Chapter 30: Risk transfer

Question 1

What is risk control?

Answer 1

Involves deciding whether to reject, share or fully accept each identified risk. This stage also involves identifying different possible mitigation options for each risk that requires mitigation.

Question 2

What are the main risk control strategies?

Answer 2

Accept/retain the risk

Reject/avoid the risk

Transfer the risk

Share the risk

Mitigate or reduce the risk
- Typically internal actions so risk is still retained to some extent

Question 3

What are the main factors to consider when determining risk control methods?

Answer 3

Risk appetite

Cost

Available capital and capital constraints
- As well as possible reduction in capital requirements

Counter-party risk

• Loss of profits
• Default risk

Secondary effects

• Strategy to reduce one element of risk could introduce an additional element of risk
• Pros and cons should be compared for relative importance

Overall effect on discounted profits
- aka impact on NPV’s

Above is from lecture, extra points included in notes are:

Likely effect on frequency, consequence and expected value

Feasibility

Question 4

What are some of the main risk transfer techniques.

Answer 4

Reinsurance

Alternative risk transfer (ART)

Derivatives

Question 5

What are the main benefits of reinsurance?

Answer 5

Reduction in claims volatility

• Smoother profits
• Reduced capital requirements
• Increased capacity to accept new business

Limitation of large losses

• From single claim, single event , or cumulative events
• From concentrations of risk within the portfolio or geographical locations
• Results in reduced risk of insolvency and and increased capacity to write business

Access to expertise and data of reinsurer

Question 6

What considerations should be made when performing a cost benefit analysis for reinsurance (i.e. deciding whether or not to use reinsurance)?

Answer 6

Risk appetite

Net cost of reinsurance

Availability & cost of own capital

Strength of reinsurers

• Liquidity
• Credit rating

Need for reinsurer expertise

Opportunity costs
- What could we have done with the money going into reinsurance

Policy wording & operation of reinsurance

Regulatory framework

Question 7

What is ART?

Answer 7

An umbrella term for non-traditional methods by which organisations can transfer risk to third parties. Broadly, these products combine traditional insurance and reinsurance protection with financial risk protection, often utilising the capital markets. ART can be tailor-made to suit the needs of the company. A combination of insurance and banking risk management techniques are used.

• This is ActEd definition, but is not a standard one
• Basically ART is anything other than reinsurance which transfers risk to a third party.

Question 8

List some types of ART.

Answer 8

Integrated risk covers

Securitisation

Post loss funding

Derivatives
- Insurance specific

Swaps
- Insurance specific

Question 9

What are integrated risk covers?

Answer 9

Typically an arrangement between insurer and reinsurer

Comprehensive reinsurance covering

• multiple product lines
• multiple years
• and may include financial and market risks.

It is used to

• avoid buying excessive cover,
• smooth profits/overall experience and
• lock in attractive terms

Some disadvantages include

• lack of availability
• large set-up costs
• concentrated counter-party risk
• Another possible risk is that the reinsurer may be too involved in the business bordering on takeover, so companies will work closely together (may be advantageous too)

Question 10

What is securitisation?

Answer 10

Transfers insurance risk to banking and/or capital markets

• Turns insurance portfolio into a bond
• Often used for catastrophe risk

Mechanism:

• Investor pays capital over to insurer (loan amount)
• Repayment contingent on risk event not occurring, i.e. if specified catastrophe event/s do not occur
• If risk event occurs, investor capital used for losses
• Remaining capital and interest paid to investor at the end of the term

Rationale

• Insurance risk largely uncorrelated to market risk related to banks
• Hence demand from capital markets for risk bonds

In practice:

• Bonds delivered via a special purpose vehicle
• Higher risk than corporate bonds in insurer
• Priced similarly to Cat XL reinsurance
• Interest may be payable more regularly than at end of term

Question 11

What is post loss funding?

Answer 11

Guaranteed funding if risk event occurs

• Insurer pays commitment fee in advance, which may be less than a suitable reinsurance premium
• Other party agrees to offer loan on pre-arranged terms
• Should the event occur, insurer gets money to cover losses
• BUT insurer incurs initial loss and must pay back loan, but loss is effectively spread out over longer term

Rationale

• Difficult to raise capital quickly on favourable terms
• Especially after risk event depletes insurer
• Allows insurer to lock in terms prior to needing loan

Question 12

What are insurance derivatives and swaps

Answer 12

Wide range of derivative possibilities

• Designed according to business needs
• E.g. weather derivatives and catastrophe derivatives

Swaps apply same principle as interest rate swaps

• Trade matching but negatively correlated/uncorrelated cash flows
• E.g. trade units of life insurance for property insurance

Question 13

What are the main reasons for ART?

Answer 13

Provision of cover otherwise unavailable

Stabilisation of profits

Cheaper cover

Tax advantages

Greater security of payment

Management of solvency margins

Reduced capital requirements

More effective provision of risk management

A source of capital