⚠️Risk Management and Insurance Unit 9 – Reinsurance & Alternative Risk Transfer

What's Reinsurance?

• Reinsurance provides insurance for insurance companies to transfer a portion of their risk to another insurer
• Allows primary insurers to increase their underwriting capacity and take on more risk without increasing their exposure
• Reinsurers assume the risk in exchange for a share of the premium paid by the policyholder to the primary insurer
• Helps stabilize the insurance market by spreading risk among multiple insurers
• Reinsurance agreements can be treaty-based (covering a class of policies) or facultative (case-by-case basis)
• Protects insurers against catastrophic losses (natural disasters, major accidents) that could threaten their solvency
• Enables insurers to maintain a balanced portfolio of risks and manage their capital more efficiently

Types of Reinsurance

• Proportional reinsurance shares premiums and losses between the primary insurer and reinsurer based on a pre-determined percentage
  • Quota share reinsurance splits premiums and losses based on a fixed percentage for all policies covered under the agreement
  • Surplus share reinsurance allows the primary insurer to retain a fixed amount of each risk and cede the excess to the reinsurer
• Non-proportional reinsurance provides coverage for losses exceeding a specified threshold, with the reinsurer responsible for the excess
  • Excess of loss (XOL) reinsurance covers losses above a certain amount (retention) up to a specified limit
  • Stop-loss reinsurance protects the primary insurer's entire portfolio against aggregate losses exceeding a predetermined level
• Facultative reinsurance is negotiated on a case-by-case basis for individual risks or policies
• Treaty reinsurance covers a class or book of business automatically based on predefined terms and conditions
• Finite reinsurance combines traditional reinsurance with financial elements to provide multi-year coverage and smooth out earnings volatility

How Reinsurance Works

• Primary insurer (cedent) transfers a portion of its risk to the reinsurer (assuming company) through a reinsurance agreement
• Reinsurer receives a share of the premiums collected by the primary insurer in exchange for assuming the risk
• When a claim occurs, the primary insurer pays the policyholder and then seeks reimbursement from the reinsurer based on the terms of the agreement
• Reinsurance can be arranged on a proportional (share of premiums and losses) or non-proportional (excess of loss) basis
• Reinsurers often retrocede a portion of their assumed risk to other reinsurers to further spread the risk
• Reinsurance agreements specify the terms, conditions, and limits of coverage, as well as the rights and obligations of both parties
• Reinsurers assess the risk profile of the primary insurer's portfolio and set premiums accordingly, considering factors such as loss history, underwriting practices, and market conditions

Key Players in Reinsurance

• Primary insurers (cedents) seek reinsurance to manage their risk exposure and increase underwriting capacity
• Reinsurers (assuming companies) provide reinsurance coverage to primary insurers in exchange for a share of the premiums
  • Professional reinsurers specialize in assuming risk from primary insurers and often have a global presence (Munich Re, Swiss Re)
  • Reinsurance departments of primary insurers also participate in the reinsurance market
• Reinsurance brokers act as intermediaries between primary insurers and reinsurers, helping to structure and negotiate reinsurance agreements
• Retrocessionaires are reinsurers that assume risk from other reinsurers through retrocession agreements
• Rating agencies assess the financial strength and creditworthiness of reinsurers, which influences their ability to attract business
• Regulators oversee the reinsurance market to ensure stability and protect the interests of policyholders

Benefits and Risks of Reinsurance

• Benefits for primary insurers:
  • Increases underwriting capacity and enables them to take on larger risks
  • Stabilizes financial results by limiting exposure to catastrophic losses
  • Enhances capital efficiency and risk management
  • Provides access to reinsurers' expertise and global market knowledge
• Benefits for reinsurers:
  • Generates premium income and diversifies risk portfolio
  • Allows participation in a wider range of risks and markets
  • Provides opportunities for investment income on premiums collected
• Risks for primary insurers:
  • Counterparty credit risk if the reinsurer fails to meet its obligations
  • Basis risk if the reinsurance coverage does not perfectly match the underlying risk exposure
  • Dependence on reinsurance capacity and pricing, which can fluctuate based on market conditions
• Risks for reinsurers:
  • Exposure to large, unexpected losses that may exceed premiums collected
  • Accumulation risk from multiple cedents exposed to the same event (natural disasters)
  • Moral hazard if primary insurers relax their underwriting standards or claims management practices

Alternative Risk Transfer (ART) Basics

• ART encompasses non-traditional methods of transferring insurance risk outside the conventional insurance and reinsurance markets
• Aims to provide customized solutions for risks that are difficult to insure or require additional capacity
• Often involves the use of capital markets to securitize insurance risks and attract a broader range of investors
• ART solutions can be structured to address specific risk management needs and risk appetites of the participants
• Common ART techniques include captives, risk retention groups, insurance-linked securities, and parametric insurance
• ART can provide multi-year coverage, reduce counterparty credit risk, and offer greater flexibility in terms and conditions
• Helps to increase overall risk transfer capacity and foster innovation in the insurance industry

Common ART Techniques

• Captive insurance companies are wholly-owned subsidiaries created to insure the risks of the parent company and its affiliates
  • Allows the parent company to retain and manage its own risks while benefiting from insurance protection and potential tax advantages
  • Can be used to cover hard-to-insure risks or access reinsurance markets directly
• Risk retention groups (RRGs) are liability insurance companies owned by their members who share similar risk exposures
  • Enables members to pool their risks and obtain coverage on a group basis, often at lower costs than traditional insurance
  • Commonly used in industries with specialized or hard-to-insure risks (healthcare, transportation)
• Insurance-linked securities (ILS) transfer insurance risks to capital market investors through securitization
  • Catastrophe bonds (cat bonds) are the most common type of ILS, providing reinsurance protection for catastrophic events
  • Investors receive periodic coupon payments and risk losing their principal if a triggering event occurs
• Parametric insurance provides coverage based on the occurrence of a predefined event or trigger, rather than actual losses incurred
  • Triggers can be based on physical parameters (wind speed, earthquake magnitude) or indices (industry loss, mortality rates)
  • Offers quick payouts and reduces the need for complex claims assessment processes
• Finite risk insurance combines traditional insurance with financial elements to provide multi-year coverage and smooth earnings volatility
  • Premiums are typically higher than traditional insurance but can be amortized over the coverage period
  • Often used for long-tail risks (asbestos, environmental) or to address accounting and tax considerations

Reinsurance vs. ART: Pros and Cons

• Reinsurance pros:
  • Well-established market with a long history and clear regulatory framework
  • Provides a reliable and efficient way to transfer risk and increase underwriting capacity
  • Reinsurers offer expertise, global market knowledge, and risk management support
• Reinsurance cons:
  • Capacity and pricing can be volatile and dependent on market cycles
  • Counterparty credit risk exposure to reinsurers
  • Limited flexibility in terms and conditions compared to some ART solutions
• ART pros:
  • Provides customized solutions for specific risk management needs and risk appetites
  • Attracts a broader range of investors and increases overall risk transfer capacity
  • Can offer multi-year coverage, reduced counterparty credit risk, and greater flexibility
• ART cons:
  • Regulatory framework is less developed and may vary across jurisdictions
  • Complexity of some ART structures can make them difficult to understand and price
  • Basis risk if the ART solution does not perfectly match the underlying risk exposure
  • Limited liquidity and secondary market for some ART instruments

Real-World Applications

• Property and casualty insurers use reinsurance to manage their exposure to natural catastrophes (hurricanes, earthquakes) and large industrial accidents
• Life and health insurers use reinsurance to mitigate mortality and morbidity risks, as well as to support product development and capital management
• Captive insurance is widely used by large corporations to self-insure their risks and optimize their risk financing strategies
• Risk retention groups are common in the healthcare industry, providing liability coverage for doctors, hospitals, and long-term care facilities
• Catastrophe bonds have been used to provide reinsurance protection for hurricanes in the US, earthquakes in Japan, and pandemic risks
• Parametric insurance has been applied to agricultural risks (crop yields, livestock mortality) and natural disasters (floods, droughts) in developing countries
• Finite risk insurance has been used to address asbestos and environmental liabilities, as well as to support mergers and acquisitions in the insurance industry