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CH 24 : Reinsurance

P

Pulit Chhajer

Member
Hi , Could you please help to get a better hold on below paragraph :

Under sum-at-risk reinsurance the insurer retains the full reserves under its contracts. The reserve does not constitute any risk to the insurer from mortality, as the reserve needs to be available whether a policyholder dies or survives during the year. So, reinsurance that covers any part of the insurer’s reserves is a waste of money, at least from the view of covering mortality
risk. Also, such reinsurance would allow the reinsurer to set up its own reserves for its share of the risk, and so would allow the reinsurer to earn investment profits at the expense of the insurer. Hence, it is (usually) in the insurer’s best interests to retain 100% of the reserve if it can do so. (The exception to this would be if the insurer wishes to share the investment risk as well as the
mortality risk with the reinsurer.)
 
Pulit Chhajer said:
Hi , Could you please help to get a better hold on below paragraph :

Under sum-at-risk reinsurance the insurer retains the full reserves under its contracts. The reserve does not constitute any risk to the insurer from mortality, as the reserve needs to be available whether a policyholder dies or survives during the year. So, reinsurance that covers any part of the insurer’s reserves is a waste of money, at least from the view of covering mortality
risk. Also, such reinsurance would allow the reinsurer to set up its own reserves for its share of the risk, and so would allow the reinsurer to earn investment profits at the expense of the insurer. Hence, it is (usually) in the insurer’s best interests to retain 100% of the reserve if it can do so. (The exception to this would be if the insurer wishes to share the investment risk as well as the
mortality risk with the reinsurer.)
Click to expand...
Hi Pulit

Maybe it's easiest to see this with a numerical example.

Consider a without-profits endowment assurance with sum assured of 100,000 and reserve of 40,000. The risk to the insurance company is that the policyholder dies and it needs to pay out 100,000, but it only has reserves of 40,000, so the sum at risk is 60,000. So it makes sense to buy reinsurance that covers the extra 60,000.

Buying reinsurance that pays out 100,000 is unnecessary. The insurer doesn't need this much cover. Note that even if the policyholder survives, it still needs its reserve to pay out the maturity benefit in the future.

(In brackets in the paragraph, the insurer could reinsure say 50% of the total, so that the insurer and reinsurer both pay 50,000 (on both death and maturity). The insurer would then have reserves of 20,000 and the insurer have reserves of 20,000 (assuming they calculate them the same way). The reinsurer is then carrying the risk that the investment return is lower than expected and that the reserve doesn't cover the maturity guarantee).

I hope the numerical example helps.

Best wishes

Mark
 
Thanks for quick turn around. Tough I got the rationale of your illustration but still unable to connect dots between your illustration and the paragraph.

Would be more helpful if you could please deconstruct the above paragraph and re share your rationale.
 
Hi Pulit

Here's my example again allocated to the appropriate parts of the quote with some extra detail.

Under sum-at-risk reinsurance the insurer retains the full reserves under its contracts.

So the insurer still has the reserve of 40,000. Mostly this is to meet the maturity claim.

The reserve does not constitute any risk to the insurer from mortality, as the reserve needs to be available whether a policyholder dies or survives during the year.

So if the policyholder claimed for 40,000, then the insurer would have enough money (of course any claim will be more and so the need to reinsure the sum at risk of 60,000).

So, reinsurance that covers any part of the insurer’s reserves is a waste of money, at least from the view of covering mortality
risk.

So no point buying reinsurance for the first 40,000 of the claim as the insurer already has this money available to pay claims.

Also, such reinsurance would allow the reinsurer to set up its own reserves for its share of the risk, and so would allow the reinsurer to earn investment profits at the expense of the insurer.

If the insurer reinsured the first 40,000 of risk then it would need to pay a very substantial premium to the reinsurer. For example if it reinsured 50% of this risk then the premium would be around 20,000 (as this is half the reserve) and so the insurer would be halving its assets and halving its investment surplus.

Hence, it is (usually) in the insurer’s best interests to retain 100% of the reserve if it can do so.

That way it keeps all the investment surplus which is a major source of profit on a without-profits endowment assurance.

(The exception to this would be if the insurer wishes to share the investment risk as well as the mortality risk with the reinsurer.)

If the insurer did reinsure the full amount then it would pass over the reserves of 20,000 in our example and so if investment returns were bad the reinsurer would instead take the loss on these reserves.

I hope this breakdown helps.

Best wishes

Mark
 
I have a few doubts related to the topic of reinsurance:
  • In the above example, we have discussed about earning investment profits at the expense of the insurer. You have given the example that insurer has to pay substantial premiums for example 20,000 which will cause a reduction in assets. But how is it sharing the investment surplus is confusing me?
  • What is the major difference between catastrophe and stop loss reinsurance?
  • I have doubt with the solution of Question 24.4(Part ii and iii). Here it is mentioned that "On the other hand the value of the future repayments is reduced in the embedded value calculation by discounting them back at the RDR reflecting the possibility that they will not be paid." What is the meaning of the above lines?
  • It is also mentioned that "Once again, this points to the exchange of cash for profits to be broadly consistent, especially if we were to value everything in the market consistent way". I don't understand where the concept of cash come in here and how is it related to market consistent way?
  • In the iii) part it is mentioned that, "With this reinsurance part of profit has been converted to current cash, making it certain. Again I don't understand the cash concept here.
  • In catastrophe reinsurance the aggregate losses are arising from a single event and is therefore designed to cover the risks from non-independent claims. How is it non-independent if the claims occur perhaps due to an industrial accident. Wont the claims be due to same cause and hence dependent?
 
Last edited by a moderator:
Hi Sayantani

I have copied in your questions and then answered each below.
  • In the above example, we have discussed about earning investment profits at the expense of the insurer. You have given the example that insurer has to pay substantial premiums for example 20,000 which will cause a reduction in assets. But how is it sharing the investment surplus is confusing me?
In this example the reinsurer gets a premium of 20,000. They will invest that premium to earn investment returns. If the insurer hadn't taken out this reinsurance then they would have kept the investment returns for themselves.
  • What is the major difference between catastrophe and stop loss reinsurance?
Catastrophe reinsurance will usually cover a large number of claims in a short period of time, eg from a fire at a factory. Stop loss looks at all claims over the year, regardless of the cause.
  • I have doubt with the solution of Question 24.4(Part ii and iii). Here it is mentioned that "On the other hand the value of the future repayments is reduced in the embedded value calculation by discounting them back at the RDR reflecting the possibility that they will not be paid." What is the meaning of the above lines?
A contingent loan is only repaid if the insurer has made profits. So the insurer's repayments are not risk free and so are discounted back at the RDR, which reduces their value.
  • It is also mentioned that "Once again, this points to the exchange of cash for profits to be broadly consistent, especially if we were to value everything in the market consistent way". I don't understand where the concept of cash come in here and how is it related to market consistent way?
A contingent loan involves the insurer swapping future profits for cash now. If the reinsurance is priced in a market-consistent way then the cash paid by the reinsurer now should be the market value of the future profits.
  • In the iii) part it is mentioned that, "With this reinsurance part of profit has been converted to current cash, making it certain. Again I don't understand the cash concept here.
A contingent loan involves the reinsurer giving the insurer a loan. So at outset the reinsurer gives the insurer cash. The insurer then repays this loan over time out of its future profits.
  • In catastrophe reinsurance the aggregate losses are arising from a single event and is therefore designed to cover the risks from non-independent claims. How is it non-independent if the claims occur perhaps due to an industrial accident. Wont the claims be due to same cause and hence dependent?
Yes, the claims will be due to some cause and hence be dependent. Dependent and non-independent mean the same thing.

Best wishes

Mark
 
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