INTRODUCTION TO INTRODUCTION TO REINSURANCEREINSURANCE

NOLAN ASCHNOLAN ASCH

CAS RATEMAKING SEMINARCAS RATEMAKING SEMINAR

MARCH 10-11, 2005MARCH 10-11, 2005

INT-6INT-6

INSURANCEINSURANCE

The insurer insures the individual or The insurer insures the individual or the corporationthe corporation

REINSURANCEREINSURANCE

The REINSURER insures the The REINSURER insures the insurance companyinsurance company

REINSURANCE REINSURANCE PLACEMENT MECHANISMSPLACEMENT MECHANISMS

DIRECTDIRECT BROKERBROKER

INSURANCEINSURANCE vs. vs.

REINSURANCE REINSURANCE BOTH concerned with future contingenciesBOTH concerned with future contingencies BOTH require underwriting skills (risk)BOTH require underwriting skills (risk) BOTH involve transfer of riskBOTH involve transfer of risk BOTH require payment of premiumBOTH require payment of premium BOTH provide protectionBOTH provide protection BOTH subject to (some) regulationBOTH subject to (some) regulation

REINSURANCEREINSURANCE

Buyers assumed to be knowledgeableBuyers assumed to be knowledgeable Responds to actual lossResponds to actual loss Provides indemnification onlyProvides indemnification only Reimburses for payments already madeReimburses for payments already made Usually GlobalUsually Global

FUNCTIONS OF FUNCTIONS OF REINSURANCEREINSURANCE

CAPACITYCAPACITY

CAPACITYCAPACITY

Single Risk (Fac - Sears Tower)Single Risk (Fac - Sears Tower) PORTFOLIO (Treaty)PORTFOLIO (Treaty)

CAPACITY MECHANISMSCAPACITY MECHANISMS

Excess-of-LossExcess-of-Loss Quota ShareQuota Share

FUNCTIONS OF REINSURANCEFUNCTIONS OF REINSURANCE

CAPACITYCAPACITY CATASTROPHECATASTROPHE

CATASTROPHECATASTROPHE

QUOTA SHAREQUOTA SHARE EXCESS OF LOSSEXCESS OF LOSS SECURITIZATIONSECURITIZATION

FUNCTIONS OF REINSURANCEFUNCTIONS OF REINSURANCE

CAPACITYCAPACITY CATASTROPHECATASTROPHE STABILIZATIONSTABILIZATION

STABILIZATIONSTABILIZATION

Reduction in Variance (swings)Reduction in Variance (swings)

STABILIZATIONSTABILIZATION

Extreme contractual caseExtreme contractual case

““STOP-LOSS”STOP-LOSS”

Aggregate ExcessAggregate Excess

FUNCTIONS OF REINSURANCEFUNCTIONS OF REINSURANCE

CAPACITYCAPACITY CATASTROPHECATASTROPHE STABILIZATIONSTABILIZATION FINANCINGFINANCING

FINANCINGFINANCINGReducing LiabilitiesReducing Liabilities

Ceding CommissionsCeding Commissions

““Overrides”Overrides”

FINANCINGFINANCING

May increase PHS due to transactionMay increase PHS due to transaction

FINANCINGFINANCING

Finite Reinsurance......Finite Reinsurance......Pre-Elliott SpitzerPre-Elliott Spitzer

ALL Reinsurance is FinancialALL Reinsurance is FinancialPost Elliott SpitzerPost Elliott SpitzerI don’t think so….I don’t think so….

FUNCTIONS OF FUNCTIONS OF REINSURANCEREINSURANCE

CAPACITYCAPACITY CATASTROPHECATASTROPHE STABILIZATIONSTABILIZATION FINANCINGFINANCING ENTER AND EXIT ENTER AND EXIT

MARKETSMARKETS

ENTER OR EXIT MARKETSENTER OR EXIT MARKETS

Lessens risk as you learnLessens risk as you learn

With 100% Q/S you exitWith 100% Q/S you exit

FUNCTIONS OF REINSURANCEFUNCTIONS OF REINSURANCE

CAPACITYCAPACITY CATASTROPHECATASTROPHE STABILIZATIONSTABILIZATION FINANCINGFINANCING ENTER AND EXIT MARKETSENTER AND EXIT MARKETS UTILIZE REINSURER EXPERTISEUTILIZE REINSURER EXPERTISE

USING REINSURER USING REINSURER EXPERTISEEXPERTISE

Large or unusual claimsLarge or unusual claims Large or unusual risksLarge or unusual risks Special relationships and/or Special relationships and/or

knowledgeknowledge

LIMITATIONS OF LIMITATIONS OF REINSURANCEREINSURANCE

Will NOT make bad business profitableWill NOT make bad business profitable Transaction CostsTransaction Costs Rating Agency Impacts (Gross/Net)Rating Agency Impacts (Gross/Net)

How Reinsurance Is PricedHow Reinsurance Is Pricedin Practicein Practice

HypotheticalHypothetical

ExamplesExamples

NO PRICE REGULATIONNO PRICE REGULATION

(virtually)(virtually)

CASE BY CASECASE BY CASE

NEGOTIATIONNEGOTIATION

FLEXIBILITY IN STRUCTUREFLEXIBILITY IN STRUCTUREContractualContractual

EXCESS OF LOSSEXCESS OF LOSS

LAYERINGLAYERING

$19.75 Mill xs $0.25 Mill$19.75 Mill xs $0.25 Mill

(sounds like a wide layer)(sounds like a wide layer)

TYPICAL LAYERINGTYPICAL LAYERING10M xs 10M10M xs 10M

5M xs 5M5M xs 5M

3M xs 2M3M xs 2M

1M xs 1M1M xs 1M

500 xs 500500 xs 500

250 xs 250250 xs 250

Price BPrice BPrice APrice A

Price CPrice CPrice DPrice DPrice EPrice EPrice FPrice F

High Frequency/ Low SeverityHigh Frequency/ Low Severity

Buffer layersBuffer layers

ie 250 xs 250ie 250 xs 250

250 xs 250250 xs 250

Price APrice A

Capacity LayersCapacity Layers

i.e. 10m xs 10mi.e. 10m xs 10m

10M xs 10M10M xs 10M

Price FPrice F

Low Frequency/ High SeverityLow Frequency/ High Severity

CLIENT/BROKERCLIENT/BROKERNEGOTIATIONNEGOTIATION

Change or re-subdivideChange or re-subdivide

the layeringthe layering

LAYER TRAPLAYER TRAPMANY PERMUTATIONSMANY PERMUTATIONS

Pricing for 500 xs 500Pricing for 500 xs 500

Later, request the 250xs 250Later, request the 250xs 250

LAYER TRAPLAYER TRAP

at “last minute” at “last minute”

Ask for 150 xs 100Ask for 150 xs 100

--Requires more data--Requires more data

PRICING TRAPSPRICING TRAPS

AGGREGATE ANNUAL DEDUCTIBLESAGGREGATE ANNUAL DEDUCTIBLES

ASSUME A 10% RATEASSUME A 10% RATE

Request a 1% AADRequest a 1% AAD Request a 2% AADRequest a 2% AAD Request an 8% AADRequest an 8% AAD NOW the risk/variance NOW the risk/variance becomes LARGE vs a 2% ratebecomes LARGE vs a 2% rate

INFORMATION FOR PRICINGINFORMATION FOR PRICING

NO standardsNO standards

WHAT THE REINSURER WHAT THE REINSURER WANTSWANTS

EVERYTHINGEVERYTHING

WHAT THE BROKER/CLIENTWHAT THE BROKER/CLIENTMAY WISH TO SUPPLYMAY WISH TO SUPPLY

NOTHINGNOTHING

POSSIBLEPOSSIBLEOUTCOMESOUTCOMES

GIGOGIGO

Garbage-InGarbage-In

Garbage-outGarbage-out

EL NIÑO EL NIÑO

NINONINO

Nothing-inNothing-in

Nothing-outNothing-out

EXPERIENCE RATINGEXPERIENCE RATING

Using losses of the riskUsing losses of the risk

to price the risk.to price the risk.

STANDARDSTANDARD

All losses at half theAll losses at half the

attachment point & upattachment point & up

ACTUARIAL APPROACHACTUARIAL APPROACH

DETRENDED LOSSESDETRENDED LOSSES

Varies with age of claimVaries with age of claim

BEGINS to show ACTUALBEGINS to show ACTUAL

CLAIMS as a sample outcomeCLAIMS as a sample outcome

EXPOSURE RATINGEXPOSURE RATINGAttempt to rate Reinsurance based upon the Attempt to rate Reinsurance based upon the

TRUE underlying exposures TRUE underlying exposures

Proxies for TRUE exposures:Proxies for TRUE exposures:Limits Profiles = Subject Premium by policy limit Limits Profiles = Subject Premium by policy limit Exposures by policy limit (still not the TRUE exposure)Exposures by policy limit (still not the TRUE exposure)

LIMITS PROFILELIMITS PROFILE$100,000 Policy Limit$100,000 Policy Limit

Yr 1997 10% of exposures at $100,000Yr 1997 10% of exposures at $100,000 Yr 1998 25% of exposures at $100,000Yr 1998 25% of exposures at $100,000 Yr 2002 90% of exposures at $100,000Yr 2002 90% of exposures at $100,000

loss was atypical in 1997loss was atypical in 1997 layer is effective 7/1/04layer is effective 7/1/04

Include ‘97 and ‘98 losses at $100,000Include ‘97 and ‘98 losses at $100,000

LIMIT LOSSLIMIT LOSS

limit loss to 1997 policy limitslimit loss to 1997 policy limits

oror

trend and develop losstrend and develop loss

beyond policy limitsbeyond policy limits

““WE DON’T DO THIS WE DON’T DO THIS ANYMORE”ANYMORE”

““Throw out “ claims fromThrow out “ claims from

MGA’s, classes or statesMGA’s, classes or states

we no longer writewe no longer write

QUOTA SHARE ISSUESQUOTA SHARE ISSUES

Moral hazard and Retention - 1% netMoral hazard and Retention - 1% net Ceding CommissionCeding Commission OverridesOverrides Sliding ScalesSliding Scales Loss CorridorsLoss Corridors