day 3: an introduction to reinsurance

DAY 3: AN INTRODUCTION TO REINSURANCETariq [email protected] – 00962 7 9767 7418

mailto:[email protected]

INDEX

▪ The statistical basis of premiums

▪ Fluctuations in technical risk

▪ About Tariq Al-Basha

THE STATISTICAL BASIS OF PREMIUMS

▪ “Force majeure” premiums and claims

▪ The statistical service provided by reinsurers acquires even greater significance incases of claims caused by force majeure or natural events, for which the periods ofreoccurrence, local circumstances and possible accumulations involved in eachone are very different.

▪ Who can compile the data required to best estimate aspects of risk such as theirfrequency, probability and intensity? Only international reinsurers who have beenoperating for long enough periods will have this information.

FLUCTUATIONS IN THE TECHNICAL RISK

▪ The insurer is subject to imponderables which it tries to overcome byapplying statistical techniques. In any case, the price of the premium isestablished before knowing whether a claim will occur with theconsequent indemnity, the amount of indemnity and when it will haveto be paid.

▪ Therefore, how the information used by the insurer corresponds to thepast and how, in order to set the premiums, statistical assumptions areused to adjust for the future. However, there are causes that may makethe forecasts incorrect, with the result that the risks can then fluctuate.We can look at two examples.


▪ Technological development is one of them. In virtually all industrial processes,recent years have seen the introduction of new raw materials derived fromthe petrochemical industry, electronic control systems, etc. The same has alsohappened with domestic risks (households, vehicles, etc.). If the insurer usespast statistics as a basis, it will have to take special care and constantly analyzethe trends of risks.

▪ Another source of possible deviations can be natural disasters: earthquakes,floods, cyclones, etc. During the period covered by the statistics, there maynot have been any occurrences but, if they occur, they can have a significanteffect on a large number of a company’s insureds, even over different classesof business. However, there are other factors that may alter an insurancecompany’s statistical calculations when setting the amount and adequacy ofthe premiums for the risks covered under their policies. We will considerbelow two risks that have a significant effect on these calculations:

▪ The risk of random fluctuations

▪ The risk of change



▪ This type of risk has to be taken into consideration in the calculations that theinsurer has to make when establishing the amount of the premium. That being thecase, it will have to decide what percentage of deviation it can accept withoutexcessively exposing the business balance sheet.

▪ In order to calculate this percentage, it will to devise models that enable it todetermine the probability of occurrence of a number of defined claims over aspecific period of time and for the number of policies it handled at the time. Theoutcome of this study will be the degree to which greater or lesser deviation isaccepted and logical conclusion is that the lower the degree of deviationaccepted, the more confidence in the statistical result.



▪ One difficulty: non-uniformity of the portfolio

▪ For the insurer, the greatest difficulty for determining the acceptance level will actuallybe the non-uniformity of its portfolio, since the sums insured on the different riskscovered can vary enormously, even though (as in any statistical study) the probability ofdeviation will reduce as the number of insured risks increases.

▪ One solution: reinsurance

▪ Insurance portfolios are normally comprised of a larger number of medium/low insuredrisks and a few higher sums insured. One solution to the problem of a portfolio’sdiversity is to have a cut-off amount of sums insured and to cede everything above thatamount of reinsurers. In this way, a more uniform portfolio will be achieved, giving theinsurer a more accurate idea of the margin of deviation accepted for the risk offortuitous deviations.



▪ This is another factor that can affect insurers’ statistical calculations and itconcerns the variability of the data that will be taken into consideration whenpreparing that information. The fact is that if all the circumstances relating to thefrequency and amount of claims are taken into account, it is unlikely that thefactors taken into consideration during the period of time studied statistically willremain constant. This almost certain variation can give rise to an increase orreduction in the liabilities borne by the insurer.

▪ The risk of change is determined by a series of factors, some more obvious thanothers, as the following examples show.



▪ Salaries and manufacturing costs

▪ If we look at the claim amounts that an insurer has to indemnify, these are the twovalues that have the most effect. Variations in salaries and manufacturing costs are verydifficult to quantify in advance as it is only known that the tendency is to increase butnot to what extent. These are two of the most obvious examples of the risk of changebut they are not the only ones.

▪ In theft insurance

▪ The tendency is for people’s standard of living to improve. This social trend isaccompanied by even greater growth in the crime rate which will naturally affect theftinsurances.



▪ In marine insurance

▪ Thanks to technological progress and the large size of vessels, there has been a significantreduction in the number of total claims affecting these insurances. By way of illustration, wecan say that is been calculated that, whereas some 200 years ago partial claims accounted foronly 3% of paid claims, in the 19th century the risk premium was made up of equal amountsfor total claims and partial claims. Currently, only 20% of the risk premium accounts for totallosses.

▪ In motor insurance

▪ It is common knowledge that the total number of vehicles is known to have experiencedrapid growth, and this growth has totally changed the medium and long-term statistical data.So, what has to be done? The data must be compiled over shorter, more immediate periods.

▪ But this is not the only factor that affects motor insurance. Factors such as the considerableimprovements in the road network and also the weather conditions (depending on whetherthere are periods of drought or of rain an snow) need to be taken into consideration.



▪ In liability insurances

▪ This is another class of insurance that has most suffered from the risk of change. Theimprovement in the standard of living and, consequently, in the level of culture andconsumer pressure have meant that the frequency and amount of liability claims haveincreased almost exponentially in recent years. This means that insurers are forced torevise their calculations and increase premiums

ABOUT TARIQ AL-BASHA• Business & Financial Modelling

Consultant at several consulting firms inthe Middle East.

• Business management graduate from theUniversity of Greenwich, London – UK.

day 3: an introduction to reinsurance

Economy & Finance