Introduction to Reinsurance

Presentation by Holborn Corporation November 11, 2004

What is Reinsurance?
“Insurance for Insurance Companies” More precisely
Reinsurance transfers insurance underwriting risk to third-party organizations.

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Introduction
(Re)Insurance Financial Strategies
Pooling Large number of small risks, where individual premiums inadequate to cover individual losses Funding Individual risks’ premiums set high enough to cover likely losses (plus expenses and profit) Speculating Large, unique exposure; low chance of loss; potential loss is very high Low enough likelihood that expected return greater than cost of capital

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Introduction
(Re)Insurance Financial Strategies
Basic Strategy
Funding

Insurance Example
• Dental insurance • WC retro

Reinsurance Example
• Net account quota

Business Constraints
• Processing • Leverage • Line size limits • Spread

Low-Cost Providers
• Class of business

share

specialists

Pooling

• HO fire • Auto BI

• Working layers

• Diversified

multi-line underwriters
• High capital • Tolerant of

Speculating

• Trophy properties • EQ shake

• Property cat • EQ quota share

• Aggregate

exposure
• Volatility

volatility
• Price-setters

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Reinsurance and Holborn’s Role
Agents

Insurance Policyholders

Insurance Companies

Reinsurance Companies
Example: Lloyd’s Of London, Berkshire Hathaway

Brokers

Reinsurance Intermediaries *Holborn* Transfer of Risk
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Risk Takers “Middle Persons” 5

Reinsurance - Other Characteristics
Reinsurance contracts derive value from insurance polices (although reinsurance transactions rarely involve original policyholders). For a premium, an insurance company cedes portions of its insurance risk to a reinsurance company to transfer possible loss. Reinsurance rates and forms are unregulated; however, the parties to a reinsurance transaction must be licensed (or reinsurers’ liability collateralized) for the reinsurance transaction to be fully recognized by insurance regulators (and, thus, for insurance companies to receive statutory accounting benefit from the transaction).

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Types of Reinsurance - Summary
There are two types of reinsurance Facultative Treaty Each type of reinsurance can be structured in one of two ways Excess of Loss (i.e., limit and retention) Pro Rata (a/k/a, “proportional”) Treaty excess of loss reinsurance can apply on one of the three basis: Per Risk Per Occurrence (a/k/a, “Catastrophe”) Aggregate (a/k/a, “Stop Loss”)

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Facultative Reinsurance
Facultative reinsurance applies to an individual risk, i.e., one commercial fire policy or even only one location. Insurer and reinsurer agree to the reinsurance terms on each individual agreement. It is generally used to reinsure:
a) b)

extra-hazardous or unusual risks which might be excluded from treaty reinsurance agreements. high valued risks with policy limits exceeding maximum treaty parameters.

For Property risks, specific information about construction, usage, contents, fire protections and other safety attributes will be assessed by the underwriter. For Casualty exposures, revenue, coverage type, and claims history are key underwriting considerations. Both pro rata and excess of loss forms are used. Facultative premiums are usually based on the ceding company’s exposures, not it’s premium. So, $25 per car, not 2% of Automobile premiums
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Treaty Reinsurance
Treaty reinsurance applies to an insurance company’s entire book of business, such as all commercial fire polices, all automobile policies, all workers’ compensation policies, all homeowners policies, or, more generally, any combination of the above. Certain risks are inevitably excluded to help define the exposure for the treaty underwriter, who must rely on the capabilities of the ceding carrier in determining the worth of any particular risk. Both pro rata and excess of loss forms are used. Treaty reinsurance premiums is usually set as a percentage of the ceding companies original premiums.

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Pro Rata (or Proportional) Reinsurance
Insurer shares with the reinsurer all of the premiums and losses in a certain percentage. Two forms of pro rata: Quota Share and Surplus Share. Example: 80% Homeowners Quota Share. Insurer retains 20% of each and every policy; the reinsurer accepts 80%.

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Pro Rata Reinsurance
Surplus Share: The insurer and reinsurer share a variable percentage of loss and premium for each risk (not a fixed percentage, like a quota share). Example: $4Mn home, subject to a surplus share contract with a minimum retention of $1Mn and maximum cession of $3Mn. In this situation, the Reinsured can choose to cede anywhere from 0% to 75% of the risk (being $3Mn. of $4Mn. value). Given no maximum retention, the Reinsured can keep the entire risk net. If the risk is deemed undesirable, the Reinsured can cede a maximum of $3Mn, and retain $1 Mn. In this instance, 75% of the loss and premium is ceded to the reinsurer. Other examples (same surplus share structure) $2Mn. Home Up to 50% cessions (being $1Mn. of $2Mn.) $1.5Mn. Home Up to 33% cession (being $500,000 of $1.5Mn.)

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Pro Rata Reinsurance
Pro Rata Pricing Mechanism: Ceding commission. Two Options: Flat: Fixed percentage. Sliding Scale: Fluctuates with actual loss experience, subject to a minimum and maximum. Why buy pro rata protection? To reduce net written premiums and underwriting leverage (i.e., Finance, “surplus relief”) Capacity for individual risks Catastrophe protection

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Excess of Loss Reinsurance
Reinsurer indemnifies reinsured (up to a stated limit) once a loss(es) exceeds a pre-determined level (i.e., the deductible or retention). Excess of Loss reinsurance is expressed as, for example, $400,000 excess $100,000. (If the insurer incurs a $500,000 loss, it is responsible for the first $100,000 of paid loss, and is reimbursed for the next $400,000). Pricing: Percentage rate applicable to insurer’s original premium (i.e., “subject premium”) for policies covered by reinsurance.

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Excess of Loss Reinsurance
Three types of Excess of Loss Reinsurance: Per Risk Retention and limit apply to each and every policy, individually (usually subject to an occurrence limit). Catastrophe (or Occurrence) Retention and limit apply to one or many policies in the same event. Aggregate (or “Stop Loss”) Retention and limit apply to all losses from all covered policies, in the aggregate, over a specified timeframe – usually no more than one year.

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Excess of Loss Reinsurance
Functions: Per Risk: Catastrophe: Aggregate: Capacity for Individual Risks Protection against accumulation of loss Stabilization – i.e., net income protection (Finance, Catastrophe)

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Functions of Reinsurance
There are four main functions of reinsurance
Finance Capacity Stabilization (net income protection) Catastrophe (surplus protection)

Another reason may include product expertise held by the reinsurer, not by the reinsured.

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Functions: i) Finance
An insurance company’s growth may be limited because of unearned premium reserve requirement(s). A company is forced to put all written premium into a UEP reserve account while still paying business (acquisition) costs, (agents’ commissions must be paid on written premium). The premium on an annual policy is earned at the rate of 1/12th per month. Because acquisition costs must be paid immediately, there can be a substantial drain on surplus, particularly when premium volume is expanding rapidly. The accounting system used by insurance companies is designed to enhance financial strength, with state insurance regulators monitoring such items as the ratio of written premium to surplus. A general rule of thumb used to be 3 to 1, but now 2 to 1 is more often used. A ratio above 2.5 to 1 (varies by Company) could result in a company being viewed as over extended, leading to rating agency action. Pro rata reinsurance enables a company to continue to write polices without draining capital and surplus. It reduces written premium and increases the surplus, by means of a ceding commission recouping pre-paid acquisition expenses.

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Functions: ii) Capacity
The ability to offer significant capacity on any given risk allows an insurance company to compete in the market. Most companies require greater capacity than their own resources can provide. By reinsuring portions of risk, through pro rata and/or excess of loss, a company can compete in the market. A company writing to a maximum policy limit of, say, $10,000,000 could double that capacity by arranging a surplus share reinsurance treaty. Thus, a $20,000,000 policy can be written with 50% of $10,000,000 ceded to a surplus share reinsurer(s). Alternatively, a per risk excess of loss contract of $10,000,000 excess $10,000,000 has similar effect. On a $20,000,000 policy, all losses over $10,000,000 are paid by the reinsurers for a predetermined premium.

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Functions: iii) Stabilization
Insurance companies generally prefer stable year-to-year underwriting results, rather than wide fluctuations. Excess of loss reinsurance enables a company to determine the loss it will assume on any one risk, in any one occurrence, or in the aggregate for the entire year. Thus, losses are stopped at a certain level above which reinsurers pay.

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Functions: iv) Catastrophe
Surplus needs to be protected against severity of major catastrophe, such as hurricanes, tornadoes, floods, earthquakes, hail, etc. Most reinsurance arrangements provide some degree of coverage for these occurrences, but catastrophe excess of loss specifically addresses the accumulation of small losses, some or all or which would not be covered under any of the company’s other reinsurance.

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Holborn’s Role as Reinsurance Intermediary
Advocate, consultant and advisor to insurance company clients. Maintain business relationships with reinsurers on a worldwide basis Structure cost effective reinsurance programs Canvass reinsurance market to determine interest among intermediary market reinsurers in a given program bearing in mind the financial strength of each reinsurer Constant monitoring of reinsurers’ financial condition - ability and “willingness” to pay claims Monitor effectiveness of reinsurance program – Increase retention? Limit needs? Coverage Provided, etc. Provide other actuarial, modeling, claims, accounting and contract wording services.
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Actuarial Support
Our Mission To offer the best combination of proprietary, commercially available and common-sense tools for our clients to systematically evaluate all of their choices for reinsurance purchasing and risk management.

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Actuarial Support
Founded in 1940’s Ahead of its time 7 employees (over 10% of our workforce) Customized models for each client Relationships with multiple vendors Proprietary original models to supplement weaknesses in vendors’ models

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Actuarial Support
Catastrophe modeling
Mapping includes
• •

Concentration studies / “Concentrics” Deterministic storms / “Look-a-likes”

Vendor-developed cat models, which we license Holborn’s proprietary Inland Wind Cat model

Dynamic Financial Analysis (DFA) Optimization / risk selection Reinsurance benchmark pricing BCAR “What-if’s” Risk transfer testing Rating agency questionnaires

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