Transcript Managing the Cost of Regulatory Compliance
Risk Mitigation and the Role of Reinsurance
John Finston
Deputy Commissioner for Corporate and Regulatory Affairs California Department of Insurance
© 2013 National Association of Insurance Commissioners All Rights Reserved 1
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 3
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 reinsurer do 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
$100,000 $200,000
Retained 60%
$60,000 $120,000
Reinsured 40%
$40,000 $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
$20,000 $40,000 $60,000
Reinsured’s Share Reinsurer’s Share
100% 0 50% 50% 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 Agreements EXCESS OF LOSS REINSURANCE
Type of Loss
Single Loss Exceeding Retention Accumulation of Losses in Single Occurrence Exceeding Retention Total Net Retained Losses Over Year Exceeding Retention Per Risk Excess of Loss Covered
Type of Reinsurance
Per Occurrence Excess of Loss Sometimes Covered Aggregate Excess of Loss Not Covered Not Covered Not Covered Covered Not Covered Not Covered Covered
Excess of Loss Contract
$ 10 M
95% of $5M xs $5M
$ 5 M $ 1 M $ 500 K
95% of $4M xs $1M 95% $500K xs $500K Retention
Reinsurance Program Example
Catastrophe 2nd Excess 1st Excess Surplus Share Retention Quota Share Non Proportional Proportional
Reinsurance Contract Basics
Proportional Reinsurance Non-Proportional Reinsurance
Reinsurance Contracts Pro Rata Quota Share Surplus Share Treaty Facultative Excess of Loss Per Risk Per Occurrence Aggregate Certificate Semi Automatic
OR Automatic
Pro Rata Excess of Loss Other Considerations:
• Occurrence vs. Claims Made • Prospective (future) vs. Retroactive (past events) • Insurance Risk Transfer
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 18
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 19
Captives
A 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% Ceding Commission 35% 1 Year Contract Effective 6/30/XX
INCOME STATEMENT
-------------- PREMIUMS WRITTEN CHANGE IN UPR -------------- PREMIUMS EARNED -------------- LOSSES INCURRED LOSS EXP.INCURRED
OTHER UND. EXPENSES -------------- UNDERWRITING DEDUCTIONS UNDERWRITING INCOME INVESTMENT INCOME OTHER INCOME/LOSS TAXES NET INCOME LOSS RATIO NPW/Surplus Commission Ratio 12/31/XX Before 80% Q/S 12/31/XX After Reinsurance Reinsurance Reinsurance -------------------- ------------------------------ --------------------------- 10,000,000
(8,000,000)
4,000,000 --------------------
(3,200,000) ------------------------------
6,000,000 --------------------
(4,800,000) ------------------------------
3,000,000 550,000 3,000,000
(2,400,000) (440,000) (2,800,000)
--------------------
------------------------------
6,550,000 ------------------- (550,000)
(5,640,000) ----------------------------- 840,000
250,000 2,000,000 800,000 --------------------------- 1,200,000 --------------------------- 600,000 110,000 200,000 --------------------------- 910,000 --------------------------- 290,000 250,000 0 ------------------- (300,000)
----------------------------- 840,000
365,000 --------------------------- 175,000 =========== ================= ================
59.17% 285.71% 30% 59.17% 46.09% 10%
Impact of Quota Share
Balance Sheet
ASSETS -------------- INVESTMENTS & CASH AGENTS' BALANCES REINSURANCE RECOV.
MISC. ASSETS 12/31/XX Before Reinsurance 20,980,000 1,650,000 150,000 135,000 --------------------- 22,915,000 =========== TOTAL ASSETS ======= LIABILITIES -------------- LOSSES & LAE REINSURANCE PAYABLE UNEARNED PREMIUMS OTHER EXP. & TAXES MISC. LIABILITIES TOTAL LIABILITIES 15,250,000 450,000 3,500,000 150,000 65,000 --------------------- 19,415,000 --------------------- CAPITAL AND SURPLUS CAPITAL UNASSIGNED SURPLUS REINS.BEN.
2,750,000 750,000 POLICYHOLDERS' SURPLUS TOTAL LIAB. AND SURPLUS Ratio of liab. to surplus --------------------- 3,500,000 --------------------- 22,915,000 ===========
554.71%
80% Q/S Reinsurance
-5,200,000 -5,200,000 =
12/31/XX After Reinsurance ------------------------------ 15,780,000 1,650,000 150,000 135,000 ------------------------------ 17,715,000 ===============
-2,840,000 -3,200,000 -6,040,000 840,000 840,000 -5,200,000 =
12,410,000 450,000 300,000 150,000 65,000 ------------------------------ 13,375,000 ------------------------------ 2,750,000 750,000 840,000 ------------------------------ 4,340,000 ------------------------------ 17,715,000 ===============
308.18%
Impact of Excess of Loss
Excess of Loss $500k XS $500k Reinsurance Premiums = 12% DPW 1 Year Contract Effective 6/30/XX
INCOME STATEMENT
-------------- PREMIUMS WRITTEN CHANGE IN UPR -------------- PREMIUMS EARNED -------------- LOSSES INCURRED LOSS EXP.INCURRED
OTHER UND. EXPENSES -------------- UNDERWRITING DEDUCTIONS UNDERWRITING INCOME INVESTMENT INCOME OTHER INCOME/LOSS TAXES NET INCOME LOSS RATIO NPW/Surplus Commission Ratio 12/31/XX 12/31/XX Before Reinsurance
Reinsurance
--------------------
------------------------------
After Reinsurance --------------------------- 10,000,000 4,000,000
(1,200,000) (600,000)
8,800,000 3,400,000 --------------------
------------------------------
6,000,000
(600,000)
--------------------------- 5,400,000 --------------------
------------------------------
3,000,000
(420,000)
--------------------------- 2,580,000 550,000 3,000,000
0 0
550,000 3,000,000 --------------------
------------------------------
6,550,000
(420,000)
--------------------------- 6,130,000 --------------------
------------------------------
(550,000) 250,000
(180,000)
--------------------------- (730,000) 250,000 0 0 --------------------
------------------------------
(300,000)
(180,000)
--------------------------- (480,000) ==========
===============
59.17% 285.71% 30% ============== 57.96% 265.06% 34%
Impact of Excess of Loss
Balance Sheet
ASSETS INVESTMENTS & CASH AGENTS' BALANCES REINSURANCE RECOV.
MISC. ASSETS TOTAL ASSETS ======= LIABILITIES -------------- LOSSES & LAE REINSURANCE PAYABLE UNEARNED PREMIUMS OTHER EXP. & TAXES MISC. LIABILITIES TOTAL LIABILITIES 12/31/XX 20,980,000 1,650,000 150,000 135,000 --------------------- 22,915,000 ===========
-1,200,000 ------------------------ -1,200,000 ============
12/31/XX 19,780,000 1,650,000 150,000 135,000 ------------------------------ 21,715,000 =============== 15,250,000 450,000
-420,000
14,830,000 450,000 3,500,000 150,000 65,000 --------------------- 19,415,000 ----------------------
-600,000 ------------------------ -1,020,000 -------------------------
2,900,000 150,000 65,000 ------------------------------ 18,395,000 ------------------------------ CAPITAL AND SURPLUS CAPITAL UNASSIGNED SURPLUS REINS.BEN.
POLICYHOLDERS' SURPLUS TOTAL LIAB. AND SURPLUS Ratio of liab. to surplus 2,750,000 750,000 --------------------- 3,500,000 --------------------- 22,915,000 =========== 554.71%
-180,000 -------------------------
2,750,000 750,000 -180,000 -------------------------------
-180,000 -------------------------
3,320,000 -------------------------------
-1,200,000 ============
21,715,000 =============== 554.07%