The main benefits of reinsurance to an insurance company:
• A reduction in claims volatility and hence
o smoother profits
o reduced capital requirement
o an increased capacity to write more business and achieve diversification
• the limitation of large losses arising from:
o a single claim on a single risk
o a single event
o cumulative events
o geographical and portfolio concentrations of risk
and hence:
o a reduced risk of insolvency
o increased capacity to write larger risks
• access to the expertise of the reinsurer
Examples of ART contracts include
- Discounted covers
- Integrated risk cover
- Securitisation
- Post loss funding
- Insurance derivatives
- Swaps
Reasons why providers take out ART contracts include:
o provision of cover that might otherwise be unavailable o stabilisation of results o cheaper cover o tax advantages o greater security of payment o management of solvency margins o more effective provision of risk management o as a source of capital
Ideas – Underwriting can be used to manage these risks in the following ways:
• It can protect a provider from anti-selection
• It will enable a provider to identify risks for which special terms need to be quoted. A provider may however aim to accept a large proportion of the business it accepts at its standard rates of premium.
• For substandard risks, the underwriting process will identify the most suitable approach and level for the special terms to be offered. Possible special terms include:
1. Increasing the premium for a given level of benefit
2. Decreasing the benefit for a given level of premium
3. Exclusion clauses
4. Deferring the cover until more information is known
5. Declining cover
• Adequate risk classification within the underwriting process will help to ensure that all risks are fairly rated
• It will help in ensuring that claim experience does not depart too far from that assumed in the pricing of the contracts being sold
• For larger proposals the financial underwriting procedures will help to reduce the risk from over-insurance
Providers of financial service products need capital to
- Provide a cushion against fluctuating trade volumes
- Finance expansion
- Finance stock and work in progress
- Obtain premises, hire staff, purchase equipment
- Meet benefits before sufficient premiums/contributions are received
- Meet development expenses
- Hold a cushion against unexpected events
- Meet statutory requirements (fund new business strain)
- Invest more freely
- Achieve strategic aims
- Smooth reported profits
- Sell products with guarantees
- Demonstrate financial strength to customers and advisors
Capital management tools:
• Reinsurance • Financial Reinsurance • Securitisation • Subordinated Debt • Banking Products 1. Liquidity facilities 2. Contingent capital 3. Senior unsecured financing 4. Derivatives • Derivatives • Equity Capital • Internal Sources of Capital 1. Funds could be merged 2. Assets could be changed 3. The valuation basis could be weakened (if justifiable) 4. The distribution surplus could be deferred 5. Capital could be retained in the organisation possibly by not paying dividends to any shareholders
Limitations of the original Basel Accord include:
- It was targeted at credit risk, whereas banks also face other types of risk
- Its approximate nature (100% weighting for commercial loans is the same for a loan to an AAA-rated counterparty as for a B-rated loan, despite the different levels of credit risk)
- There was no reward for effective risk management
Basel II is based on the three pillars
- Quantification of regulatory capital regimes
- A supervisory regime
- Disclosure requirements
Solvency II is based on the three pillars
- Quantification of risk exposure and capital requirements
- A supervisory regime
- Disclosure
The experience will be monitored so as to:
- Update assumptions as to future experience
- Monitor any adverse trends in experience so as to take corrective actions
- Provide management information
Monitoring investigations typically involve the following stages:
• The division of data into suitable groups that are homogeneous by risk – need to consider:
1. The volume of data in each cell (its credibility)
2. The risk factors for the investigation (e.g. age, sex etc)
3. Changes that have occurred that will reduce the credibility of the old data
• Identification of any past trends, cycles and anomalies and random variation in the past data
• Using the results to revise models and assumptions used – need to consider:
1. The purpose, and hence the need for accuracy and margins for prudence
2. Allowance for future trends
3. Likely differences in future experience from past experience
