Insurance Operations CPCU 520 Syllabus PDF

INSURANCE OPERATIONS CPCU 520 NOVEMBER 12, 2024 WEEK 9 REINSURANCE AND ALTERNATIVE RISK FINANCING SYLLABUS ⁃ Reinsurance & Alternative Risk Financing (Chapter 8 Textbook – Online CPCU Assignment 10) – Part One OBJECTIVES Summarize the principal functions of reinsurance. Describe the thr...

INSURANCE OPERATIONS CPCU 520 NOVEMBER 12, 2024 WEEK 9 REINSURANCE AND ALTERNATIVE RISK FINANCING SYLLABUS ⁃ Reinsurance & Alternative Risk Financing (Chapter 8 Textbook – Online CPCU Assignment 10) – Part One OBJECTIVES Summarize the principal functions of reinsurance. Describe the three sources of reinsurance. Contrast treaty reinsurance with facultative reinsurance. Given a case, determine the amount of a loss that would be payable under a pro rata reinsurance contract. Given a case, determine the amount of a loss that would be payable under an excess of loss reinsurance contract. SUMMARIZE THE PRINCIPAL FUNCTIONS OF REINSURANCE Key Points: Reinsurance is one way insurers protect themselves from the financial consequences of insuring others. Basic Terms and Concepts Reinsurance is the transfer from one insurer (the primary insurer) to another (the reinsurer) of some or all of the financial consequences of certain loss exposures covered by the primary insurer’s policies. Reinsurance is transacted through a reinsurance agreement, which specifies the terms under which the reinsurance is provided. The reinsurer typically does not assume all of the primary insurer’s insurance risk. The reinsurance agreement usually requires the primary insurer to retain part of its original liability. This retention can be expressed as a percentage of the original amount of insurance or as a dollar amount of loss. SUMMARIZE THE PRINCIPAL FUNCTIONS OF REINSURANCE Basic Terms and Concepts In reinsurance, the term “risk” often refers to the subject of insurance, such as a building, a policy, a group of policies, or a class of business. The primary insurer pays a reinsurance premium for the protection provided, just as any insured pays a premium for insurance coverage, but, because the primary insurer incurs the expenses of issuing the underlying policy, the reinsurer might pay a ceding commission to the primary insurer. Under a retrocession, one reinsurer, the retrocedent, transfers all or part of the reinsurance risk that it has assumed or will assume to another reinsurer, the retrocessionaire. SUMMARIZE THE PRINCIPAL FUNCTIONS OF REINSURANCE Reinsurance Functions - Although several of its uses overlap, reinsurance is a valuable tool that can perform six principal functions for primary insurers: Increase large-line capacity Increasing large-line capacity allows a primary insurer to assume more significant risks than its financial condition and regulations would otherwise permit The maximum amount (or line) of insurance that an under- writer is willing to accept on a single account is subject to these influences: The maximum amount of insurance or limit of liability allowed by insurance regulations, which prohibit an insurer from retaining more than 10 percent of its policyholders’ net worth on any one loss exposure The size of a potential loss or losses that can safely be retained without impairing the insurer’s earnings or policy- holders’ surplus The specific characteristics of a particular loss exposure The amount, types, and cost of available reinsurance SUMMARIZE THE PRINCIPAL FUNCTIONS OF REINSURANCE Reinsurance Functions Provide catastrophe protection Without reinsurance, catastrophes could greatly reduce insurer earnings or even threaten insurer solvency when a large number of its insured loss exposures are concentrated in an area that experiences a catastrophe. Stabilize loss experience Volatile loss experience can affect the stock value of a publicly traded insurer; alter an insurer’s financial rating by independent rating agencies; cause abrupt changes in the approaches taken in managing the underwriting, claim, and marketing departments; or undermine the confidence of the sales force. In addition to aiding financial planning and supporting growth, this function of reinsurance encourages capital investment because investors are more likely to invest in companies whose financial results are stable. Reinsurance can be arranged to stabilize the loss experience of a line of insurance, a class of business, or a primary insurer’s entire book of business. Reinsurance can limit a primary insurer’s liability for loss exposures SUMMARIZE THE PRINCIPAL FUNCTIONS OF REINSURANCE Reinsurance Functions Provide surplus relief Many insurers use reinsurance to provide surplus relief, which satisfies insurance regulatory constraints on excess growth. State insurance regulators monitor several financial ratios as part of their solvency surveillance eff orts, but the relationship of written premiums to policyholders’ surplus is generally a key financial ratio and one considered to be out of bounds if it exceeds 3 to 1, or 300 percent. Some reinsurance agreements facilitate premium growth by allowing the primary insurer to deduct a ceding commission, an amount paid by the reinsurer to the primary insurer to cover part or all of a primary insurer’s policy acquisition expenses. Because the ceding commission replenishes the primary insurer’s policyholders’ surplus, the surplus relief facilitates the primary insurer’s premium growth and the increase in policyholders’ surplus lowers its capacity ratio SUMMARIZE THE PRINCIPAL FUNCTIONS OF REINSURANCE Reinsurance Functions Facilitate withdrawal from a market segment A primary insurer may want to withdraw from a market segment that is unprofi table, undesirable, or incompatible with its strategic plan. One approach to withdrawal is for the primary insurer to transfer the liability for all outstanding policies to a reinsurer by purchasing portfolio reinsurance. The reinsurer accepts all the liability for certain loss exposures covered under the primary insurer’s policies, but the primary insurer must continue to fulfill its obligations to its insureds. A novation completely eliminates the liabilities a primary insurer has assumed. It is not considered portfolio reinsurance because the substitute insurer assumes the direct obligations to insureds covered by the underlying insurance. SUMMARIZE THE PRINCIPAL FUNCTIONS OF REINSURANCE Reinsurance Functions Provide underwriting guidance Reinsurers work with a wide variety of insurers in the domestic and global markets under many different circumstances and accumulate a great deal of underwriting expertise. Reinsurers that provide underwriting assistance to primary insurers must respect the confidentiality of their clients’ proprietary information. DESCRIBE THE THREE SOURCES OF REINSURANCE Key Points: Participants in the international reinsurance market can take many forms, including professional reinsurers that deal only in reinsurance, licensed insurers that also market reinsurance, and organized entities that allow small organizations to pool their resources so that they can participate in lines of reinsurance that would otherwise be out of reach. DESCRIBE THE THREE SOURCES OF REINSURANCE Professional Reinsurers Professional reinsurers interact with other insurers directly or through intermediaries, as primary insurers do. A reinsurer whose employees deal directly with primary insurers is called a direct writing reinsurer. However, most direct writing reinsurers in the United States also solicit reinsurance business through reinsurance intermediaries. A reinsurance intermediary generally represents a primary insurer and works with that insurer to develop a reinsurance program that is then placed with one or more reinsurers. The reinsurance intermediary receives a brokerage commission for performing other necessary services in addition to placing the reinsurance. DESCRIBE THE THREE SOURCES OF REINSURANCE Professional Reinsurers Although the variety of professional reinsurers leads to differences in how they are used and what they can off er, some broad generalizations may be made about professional reinsurers: Primary insurers dealing with direct writing reinsurers often use fewer reinsurers in their reinsurance program. Reinsurance intermediaries often use more than one reinsurer to develop a reinsurance program for a primary insurer. Reinsurance intermediaries can often help secure high coverage limits and catastrophe coverage. Reinsurance intermediaries usually have access to various reinsurance solutions from both domestic and international markets. Reinsurance intermediaries can usually obtain reinsurance under favorable terms and at a competitive price because they work regularly in this market with many primary insurers and can therefore determine prevailing market conditions. DESCRIBE THE THREE SOURCES OF REINSURANCE Professional Reinsurers Professional reinsurers evaluate the primary insurer before entering into a reinsurance agreement. Reinsurers also consider the primary insurer’s experience, reputation, and management. The reinsurer relies on the quality of the management team, and a relationship of trust must underlie any reinsurance agreement. DESCRIBE THE THREE SOURCES OF REINSURANCE Reinsurance Departments of Primary Insurers Unless prohibited from doing so by statute or charter, primary insurers may also provide treaty and facultative reinsurance through their reinsurance departments. A primary insurer may offer reinsurance to affiliated insurers, regardless of whether it offers reinsurance to unaffiliated insurers. To ensure that information from other insurers remains confidential, a primary insurer’s reinsurance operations are usually separate from its primary insurance operations. Intragroup reinsurance agreements are used to balance the financial results of all insurers in the group. The use of intragroup reinsurance agreements does not preclude using professional reinsurers. DESCRIBE THE THREE SOURCES OF REINSURANCE Reinsurance Pools, Syndicates, and Associations These entities provide member companies the opportunity to participate in a line of insurance with a limited amount of capital without having to employ the specialists needed for such a venture. Whether a pool is a reinsurance device is determined by the organizational structure, the type of contract issued, and the internal accounting procedures. The terms “pool,” “syndicate,” and “association” are often used interchangeably, although there are some fi ne differences. In a reinsurance pool, a policy for the full amount of insurance is issued by a member company and reinsured by the remainder of the pool members according to predetermined percentages. Reinsurance intermediaries also form reinsurance pools to provide reinsurance to their clients. DESCRIBE THE THREE SOURCES OF REINSURANCE Reinsurance Pools, Syndicates, and Associations In a syndicate, each member shares the risk with other members by accepting a percentage of the risk. These members collectively constitute a single, separate entity under the syndicate name. An association consists of member companies that use both reinsurance and risk-sharing techniques. In many cases, the member companies issue their own policies; however, a reinsurance certificate is attached to each policy, under which each member company assumes a fixed percentage of the total amount of insurance. One member company is usually responsible for inspection and investigation, while a committee comprising underwriting executives from the member companies establishes the association’s underwriting policy. CONTRAST TREATY REINSURANCE WITH FACULTATIVE REINSURANCE Key Points: No single reinsurance agreement performs all the reinsurance functions. Each reinsurance agreement is tailored to the specific needs of the primary insurer and the reinsurer. There are two types of reinsurance transactions: treaty and facultative. CONTRAST TREATY REINSURANCE WITH FACULTATIVE REINSURANCE Treaty Reinsurance With treaty reinsurance, the reinsurer agrees in advance to reinsure all the loss exposures that fall under the treaty. Although some treaties allow the reinsurer limited discretion in reinsuring individual loss exposures, most treaties require that all loss exposures within the treaty’s terms be reinsured. Treaty reinsurance provides primary insurers with the certainty needed to formulate underwriting policy and develop underwriting guidelines. Treaty reinsurance agreements are tailored to fi t the primary insurer’s individual requirements. The price and terms of each reinsurance treaty are individually negotiated. Treaty reinsurance agreements are usually designed to address a primary insurer’s need to reinsure many loss exposures over a period of time. Although the reinsurance agreement’s term may be for only one year, the relationship between the primary insurer and the reinsurer often spans many years. Most, but not all, treaty reinsurance agreements require the primary insurer to cede all eligible loss exposures to the reinsurer. If treaty reinsurance agreements permitted primary insurers to choose which loss exposures they ceded to the reinsurer, the reinsurer would be exposed to adverse selection. CONTRAST TREATY REINSURANCE WITH FACULTATIVE REINSURANCE Facultative Reinsurance With facultative reinsurance, the primary insurer negotiates a separate reinsurance agreement for each loss exposure it wants to reinsure. The primary insurer is not obligated to purchase reinsurance, and the reinsurer is not obligated to reinsure loss exposures submitted to it. A facultative reinsurance agreement is written for a specified time period and cannot be canceled by either party unless contractual obligations, such as payment of premiums, are not met. The reinsurer issues a facultative certificate of reinsurance, which is attached to the primary insurer’s copy of the policy being reinsured. CONTRAST TREATY REINSURANCE WITH FACULTATIVE REINSURANCE Facultative Reinsurance Facultative reinsurance serves four functions: Facultative reinsurance can provide large-line capacity for loss exposures that exceed the limits of treaty reinsurance agreements. Facultative reinsurance can reduce the primary insurer’s exposure in a given geographic area. Facultative reinsurance can insure a loss exposure with atypical hazard characteristics and thereby maintain the favorable loss experience of the primary insurer’s treaty reinsurance and any associated profit-sharing arrangements. Facultative reinsurance can insure particular classes of loss exposures that are excluded under treaty reinsurance. The expense of placing facultative reinsurance may be high for both the primary insurer and the reinsurer. GIVEN A CASE, DETERMINE THE AMOUNT OF A LOSS THAT WOULD BE PAYABLE UNDER A PRO RATA REINSURANCE CONTRACT Key Points: Primary insurers have unique needs, so each reinsurance agreement between a primary insurer and reinsurer must be uniquely designed to meet those needs. As a result, several types of reinsurance have been developed. The more you know about these different types of reinsurance, the better you’ll be able to navigate the reinsurance process. GIVEN A CASE, DETERMINE THE AMOUNT OF A LOSS THAT WOULD BE PAYABLE UNDER A PRO RATA REINSURANCE CONTRACT Pro Rata Reinsurance Under pro rata reinsurance, or proportional reinsurance, the amount of insurance, premium, and losses (including loss adjustment expenses) is divided between the primary insurer and the reinsurer in the same proportions as the loss exposure. The reinsurer usually pays the primary insurer a ceding commission for the ceded loss exposures. A flat commission is commonly the type of ceding commission used. However, profit sharing com- mission or sliding scale commission arrangements are also used often and provide an incentive to the primary insurer for ceding profitable business. Pro rata reinsurance is generally chosen by newly incorporated insurers or insurers with limited capital because it’s effective at providing surplus relief. GIVEN A CASE, DETERMINE THE AMOUNT OF A LOSS THAT WOULD BE PAYABLE UNDER A PRO RATA REINSURANCE CONTRACT Two Classifications of Pro Rata Reinsurance Quota share reinsurance The distinguishing characteristic of quota share reinsurance is that the primary insurer and the reinsurer use a fixed percentage when sharing the amounts of insurance, policy premiums, and losses. A variable quota share treaty enables a primary insurer to retain a larger proportion of the small loss exposures it’s capable of absorbing while maintaining a safer and smaller retention on larger loss exposures. Most reinsurance agreements specify a maximum dollar limit above which responsibility for additional coverage limits or losses reverts back to the primary insurer (or is taken by another reinsurer). With a quota share reinsurance agreement, that maximum dollar amount is stated in terms of the coverage limits of each policy subject to the treaty. In addition to a maximum coverage amount limitation, some quota share reinsurance agreements include a per occurrence limit, stated as an aggregate dollar amount or as a loss ratio cap, which restricts the primary insurer’s reinsurance recovery for losses originating from a single occurrence. GIVEN A CASE, DETERMINE THE AMOUNT OF A LOSS THAT WOULD BE PAYABLE UNDER A PRO RATA REINSURANCE CONTRACT Surplus share reinsurance A distinguishing characteristic of surplus share reinsurance is that when an underlying policy’s total amount of insurance exceeds a stipulated dollar amount, or line, the reinsurer assumes the surplus share of the amount of insurance. Under surplus share reinsurance, the primary insurer and the reinsurer share the policy premiums and losses proportionately. The primary insurer’s share is the proportion that the line bears to the total amount of insurance; the reinsurer’s share is the proportion that the amount ceded bears to the total. The reinsurance limit of a surplus share treaty is expressed in multiples of the primary insurer’s line. GIVEN A CASE, DETERMINE THE AMOUNT OF A LOSS THAT WOULD BE PAYABLE UNDER AN EXCESS OF LOSS REINSURANCE CONTRACT Key Points: Among the several types of reinsurance that have been developed to help insurers meet their goals and fulfill their promises is excess of loss reinsurance. Knowing how a loss would be paid under an excess of loss reinsurance program will put you in a better position to decide which reinsurance product would work best in a given situation. GIVEN A CASE, DETERMINE THE AMOUNT OF A LOSS THAT WOULD BE PAYABLE UNDER AN EXCESS OF LOSS REINSURANCE CONTRACT Excess of Loss Reinsurance Under an excess of loss reinsurance agreement, also called nonproportional reinsurance, the reinsurer responds to a loss only when it exceeds the primary insurer’s retention, often referred to as the attachment point. The primary insurer fully retains losses below the attachment point. Sometimes, the reinsurer requires the primary insurer to retain a percentage of the losses that exceed the attachment point. An excess of loss reinsurer’s obligation to indemnify the primary insurer for losses depends on the amount of the loss and the layer of coverage the reinsurer provides. Excess of loss reinsurance premiums are calculated according to the likelihood that losses will exceed the attachment point. The premium is usually stated as a percentage of the policy premium charged by the primary insurer. Therefore, unlike with quota share and surplus share reinsurance, the excess of loss reinsurer receives a nonproportional share of the premium. GIVEN A CASE, DETERMINE THE AMOUNT OF A LOSS THAT WOULD BE PAYABLE UNDER AN EXCESS OF LOSS REINSURANCE CONTRACT Excess of Loss Reinsurance Reinsurers generally do not pay ceding commissions under excess of loss reinsurance agreements, but they may reward a primary insurer for favorable loss experience by paying a profit commission or reducing the rate used to calculate the reinsurance premium. The primary insurer’s attachment point is usually set at a level where expected claims would be retained. But if the primary insurer’s volume of losses is expected to be significant, a lower attachment point may be set. This type of reinsurance agreement is sometimes referred to as a working cover. It enables the primary insurer to spread its losses over several years. GIVEN A CASE, DETERMINE THE AMOUNT OF A LOSS THAT WOULD BE PAYABLE UNDER AN EXCESS OF LOSS REINSURANCE CONTRACT Five Types of Excess of Loss Reinsurance These are the five types of excess of loss reinsurance and their specific uses: Per risk excess of loss reinsurance is often referred to as property per risk excess of loss and is generally used with property insurance. Catastrophe excess of loss reinsurance protects the primary insurer from an accumulation of retained losses that arise from a single catastrophic event, such as a tornado, a hurricane, or an earthquake. Per policy excess of loss reinsurance is used primarily with liability insurance. It applies the attachment point and the reinsurance limit separately to the losses occurring under each insurance policy and is triggered when a loss exceeds the attachment point. GIVEN A CASE, DETERMINE THE AMOUNT OF A LOSS THAT WOULD BE PAYABLE UNDER AN EXCESS OF LOSS REINSURANCE CONTRACT Five Types of Excess of Loss Reinsurance These are the five types of excess of loss reinsurance and their specific uses: Per occurrence excess of loss reinsurance is also typically used for liability insurance. It applies the attachment point and the reinsurance limit to the total losses arising from a single event, regardless of the number of policies or risks involved. Aggregate excess of loss reinsurance can be used for property or liability insurance and covers aggregated losses that exceed the attachment point and occur over a stated period, usually one year. The attachment point can be stated in a dollar amount of loss or as a loss ratio. When the attachment point is stated as a loss ratio, the treaty is called stop-loss reinsurance. EXPLAIN HOW FINITE RISK REINSURANCE AND CAPITAL MARKET BASED METHODS ARE USED AS ALTERNATIVES TO TRADITIONAL REINSURANCE Key Points: Alternatives to traditional reinsurance have emerged as the industry adapts to new economic and regulatory pressures. Knowing what’s available can help primary insurers meet their changing reinsurance needs. EXPLAIN HOW FINITE RISK REINSURANCE AND CAPITAL MARKET BASED METHODS ARE USED AS ALTERNATIVES TO TRADITIONAL REINSURANCE Finite Risk Reinsurance Under finite risk reinsurance, the reinsurer’s liability is limited (or finite), and anticipated investment income is an underwriting component. Finite risk reinsurance can be arranged to protect a primary insurer against traditionally insurable loss exposures as well as traditionally uninsurable loss exposures. It also handles extremely large and unusual loss exposures. A finite risk reinsurance agreement typically has a multiyear term. This allows the reinsurer to spread the risk and losses over several years while imposing an aggregate limit for the agreement’s entire term. With finite risk reinsurance, the primary insurer can rely on long-term protection and a predictable reinsurance cost over the coverage period, while the reinsurer can rely on a continual flow of premiums. EXPLAIN HOW FINITE RISK REINSURANCE AND CAPITAL MARKET BASED METHODS ARE USED AS ALTERNATIVES TO TRADITIONAL REINSURANCE Finite Risk Reinsurance Finite risk reinsurance premiums can be a substantial percentage of the reinsurance limit. This relationship between premium and reinsurance limit reduces the reinsurer’s potential underwriting loss to a level that is much lower than that typically associated with traditional types of reinsurance. Finite risk reinsurance is designed to cover high severity losses. The reinsurer commonly shares profits with the primary insurer when it has favorable loss experience or generates investment income. This profit sharing income can compensate the primary insurer for the higher-than-usual premium of finite risk reinsurance. Also, the reinsurer will not assess any additional premium, even if losses exceed the premium. EXPLAIN HOW FINITE RISK REINSURANCE AND CAPITAL MARKET BASED METHODS ARE USED AS ALTERNATIVES TO TRADITIONAL REINSURANCE Capital Market Alternatives Capital markets have emerged as tools primary insurers can use to finance risk as an alternative to insurance. Some of the capital market instruments are rooted in the concepts of securitization of risk and special purpose vehicles (SPVs),which allow primary insurers to exchange assets for cash. Others are based on insurance derivatives or contingent capital arrangements. EXPLAIN HOW FINITE RISK REINSURANCE AND CAPITAL MARKET BASED METHODS ARE USED AS ALTERNATIVES TO TRADITIONAL REINSURANCE Capital Market Alternatives Although capital market alternatives can evolve rapidly, these are among the products and methods most often used: Catastrophe bond—A type of insurance-linked security that is specifically designed to transfer insurable catastrophe risk to investors. A bond is issued with a condition that if the issuer suffers a catastrophe loss greater than the specified amount, the obligation to pay interest and/or repay principal is deferred or forgiven by bondholders and used to pay losses. Catastrophe risk exchange—A means through which a primary insurer can exchange a portion of its insurance risk for another insurer’s. The insurance risk traded may diff er by geographic area, type of property, or cause of loss insured against. Contingent surplus note—A surplus note that has been designed so a primary insurer, if it chooses, can immediately obtain funds by issuing notes at a previously agreed-upon rate of interest. A benefit of surplus notes is that they increase a primary insurer’s assets without increasing its liabilities. EXPLAIN HOW FINITE RISK REINSURANCE AND CAPITAL MARKET BASED METHODS ARE USED AS ALTERNATIVES TO TRADITIONAL REINSURANCE Capital Market Alternatives Although capital market alternatives can evolve rapidly, these are among the products and methods most often used: Industry loss warranty (ILW)—An insurance-linked security that covers the primary insurer in the event that an industry-wide loss from a particular catastrophic event exceeds a predetermined threshold. The distinguishing characteristic of this instrument is that its coverage is triggered by industry losses as a whole, rather than only a loss for the primary insurer. Catastrophe option—An agreement that gives the primary insurer the right to a cash payment from investors if a specified index of catastrophe losses reaches a specified level (the strike price). The catastrophe loss index keeps track of catastrophe losses by geographic region, by cause of loss, and by time of occurrence. EXPLAIN HOW FINITE RISK REINSURANCE AND CAPITAL MARKET BASED METHODS ARE USED AS ALTERNATIVES TO TRADITIONAL REINSURANCE. Capital Market Alternatives Although capital market alternatives can evolve rapidly, these are among the products and methods most often used: Line of credit—An arrangement under which a bank or another financial institution agrees to provide a loan to a primary insurer in the event that the primary insurer suffers a loss. The credit is prearranged so that the terms are known in advance of a loss. In exchange for this credit commitment, the primary insurer taking out the line of credit pays a commitment fee. A line of credit does not represent any risk transfer; it simply provides access to capital. Sidecar—A limited-existence SPV, often formed as an independent company, that provides a primary insurer more capacity to write property catastrophe business or other short-tail lines through a quota share agreement with private investors. Investors in the SPV assume a proportion of the risk and earn a corresponding portion of the profit on the primary insurer’s book of business. The primary insurer charges a ceding com- mission and may receive an additional commission if the book of business is profitable. NEXT WEEK Week 10 (November 19th) ⁃ Test 2 (30% of your grade) ⁃ Review Test 2 ⁃ Reinsurance & Alternative Risk Financing (Chapter 8 Textbook – Online CPCU Assignment 10) – Part One Reminder: Week 11 (November 26th) Thanksgiving week is a remote/virtual class.