insurance for a single risk, often a requirement in today’s market. • Reinsurance can help limit an insurer’s loss from one risk to a level with which management and shareholders are comfortable. • Most states require that the maximum “net retention” from one risk must be less than 10% of policyholders’ surplus.
Catastrophe Protection • Objective is to limit adverse effects on P&L and surplus from a catastrophic event to a predetermined amount. • Covers multiple smaller losses from numerous policies issued by one primary insurer arising from one event.
Financing • It is growing and needs additional surplus to maintain acceptable premium to surplus ratios. • Unearned premium demands reduce surplus. • In a down cycle, underwriting results are bad and reduce surplus. • Investment valuation negatively impacts surplus. • Marketing considerations dictate that an insurer enter new lines of business or new territories.
Stabilization Marketing Consideration Policyholders and stockholders like to be identified with a stable and well managed company. Management Consideration Planning for long term growth and development requires a more stable environment than an insurance company’s book of business is apt to provide.
Services 1. Claims Audit 2. Underwriting 3. Product Development 4. Actuarial Review 5. Financial Advice 6. Accounting, EDP and other systems 7. Engineering - Loss Prevention
Process Risk • Reinsurance basis risk is the risk that the reinsurance cover might prove insufficient for the risk in question because the need for reinsurance has not been precisely identified. This may occur if theinsurer incorrectly identifies the need for reinsurance or incorrectly describes the need to reinsurers. This might occur if relevant clauses in the reinsurance contract are inappropriate or omitted. Also, the wording of reinsurance contracts may be incompatible with the underlying insurance contracts, particularly in harder reinsurance markets when greater exclusions may be applied. • Operational risk is the risk that the people, process, or systems on which the management and execution of the reinsurance process depend will fail or be inadequate.
Reinsurance Credit Risk • Reinsurance credit risk. While the insurer may pass risk to the reinsurer, the insurer takes on some risks, of a different nature, as a consequence. In particular, the insurer takes on the risk that its reinsurer might fail and so void the reinsurance coverage.
Specialization • A given insurer may be a direct insurer for certain risks, but a reinsurer for other risks. This gives rise to the use of the terms outward reinsurance and inward reinsurance (sometimes called reinsurance assumed) to describe the two directions in which the reinsurance arrangement may flow. • While insurers may be specialist reinsurers or specialist insurers, it is not uncommon for insurance entities to be involved with both outward and inward reinsurance. From a supervisory perspective, it is important to recognize the different issues relating to whether the entity is seeking or providing reinsurance to other insurers.
Law of Large Numbers • In general, insurance can be viewed as an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) that would exist if it were not for the insurance contract. • Capital. • The variability of results is reduced, because capital typically must be held to provide support in the case of adverse results—that is, adverse variations from expected results. In practice, capital is in limited supply for insurers and reinsurers. The pooling effect of reducing variability of results translates to reducing the capital requirements, when measured on a per policy basis. Reinsurance can reduce the probability of occasional large losses, reducing the variability of results, thereby potentially reducing the minimum capital that the insurer is required to hold. Alternatively, the need for capital increases at a slower rate than the growth rate of an insurance portfolio (assuming statistically independent and identical risks).
Law of Large Numbers • Homogeneous risks • In practice most pools of insured risks are not homogeneous. While homogeneity is a useful assumption for demonstrating the validity of the insurance concept and may be assisted by appropriate underwriting, it does not hold in practice. To the extent that risks are not homogeneous in type, severity, or frequency, the theoretical results are weakened. This highlights the importance of insurers and reinsurers understanding the structure of their insured pools and subpools of risks. In the case of reinsurers who rely, perhaps entirely, on the underwriting of the ceding insurer, there is the added risk of underwriting error or bias of the insurer to consider. • Independence of risks • The justification for pooling presumes that risks are independent of each other. Again this is rarely true in practice, and there may be correlations, albeit of varying strengths. A clear example of correlations is the level of geographic concentration of risk for, say, hailstone damage to motor vehicles.
Reinsurance Contracts Basics Proportional Reinsurance Non-Proportional Reinsurance Reinsurance Contracts Treaty Facultative Semi Automatic Pro Rata Excess of Loss Certificate OR Automatic Quota Share Surplus Share Per Risk Per Occurrence Aggregate Pro Rata Excess of Loss • Other Considerations: • Occurrence vs. Claims Made • Prospective vs. Retroactive
Facultative Protects individual risks Offer and acceptance basis. Reinsurer retains the right to accept or reject each risk. Supported by a Certificate Certificate attaches to the conditions on the underlying insurance policy Cession is optional Treaty Protects a large block of business. The reinsurer does not have the right of rejection on a per risk basis. Supported by a contract Pre-agreed conditions Cession is obligatory Acceptance is automatic Reinsurance Forms Book of Business Individual Risk
Types of Agreements Proportional • Quota Share • Surplus Share • Excess of Loss
Reinsurance Issues • Types of Reinsurance Contracts • Functions of Reinsurance • Why reinsure? • Forms of Reinsurance • How is reinsurance effected? • Reinsurance Markets • Who are the reinsurers? • Reinsurance Security • Where to place the reinsurance? • Classes of Business Protected • What are we reinsuring? • Retentions and Deductibles to be carried • When do we reinsure?
Types of Agreements Quota Share: Simplest type, reinsurer and reinsured share in every loss and in the premiums at a fixed percentage. Example: Retention 60% / Reinsurance 40% Policy Limit $100,000 $200,000 Retained Amount – 60% $ 60,000 $120,000 Reinsured Amount – 40% $40,000 $80,000
All premiums, losses, loss adjustment expenses, unearned premium reserves and case reserves are shared according to the contract terms from the first dollar of coverage.The reinsurer receives $800.00 in premium and the ceding company retains $200.00.If a loss of $ 100,000 occurs, the reinsurer will pay $80,000 and the cedant pays $ 20,000. Policy Limit $ 300,000 Premium: $ 1,000 Loss: $100,000 Ignoring any ceding commission.
Types of Agreements Surplus Share: Greater flexibility. Reinsured selects retention each risk, and cedes multiples of the retention (lines) to the reinsurer. Compared ceded amount to policy limit. Create a proportion. Reinsurer chares in that proportion of loss and premiums for each loss under that policy. Policy Limit $20,000 $40,000 $60,000 Reinsured’s Share 100% 50% 33.33% Reinsurer’s Share 0 50% 66.66%
The first $ 200K of each risk is kept net of reinsurance (blue). The first three risks are kept entirely by the reinsured. The ceding insurer then keeps the following percentage of the premiums and losses for each subsequent risk (66.7%, $ 200K/$ 300K), 50%, 40%, 33.3%, 28.6%, and 25% respectively. Surplus Reinsurance
Quota Share Vs. Surplus Share Both Always Pay Proportionate Share of Any Loss QS Surplus Cession % Varies Based on Size of each Risk and ceding company retention Cession % the Same for every risk Protects Cedent’s Entire Book Used Mostly for Larger Risks Always Obligatory Can Be Obligatory or Non-Obligatory
Excess Of Loss Reinsured retains a predetermined dollar amount (the retention). The reinsurer then indemnifies loss excess of that retention up to a stated limit. • Per risk excess of loss • Per risk aggregate excess of loss • Per occurrence excess • Aggregate Excess of Loss (Catastrophe)
Excess Of Loss With excess of loss reinsurance no insurance is ceded and no sharing is involved. The reinsurer promises to reimburse the reinsured company for losses above a set retention in return for a stated premium rather than promising to share premiums and losses based on some proportional basis Excess of loss reinsurance is frequently provided in layers with the retention at each layer equal to the reinsured company’s retention plus the reinsurance limit of the layer(s) above. As the limits of the layer are exhausted the next layer of excess reinsurance becomes available.
20 $ 10 M 95% of $ 5M xs $ 5M Catastrophe Excess of Loss Cover $ 5 M 95% of $ 4M xs $ 1M $ 1 M 95% $ 500K xs $ 500K $ 500 K Retention
Reinsurance Program Example Catastrophe Non-Proportional 2nd Excess 1st Excess $ Loss Surplus Share Proportional Quota Share Retention
Life vs. Non-Life Reinsurance • Several differences have been noted between Life and Non-Life reinsurance: • Reinsurance program structure. Life reinsurance treaties tend to cover indefinite periods, and the termination conditions affect new business only, whereas nonlife reinsurance arrangements traditionally last for one year and cover only a specific line of business. This increases the importance, for non-life reinsurance, of ensuring that proper documentation, such as cover notes, is in place.
Life vs. Non-Life Reinsurance • Facultative reinsurance is more common for life insurance. The term “co-insurance” has very different meanings in the context of life and non-life reinsurance, as may the usual order of application of reinsurance cover. The use of layers is common in non-life insurance, but not in life insurance. • Product structure. Many life insurance products, especially traditional whole-life and endowment products, have high initial expenses that are expected to be recouped over the later years of the contract. This can lead to initial capital strain for life insurers. Reinsurance may alleviate some of this initial capital strain. This phenomenon is not as pronounced with non-life insurance, in which one-year insurance contracts predominate.
Life vs. Non-Life Reinsurance • Finite risk and alternative risk transfer. While more recent developments in reinsurance can be used in the context of life insurance, they have developed primarily in the non-life context. • Supervisory regimes and practices. Legislative requirements, actuarial approaches, and industry practices vary between life and non-life insurance and hence are reflected in reinsurance considerations. This is not surprising given the nature of the risks covered.
Life vs. Non-Life Reinsurance • Retention levels. Industry retention levels, in general, are significantly higher in life insurance than in non-life insurance. This reflects the increased heterogeneity of non-life insurance risks as well as the increased volatility of non-life insurance risks. • Credit risk. Reinsurance failures of some type are a significant, although not the most likely, cause of failures of insurers, particularly for non-life insurance.
Life vs. Non-Life Reinsurance • Complexity, volatility, and change. As a general comment, the role of reinsurance is more important, more complex, and more subject to change and volatility in the non-life than in the life insurance industry. The non-life insurance, and so reinsurance, industry is more subject to changes in expectation, legislation, and volatility in potential claims than the life insurance industry. As a specific example, consider the ongoing risks and issues relating to the past use of asbestos.
Types of Life Reinsurance • Indemnity • Traditional Spread or Lessen Risk • Financial Meets Financial Goals • Non-Proportional Catastrophe, Stop Loss • Retrocession Reinsurance of Reinsurance • Assumption • Transfers Business Permanently
Reasons for Indemnity Reinsurance • Transfer Mortality/Morbidity Risk • Transfer Lapse or Surrender Risk • Transfer Investment Risk • Help Ceding Insurer Finance Acquisition Costs
Reasons for Indemnity Reinsurance • Provide Ceding Company • Underwriting Assistance • Product Expertise • Tax Planning • Help Manage Capital and Surplus and/or RBC Objectives • Limit Adverse Effects of Catastrophic Events • Help Enter New Market
Assumption Reinsurance • Sale of a block of business • Novation of a contract • Reasons For Assumption • Divesture • Raise Capital • RBC Issues • Help Ratings • Rehabilitation
Yearly Renewable Term (YRT) Insurance • Only the Mortality Risk is Transferred • Premium varies yearly • Rates vary by age, sex, duration, smoking • Quoted by reinsurer, subject to negotiations • Not usually guaranteed, but rarely changed • Coverage continues until original policy terminates
COINSURANCE • Simplest and purest form of reinsurance; all significant risks are transferred • Mortality, Investment, Lapse Risk • Company receives same share of benefits and expense • Premium = Policyholder Premium - Allowances • Reinsurer holds its reserves that match with Company’s reserve credit
MODIFIED COINSURANCE • Ceding company retains reinsurer’s share of reserves & related assets • Reinsurer pays amount equal to its share of reserve increase to company periodically
COINSURANCE WITH FUNDS WITHHELD • Company takes reserve credit & reinsurer sets up its share of reserves • Assets backing reinsurer’s reserve are withheld & retained with company
Appendix A-791 • Life & Health Reinsurance Agreements has a table reflecting products and their underlying risk components: • Morbidity • Mortality • Lapse • Credit Quality • Reinvestment and • Disintermediation
Supervisor’s Perspective • At a high level, the process for assessing a reinsurer’s risk profile includes • Examining recent compliance issues, • Conducting financial analysis and comparing the industry and performance indicators over a recent period (for example, three or five years) • Assessing the reinsurer’s current business strategy, assessing the various risks inherent in the reinsurer (in particular, corporate governance matters and “fit and proper” consideration for board and senior management) • Judging the effectiveness of risk mitigators, control functions, and capital availability.
Supervisor’s Perspective • Appropriate powers include matters such as the ability of the supervisor to require: • Reinsurance arrangements (changes both in the coverage desired by the insurer and in the treaty conditions), • Reinsurance providers (changes in providers, including the power to prohibit a particular reinsurance arrangement), • Capital (the power to require the provision of additional capital, technical provisions, or collateral) • Information and analysis (regular provision of information regarding reinsurance programs, for example, the power to require reporting and analysis through financial condition reports), and • Independent reviews (independent third-party reviews of matters relating to reinsurance and its administration).
Supervisor’s Perspective • Do any insurers in your jurisdiction have in place reinsurance arrangements with reinsurers who are not supervised within your jurisdiction? If so, how are these arrangements treated in the insurer’s balance sheet?