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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
Correction – Figure 23
One in each
category of this
column has to be
non-proportional!
3
Study Points
Worldwide risk sharing
Reinsurance demand
Reinsurance fundamentals and operations
Reinsurance markets
Reinsurance regulation
4
Worldwide Risk Sharing Through Reinsurance
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.
6
Worldwide Risk Sharing (Figure 23.1)
Insured

Insured
Insured
Insured
Insured
Insured
Primary
Insurer
(Canada)
Reinsurer/
Retrocessionaire
(France)
Reinsurer
(U.S)
Retrocessionaire
(Italy)

Insured
Insured
Primary
Insurer
(China)
Reinsurer
(Germany)
Retrocessionaire
(Bermuda)
Reinsurer
(Japan)
Retrocessionaire
(U.S.)
Reinsurer
(Singapore)
Retrocessionaire
(Korea)
Reinsurer
(Mexico)
Retrocessionaire
(Brazil)
Another version of
the same figure in
the next slide.
7
Worldwide Risk Sharing (Figure 23.1)
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Rationales for Reinsurance Demand
Ownership structure
Cost of financial distress
Capital market imperfections
Real service efficiency
Reduction of tax liability
Volatility control
Refer to “Insurance
Demand” in
Chapters 2 and 19.
Regulatory constraints
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Reinsurance Fundamentals
Types of Reinsurers
Professional reinsurers
Reinsurance departments (of insurance companies)
Pools
Lloyd’s associations
11
Reinsurance Distributions
Direct writing reinsurer
Reinsurance brokerage firm
Slip
Lead (leading underwriter)
Broker’s cover
12
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
13
Classification of Reinsurance Contracts
(Figure 23.2)
Facultative
Proportional
Reinsurance Contract
The contract is on individual risk basis; that is, there is no preexisting 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.
Non-proportional
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.
Proportional
Non-proportional
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).
Source: Kwon (1999)
Another
version in
the next
slide.
14
Classification of Reinsurance Contracts
(Figure 23.2)
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Forms of Reinsurance (Figure 23.3)
Proportional (Pro-rata)
Sharing the amount of insurance, premium and loss on a proportional basis
Forms of Reinsurance
• 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
Source: Kwon (1999)
Another
version in
the next
slide.
16
Forms of Reinsurance (Figure 23.3)
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Proportional Reinsurance – Quota Share (Table 23.1)
18
Proportional Reinsurance – Surplus (Table 23.2)
19
Illustrative Proportional Treaty (Figure 23.4)
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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)
21
Excess-of-loss Reinsurance (Figure 23.5)
22
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
23
Reinsurance Program Design
Commissions
Types
Ceding commissions
Profit commissions
You may use the example
in pages 609-610 to
describe the relief from
ceding commissions.
Not all reinsurance contracts offer commissions
Ceding commissions
differ from reinsurance
brokerage fees.
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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.
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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
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Prospective Financial Reinsurance
Length of coverage period
Finite term of contract (non-renewability)
Explicit profit sharing agreement
Limit on coverage
27
Prospective Financial Reinsurance (Insight 23.1)
28
Reinsurance Markets
Reinsurance Premiums Globally (2005) (Figure 23.6)
Asia
10.3%
Rest of the
World
5.1%
North
America
50.4%
Europe
34.2%
Source: Datamonitor (2005)
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Cession Rate by Region (1998) (Table 23.3)
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Largest Reinsurers (2005) PART 1 (Table 23.4)
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Largest Reinsurers (2005) PART 2 (Table 23.4)
33
Top 10 Global Reinsurers (2006)
34
Top 10 Global Reinsurance Brokers (2006)
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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.
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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.
37
Compulsory Reinsurance Cessions (Table 23.5)
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Reinsurance Regulation
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
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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.
41
Reinsurance Regulation
The E.U. Reinsurance Directive (2005)
Supervisory power
Single licensing
Solvency provision
42
Regulatory Developments in Reinsurance (Table 23.6)
43
Reinsurance Issues (new for discussion)
Meaning and application of reinsurance
Alternative risk transfers, especially insurance-linked securitizations
Taxatio issues
44
Discussion Questions
Discussion Question 1
What advantages and disadvantages would an insurance
company expect from ceding its risks (a) facultatively or (b)
using a treaty?
46
Discussion Question 2
Describe how premiums and losses are shared in (a) surplus
treaty reinsurance and (b) working XL reinsurance.
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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.
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Discussion Question 4
An author cited in this chapter wrote “reinsurance can be
viewed as both a leverage and a risk management
mechanism.” Explain.
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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?
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Discussion Question 6
In view of the trends in the reinsurance market, what is their
likely impact on reinsurance distribution systems.
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Discussion Question 7
Why are the world’s largest reinsurance firms located in
Europe?
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