Risk Mitigation and the

Role of Reinsurance John FinstonDeputy Commissioner for Corporate and Regulatory AffairsCalifornia Department of Insurance

© 2013 National Association of Insurance Commissioners All Rights Reserved

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Reinsurance• Essentially “insurance for insurance companies”

• An insurer issuing policies becomes a “Ceding insurer” in a reinsurance transaction when it transfers insurance risk via a reinsurance contract to the “Reinsurer.” If a Reinsurer enters into another reinsurance agreement ceding its risk, its reinsurer is called a “Retrocessionaire” and the contract is called a retrocession agreement.

• Reinsurance is a form of insurance, not a lending or money, that requires actual transfer of risk.

Risk Transfer• Insurance risk transfer is the essential

ingredient of a reinsurance contract

• Under U.S. statutory accounting guidance, insurance risk includes both:– Underwriting risk – uncertainties about the ultimate amount of net

cash flows from premiums, commissions, claims and claim settlement expenses

– Timing risk – the timing of the receipt and payment of those cash flows

• Various analytical methods are utilized to evaluate contracts for risk transfer

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Advantages of Reinsurance:Risk Mitigation / Insurance Risk Transfer / Financial Credit• Maximizes spreading of risk to multiple insurers

• Insurers generally transfer insurance risk for one or more of the following purposes:– Capacity– Catastrophe Protection– Stabilization– Financing

• Financial statement credit for reinsurance is generally allowed if contract meets certain requirements

Parties to a Reinsurance Contract

Policyholder to insurer is direct

premium

Ceded premium for the insurer is

assumed premium for the reinsurer

Policyholder

Direct writer cedes

Reinsurer assumes

Policyholder and insurer

have a contract (policy)

Insurer and reinsurer

have a contract(Reinsurance contract)

Policyholder and reinsurerdo not have a contract

Property Casualty Reinsurance• Treaty vs. Facultative• Proportional

– Quota Share– Surplus Share

• Non-Proportional– Excess of Loss

• Per Risk• Per Occurrence (e.g., Catastrophe)• Aggregate

Proportional Agreement Types• Quota Share

– Simplest type, reinsurer and reinsured share in premiums and losses at a fixed percentage on a first dollar basis

– Example: Retention 60% / Reinsurance 40%

Policy Limit Retained 60% Reinsured 40%

$100,000 $60,000 $40,000

$200,000 $120,000 $80,000

Proportional Agreement Types• Surplus Share

– Greater flexibility, reinsured selects retention for each risk, and cedes multiples of the retention (lines) to the reinsurer

– Compare ceded amount to policy limit. Create a proportion. Reinsurer shares in that proportion of losses and premiums applicable to the policy from a first dollar basis.

– Example: Retention $20,000

Policy Limit Reinsured’s Share Reinsurer’s Share

$20,000 100% 0

$40,000 50% 50%

$60,000 33.33% 66.67%

Non-Proportional Agreements• Reinsured retains a predetermined dollar amount

(retention). Reinsurer then indemnifies loss in excess of that retention up to a stated limit.

• Coverage is frequently provided in layers

• As the limits of the layer are exhausted, the next layer of excess reinsurance becomes available

Types of AgreementsTypes of Agreements

EXCESS OF LOSS REINSURANCE

Type of Loss

Type of Reinsurance

Per RiskExcess of

Loss

Per Occurrence

Excess of Loss

AggregateExcess of Loss

Single LossExceeding Retention

CoveredSometimes

CoveredNot Covered

Accumulation of Losses in Single OccurrenceExceeding Retention

Not Covered Covered Not Covered

Total Net RetainedLosses Over YearExceeding Retention

Not Covered Not Covered Covered

Excess of Loss Contract

$ 10 M

$ 500 K

$ 5 M

$ 1 M

Retention

95% of $5M xs $5M

95% of $4M xs $1M

95% $500K xs $500K

Catastrophe

2nd Excess

Surplus Share

RetentionQuotaShare

Reinsurance Program Example

$ L

oss

$ L

oss

ProportionalProportional

Non-Non-ProportionalProportional

1st Excess

Excess of Loss

Treaty

Quota Share Surplus Share Per Risk Per Occurrence Aggregate

Pro RataSemi AutomaticOR Automatic

Certificate

Facultative

Reinsurance Contracts

Pro Rata Excess of Loss

Proportional Reinsurance

Non-Proportional Reinsurance

Other Considerations:• Occurrence vs. Claims Made• Prospective (future) vs. Retroactive (past events)• Insurance Risk Transfer

Reinsurance Contract Basics

Life Reinsurance• Automatic vs. Facultative• Proportional

– Yearly Renewable Term– Co-insurance

• Modified Co-insurance• Co-insurance with Funds Withheld

• Non-proportional– Yearly Renewable Term can also be non-proportional– Catastrophe– Stop Loss

• Indemnity vs. Assumption

Yearly Renewable Term

• A form of life reinsurance usually covering only mortality risk under which the ceding insurer buys coverage for the net amount at risk on the reinsured portion of the policy for a specified premium that may vary each year with the amount at risk, the duration of the policy, and the ages of the insured(s).

• The ceding insurer retains responsibility for establishing reserves and the payment of all surrenders, dividends, commissions, and expenses.

• Despite its name, YRT reinsurance contracts typically obligate the reinsurer to continue coverage throughout the life of the policy.

Coinsurance

• A method of reinsurance under which the reinsurer receives a proportionate share of the premiums, sets up a proportionate share of the reserves and pays its proportionate share of the benefits of the reinsured policy.

• The reinsurer pays the ceding commission and expense allowance to the ceding company to represent the reinsurer’s share of the acquisition and maintenance expenses.

Modified Coinsurance• Indemnity life reinsurance that differs from

coinsurance only in that the assets supporting the reserves are transferred back to the ceding company while the risk remains with the reinsurer.

• The ceding company is required to pay interest to replace that which would have been earned by the reinsurer if it had held the assets corresponding to the reserves in its own investment portfolio.

• Used to retain control of investments or to reduce potential credit risk.

Reinsurance Analysis• Adequate reinsurance cover

• Quality / financial strength of reinsurers

• Diversification / concentration of risk

• Affiliated reinsurance arrangements

• Proper transparency / disclosure in the financial statements

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Importance to Financial Solvency Regulation• Reinsurance significantly affects reported financial results,

reflected as an asset or a reduction of liability.

• Accounting and reporting differs significantly depending on characteristics of reinsurance agreement;

• Ceding insurer maintains obligation to primary policyholder regardless of whether reinsurer meets its obligations

• Contracts can be complex, subject to misinterpretation

• Successful insurance company management generally requires high degree of reinsurance understanding

• Comprehensive analysis of a reinsurance program requires a thorough understanding of the rights and obligations of each party under the agreements

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CaptivesA special type of insurer that is set up by a parent company, trade association or group of companies in a common business that exclusively insure the risks of their owner or owners

• Types of Captives– Pure (single parent captive)– Group– Association– Rent-a-captive– Special Purpose

Captives - Benefits• Broader coverage through underwriting

flexibility

• Improved service through claims management (greater control) and better risk management

• Potential Cost Savings– Direct reinsurer access

– Investment income and capture underwriting profits

– Tax benefits

• Fewer regulatory restrictions

Captives - Risks• From Company Perspective:

– Lack of diversification of risk and potential risk concentration

– Dependence on service providers

– Internal administrative costs

– Capitalization and commitment

– Taxation issues

– Increased cost and reduced availability of other insurance

• From Regulator’s Perspective:– Potential loss of consumer protection & safeguards

– Lack of transparency

Reinsurance and the Capital Markets• Convergence of reinsurance and capital markets has

resulted in development of Hybrid Products and Financial Instruments (Insurance-Linked Securities) as alternatives or compliments to traditional reinsurance

• Convergence drivers:– Growth in insured values in catastrophe-prone areas

– Reinsurance market inefficiencies/underwriting cycle

– Advances in computing/communications technologies

– Regulatory, accounting, tax and rating agency factors

– Modern financial theory/deeper understanding of risk management has facilitated financial engineering

Reinsurance and the Capital Markets• Property/Casualty

– Catastrophe Bonds– Reinsurance Sidecars – Collateralized Reinsurance Investment– Industry Loss Warranties– Contingent Capital– Catastrophe Futures and Insurance Derivatives

• Life – Value in Force or Embedded Value Transaction– Reserve Funding– Extreme Mortality Bonds– Longevity Swaps

Impact of Quota Share

Quota Share 80%Acquisition Costs 30% 12/31/XX 80% 12/31/XXCeding Commission 35% Before Q/S After 1 Year Contract Effective 6/30/XX Reinsurance Reinsurance Reinsurance

-------------------- ------------------------------ ----------------------------INCOME STATEMENT---------------PREMIUMS WRITTEN 10,000,000 (8,000,000) 2,000,000CHANGE IN UPR 4,000,000 (3,200,000) 800,000--------------- -------------------- ------------------------------ ----------------------------PREMIUMS EARNED 6,000,000 (4,800,000) 1,200,000--------------- -------------------- ------------------------------ ----------------------------LOSSES INCURRED 3,000,000 (2,400,000) 600,000LOSS EXP.INCURRED 550,000 (440,000) 110,000OTHER UND. EXPENSES 3,000,000 (2,800,000) 200,000--------------- -------------------- ------------------------------ ----------------------------UNDERWRITING DEDUCTIONS 6,550,000 (5,640,000) 910,000

-------------------- ------------------------------ ----------------------------UNDERWRITING INCOME (550,000) 840,000 290,000INVESTMENT INCOME 250,000 250,000OTHER INCOME/LOSSTAXES 0 365,000

-------------------- ------------------------------ ----------------------------NET INCOME (300,000) 840,000 175,000

=========== ================= ================LOSS RATIO 59.17% 59.17%NPW/Surplus 285.71% 46.09%Commission Ratio 30% 10%

Balance Sheet 12/31/XX 80% 12/31/XXASSETS Before Q/S After Reinsurance--------------- Reinsurance Reinsurance -------------------------------INVESTMENTS & CASH 20,980,000 -5,200,000 15,780,000AGENTS' BALANCES 1,650,000 1,650,000REINSURANCE RECOV. 150,000 150,000MISC. ASSETS 135,000 135,000

---------------------- - -------------------------------TOTAL ASSETS 22,915,000 -5,200,000 17,715,000======= =========== = ===============LIABILITIES---------------LOSSES & LAE 15,250,000 -2,840,000 12,410,000REINSURANCE PAYABLE 450,000 450,000UNEARNED PREMIUMS 3,500,000 -3,200,000 300,000OTHER EXP. & TAXES 150,000 150,000MISC. LIABILITIES 65,000 65,000

---------------------- - -------------------------------TOTAL LIABILITIES 19,415,000 -6,040,000 13,375,000

---------------------- - -------------------------------CAPITAL AND SURPLUSCAPITAL 2,750,000 2,750,000UNASSIGNED SURPLUS 750,000 750,000REINS.BEN. 840,000 840,000

---------------------- - -------------------------------POLICYHOLDERS' SURPLUS 3,500,000 840,000 4,340,000

---------------------- - -------------------------------TOTAL LIAB. AND SURPLUS 22,915,000 -5,200,000 17,715,000

=========== = ===============Ratio of liab. to surplus 554.71% 308.18%

Impact of Quota Share

Impact of Excess of Loss

Excess of Loss$500k XS $500k 12/31/XX 12/31/XXReinsurance Premiums = 12% DPW Before After 1 Year Contract Effective 6/30/XX Reinsurance Reinsurance Reinsurance

-------------------- ------------------------------ ----------------------------INCOME STATEMENT---------------PREMIUMS WRITTEN 10,000,000 (1,200,000) 8,800,000CHANGE IN UPR 4,000,000 (600,000) 3,400,000--------------- -------------------- ------------------------------ ----------------------------PREMIUMS EARNED 6,000,000 (600,000) 5,400,000--------------- -------------------- ------------------------------ ----------------------------LOSSES INCURRED 3,000,000 (420,000) 2,580,000LOSS EXP.INCURRED 550,000 0 550,000OTHER UND. EXPENSES 3,000,000 0 3,000,000--------------- -------------------- ------------------------------ ----------------------------UNDERWRITING DEDUCTIONS 6,550,000 (420,000) 6,130,000

-------------------- ------------------------------ ----------------------------UNDERWRITING INCOME (550,000) (180,000) (730,000)INVESTMENT INCOME 250,000 250,000OTHER INCOME/LOSSTAXES 0 0

-------------------- ------------------------------ ----------------------------NET INCOME (300,000) (180,000) (480,000)

========== =============== ==============LOSS RATIO 59.17% 57.96%NPW/Surplus 285.71% 265.06%Commission Ratio 30% 34%

Impact of Excess of Loss

Balance Sheet 12/31/XX 12/31/XXASSETSINVESTMENTS & CASH 20,980,000 -1,200,000 19,780,000AGENTS' BALANCES 1,650,000 1,650,000REINSURANCE RECOV. 150,000 150,000MISC. ASSETS 135,000 135,000

---------------------- ------------------------- -------------------------------TOTAL ASSETS 22,915,000 -1,200,000 21,715,000======= =========== ============ ===============LIABILITIES---------------LOSSES & LAE 15,250,000 -420,000 14,830,000REINSURANCE PAYABLE 450,000 450,000UNEARNED PREMIUMS 3,500,000 -600,000 2,900,000OTHER EXP. & TAXES 150,000 150,000MISC. LIABILITIES 65,000 65,000

---------------------- ------------------------- -------------------------------TOTAL LIABILITIES 19,415,000 -1,020,000 18,395,000

---------------------- ------------------------- -------------------------------CAPITAL AND SURPLUSCAPITAL 2,750,000 2,750,000UNASSIGNED SURPLUS 750,000 750,000REINS.BEN. -180,000 -180,000

---------------------- ------------------------- -------------------------------POLICYHOLDERS' SURPLUS 3,500,000 -180,000 3,320,000

---------------------- ------------------------- -------------------------------TOTAL LIAB. AND SURPLUS 22,915,000 -1,200,000 21,715,000

=========== ============ ===============Ratio of liab. to surplus 554.71% 554.07%