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Learn about reinsurance basics, catastrophe excess, cost justification, premium components, and methods for including reinsurance costs in homeowners indication. Understand examples and alternatives, with a focus on risk transfer and rate development principles.
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Reinsurance and the Homeowners Indication CAS Ratemaking Seminar March 10-11, 2005
Agenda • Brief Review of the Basics • Catastrophe Excess Reinsurance • Justification for Including Cost in Rates • Components of the Reinsurance Premium • Two Methods to Include the Cost of Reinsurance into the Rate • An Example of the “Net Cost of Reinsurance Method” • Miscellaneous/Related Topics
The Basics of Reinsurance • Reinsurance is simply insurance for insurance companies • In exchange for a premium, the reinsurer agrees to assume all or part of some risk that had previously been assumed by the primary insurer.
The Basics of Reinsurance • Primary insurers purchase reinsurance for a variety of reasons, including: • To increase capacity • To stabilize underwriting results • To provide catastrophe protection • To obtain surplus relief
Catastrophe Excess Reinsurance • Under a catastrophe excess agreement, the reinsurer indemnifies the primary insurer for aggregate losses in excess of a given amount, called the retention, arising from a catastrophic event • The reinsurer’s risk is generally limited to some amount • A reinsurer may only indemnity the primary company for a percentage of loss in excess of the retention
Catastrophe Excess Reinsurance - Example • Assume a reinsurance contract provides coverage for 50% of $600MM of loss in excess of $400MM per catastrophic event • If no event causes loss in excess of $400MM, the reinsurer pays nothing
Catastrophe Excess Reinsurance - Example • Assume a reinsurance contract provides coverage for 50% of $600MM of loss in excess of $400MM per catastrophic event • If an event causes loss in excess of $1 billion, the reinsurer pays $300MM (= $600MM limit x 50%)
Catastrophe Excess Reinsurance - Example • Assume a reinsurance contract provides coverage for 50% of $600MM of loss in excess of $400MM per catastrophic event • If an event causes loss between $400MM and $1 billion, the reinsurer pays 50% of the amount in excess of $400MM.
Catastrophe Excess Reinsurance • Reasons to purchase catastrophe excess reinsurance • Catastrophic events may cause an unacceptable drain on company surplus • Company is unable to achieve the required return on the capital it must hold because of the risk of catastrophic events
Alternatives to Catastrophe Excess Reinsurance • Possible Alternatives to Catastrophe Excess Reinsurance • Non-renewal of existing policies • Restrictions on new business
Justifying Including Reinsurance in the Rate • Catastrophe Excess Reinsurance • contributes to the availability of insurance • is a legitimate business expense that benefits both the insurer, and the market as a whole
Catastrophe Excess Reinsurance • A rate should provide for “all costs associated with the transfer of risk” • “Consideration should be given to the effect of reinsurance agreements in the development of the rate” - Statement of Principles Regarding Property and Casualty Ratemaking
Components of the Reinsurance Premium • Expected Loss and Loss Adjustment Expenses • Reinsurer Expenses • Reinsurer Profit
Components of the Reinsurance Premium • Expected Loss and Loss Adjustment Expenses – “Reinsurance Benefit” • Reinsurer Expenses • Reinsurer Profit • Terminology from Reflecting Reinsurance Costs in Rate Indications for Homeowners by Mark J. Homan “Transaction Costs”
Components of the Reinsurance Premium • Only the transaction costs represent incremental, or “net,” costs to the primary insurer • This is because the premium for the reinsurance benefit is offset by a corresponding reduction in the primary company’s losses
Including the Cost of Reinsurance in the Indication • Two possible methods • Distinct, but theoretically equivalent • Arise from the separation of the reinsurance premium into its transaction cost on reinsurance benefit components
Including the Cost of Reinsurance in the Indication • First Possible Method • “Net Cost of Reinsurance” method • Include only the transaction costs, or net cost, of the contract as an expense • Leave expected losses unadjusted
Including the Cost of Reinsurance in the Indication • Second Possible Method • “Net Loss Plus Reinsurance” method • Include the entire reinsurance premium as an expense • Reduce expected losses by the amount of the expected reinsurance benefit
Net Cost of Reinsurance vs.Net Loss Plus Reinsurance • Which is preferable? • Theoretically, they are identical • Reduction in losses under the Net Loss Plus Reinsurance method is offset exactly by the inclusion of the additional portion of the reinsurance premium as an expense • No preference on theoretical grounds
Net Cost of Reinsurance vs.Net Loss Plus Reinsurance • Which is preferable? • Preference given to the method that best conveys the pertinent information within. • If the total effect of the reinsurance agreement on the indication is of interest, the Net Cost of Reinsurance method is preferred.
Net Cost of Reinsurance vs.Net Loss Plus Reinsurance • An example…. • Reference Exhibit 1
A Complete Example • Flannel Insurance Company (FIC) • State of Armstrongland • Current rates appear to be perfectly adequate • Reference Exhibit 2
A Complete Example • Subsequently, FIC enters into the following reinsurance agreement • Reference Exhibit 3
A Complete Example • A few assumptions: • The exposure base for the development of the hurricane catastrophe provision is the AIY, where 1 AIY = $1000 of Dwelling Coverage insured for 1 year • A model is used to simulate a sufficient number of years of experience from which to develop an expected hurricane loss per AIY • Only hurricane events will trigger a reinsurance recovery
Quantifying the Reinsurance Benefit • Quantifying the Reinsurance Benefit • Reinsurer’s Estimate • Internal Estimate
Quantifying the Reinsurance Benefit • The Reinsurer’s Estimate • Advantages • Saves the primary company the work of developing its own estimate • Disadvantages • May be difficult to obtain • May not be compatible with the primary company’s estimate of expected hurricane losses
Quantifying the Reinsurance Benefit • Problems with using the Reinsurer’s Estimate: • Insurer expects $10 million in hurricane loss/year • Cedes all hurricane risk to reinsurer • Reinsurer estimates loss at $12 million/year • This implies negative net losses!
Quantifying the Reinsurance Benefit • Problems with using the Reinsurer’s Estimate: • Same may arise within any individual layer or portion of loss that might be reinsured • When possible, internally generated estimate should be used
Quantifying the Reinsurance Benefit • Developing an Internal Estimate • Obtain modeled loss for each simulated event, and the AIYs underlying those losses • Determine AIYs to be insured during the reinsurance contract period • Adjusted modeled losses to future exposure level • Apply contract terms to each adjusted modeled loss • Determine average annual reinsurance benefit as average annual simulated reinsured loss • Reference Exhibits 4 and 5
Quantifying the Reinsurance Benefit • Consider Event 4 from Year 5 • Model simulates $97,275,005 in loss • Model assumes 13,248,231 AIYs • We expect 15,891,785 AIYs will actually be insured over the reinsurance contract period.
Quantifying the Reinsurance Benefit • Consider Event 4 from Year 5 cont. • Adjust the expected loss by multiplying it by the ratio of expected AIYs to modeled AIYs • $97,275,005 x (15,891,785 / 13,248,231) = $116,685,274
Quantifying the Reinsurance Benefit • Consider Event 4 from Year 5 cont.. • We then apply the contract terms to the $116,685,274 loss • 8,342,637 of the loss is reinsured
Quantifying the Reinsurance Benefit • We follow this process for each modeled loss • Losses under $100 million do not trigger coverage • Losses over $500 million trigger maximum coverage of $200 million • Losses between $100 million and $500 million trigger coverage of 50% of the loss excess of $100 million
Quantifying the Reinsurance Benefit • Then sum up the reinsured losses and divide by 100,000 years (or however many have been modeled) to determine an expected annual reinsurance benefit of $4,767,536
Determining the Net Cost of Reinsurance • The net cost of reinsurance equals: $11,000,000 reinsurance premium - $ 4,767,536 reinsurance benefit $ 6,232,464 net cost of reinsurance
Incorporating the Net Cost of Reinsurance into the Indication • Now must adjust for difference in reinsurance period and ratemaking period
Incorporating the Net Cost of Reinsurance into the Indication • If the company believes the terms of the contract will be similar in the remaining years, it may be easiest to relate the net cost to some base, and assume a constant net cost relative to that base over time
Incorporating the Net Cost of Reinsurance into the Indication • In this instance we’ll assume the net cost of reinsurance is proportional to AIYs. • This assumption is not quite true, since expected losses within a layer are not exactly proportional to exposure, even if total losses are • However, it is a reasonable, and easy to calculate, approximation
Incorporating the Net Cost of Reinsurance into the Indication • Net cost of reinsurance per AIY = $6,232,464 / 15,891,785 = $.39/AIY • Reference Exhibit 6
Incorporating the Net Cost of Reinsurance into the Indication • Once net cost per AIY is determined, incorporate it as an expense into the indication • (Reference Exhibit 7)
Incorporating the Net Cost of Reinsurance into the Indication
Incorporating the Net Cost of Reinsurance into the Indication
Incorporating the Net Cost of Reinsurance into the Indication • Indication increased 12.2% • Indicated premium increased $60.94 • In return for the additional premium, policyholders are more assured that coverage will remain available, both before and after a catastrophic event, and, in the case of such an event, that their own losses will be paid.