Allocating reinsurance costs

[jensen]

Hi

Just wondering how does a general insurer allocate cost of (non-proportional) reinsurance to its policyholders for the year, since reinsurance is only arranged at the beginning of the year and we don't know how many policies we will write throughout the year.

I am guessing they have an target number of policies to write, so allocate the reinsurance cost using that. If the insurer write more policies than projected, then no issue but when estimated number is higher, then the insurer need to absorb the excess costs.

Am I right?

 

[mattt78]

allocating ri costs

Its worth noting that non-proportional reinsurance treaties typically have some exposure related adjustment feature, so the total cost of the reinsurance treaty to the reinsured will be adjusted, usually on expiry, to reflect the original under- or over- estimation of exposure on which the treaty was originally priced. Usually this is just done by making the ri premium a % of insurers GWP (so usuing premium as a proxy for exposure).

Usually this is acheived by agreeing a deposit premium, with an adjustable rate (of GWP) on which the treaty is adjusted at expiry. However, a minimum premium is often included, so if the insurer significantly overestimates its income, it will be left 'holding the baby' so to speak, as you said.

On your main point, whilst in theory this should happen (i.e. allocation of NP RI costs back to individual policies), i'm not sure it often happens in practice. In theory, for a risk xl, I would propose that the insurer should calculate the proportion of expected losses to an ri treaty that an individual policy would make up, and allocate the policy the same proportion of ri costs. (Or perhaps take a marginal approach in considering new policies). However, this is likely to be impractical for all but the largest of policies, so presumably a more broad brush approach is typically taken. But it wouldn't really make sense to allocate costs equally amongst all policies, as you seemed to be suggesting. Allocation in proportion to GWP would make sense for a cat xl, or agg xl treaty, but not for a risk xl - since for example, policies with limits below the NP RI retention will not expose the RI treaty at all, so should not be allocated any of the risk xl costs. (For risk xl treaties a reinsurer is less likely to use GWP as a proxy for exposure, but may still do so on the assumption that the line size profile of the insurer's business will remain fairly constant).

 

[jensen]

Hi mattt78

Thanks for replying. Quite surprised to learn that in practice the RI cost is not allocated back to policyholders, but you are right that it can be impractical to do so.

Anyone else working in with an insurer?

 

[didster]

I don't work in insurance, but I would tend to think of it as two separate transactions.

Insurer sells policies for particular risks with acceptable expense and profit margin.

They can choose to keep it themselves or sell it off, but that's their choice and shouldn't affect policy holder. RI "costs" are really passing a share of the profits along.

That's the way I conceptualize it anyway.

That being said, in practice, "greedy" shareholders/insurance companies may pass these costs onto the policyholder and take bigger profits than reasonable for the risks that they're keeping.

 

[mattt78]

I disagree with didster on this one. Since reinsurers need to cover their costs and aim to make a profit, reinsurance will generally involve passing profit to reinsurers, so this will be an expected cost to the insurer - probably a significant one, and will therefore need to be included in original pricing, just like any other cost. Otherwise insurers won't meet their planned net profit, or ROC etc. If they planned their business and priced their policies whilst ignoring a major cost they would be rather foolish, not "greedy"! (Or maybe didster was joking about that?)

I assume the original question was looking for a theoretical answer, which is what I made a poor attempt at earlier, but I think the reality is more a case of things working the other way around (which is maybe what didster was getting at).
By that I mean that a business plan will be drawn up on a gross basis, considering expeced rate changes, mix of business changes etc, to calculate capital costs and expected profit etc. Then likely reinsurance structures and costs will be considered, along with the impact on profit and ROC etc, and assumptions (gross or ri) tweaked until an optimal arrangement is found based on the company's objectives and constraints. Some reinsurance may be optional depending on terms/price, but often some will be essential to stay within risk tolerance and available capital limits etc, so good planning and costing will be needed if the company is to meet its business plans.

 

[didster]

It would certainly be foolish to sell a policy for 100 if it costs 110 to reinsure, so you do need to take them into account.

The points I was trying to make are that you can look at it from different view points (some of which it may be ok to ignore the costs of reinsurance), and that the profit is compensation for holding the risk.

Say your capital is sufficient to sell 100 policies with a profit of 10. If you reinsure you can increase your capacity and sell 200 policies, but it's not reasonable to expect that you'll now make 200x10 in profit. Remember you only have capital for 100, and hold the risk for 100 so roughly make ROI for 100 (plus a little for facilitating the other 100).
As another example, if a reasonable profit is 10 per policy if you keep it, and the reinsurer wants another 10. Simply adding 20 to the premium to maintain your 10 is a bit much (the policyholder pays too much for what he gets or the reinsurer could sell insurance himself for the full 20 if he cuts out the middleman)

Some insurers may not have the ability to do pricing properly and just use the reinsurance rates as a gauge to set their own rates, instead of properly pricing the risks. In this case the reinsurance rates "filter down" to the policyholder.

In terms of the original question I think there will be a few ways to do it and the one you proposed sounds reasonable.

Finally, in practice the actuary may create fancy pricing models, only to find that his recommendations reach the sales teams who "ignore" the actuary's price and use their own. "ignore" is a bit of exaggeration here.

 

[mattt78]

allocating ri costs

i'm not really getting the concept of 'a reasonable profit' - profit loadings will be largely dictated by various market forces and competitive pressures etc. Companies will seek to maximise profits whilist operating within their constraints (like risk appetite), and competitors will seek to do the same, and those that don't do it so well are likely to fall by the wayside. That's what I thought anyway (although obviously its not quite as simple as that). My point is that nobody sits around deciding how much profit might be 'reasonable' to allocate.

 

[didster]

Perhaps I should avoid commenting on stuff I'm not too familiar with.

By reasonable profit I mean something close to the true price dictated by market forces for trading the risk between two parties in an efficient market.

Basically if you can get the same bottle of water in adjacent stores you'd expect to pay the same price, otherwise everyone will buy the cheaper one, irrespective of how much each store paid to put the bottle on the shelf.
Applying this to insurance, the insurer who keeps the risk may get 10 in profit, the one who reinsures may only keep 3, passing 7 to the reinsurer.

Pricing is not an exact science.

 

[mattt78]

allocating costs

Its not really an insurance point, just an economics point. If we have efficient markets, then pricing (actual price, rather than technical price) is an exact science. Obviously we don't have perfectly efficient markets though!

I know we're way off topic here, but as an aside, generally I think alot of rubbish gets talked about 'excessive prices' and 'excessive profits' and 'greedy corporations', as if we don't live in a capitalist society and companies don't operate in a competitive environment and companies don't exist primarily to generate as much profits as they can. People prefer not to realise the effects of market forces, or recognising competitive pressures, because its can seem confusing or inconvenient. It's much easier to just label corporations 'greedy' and blame 'globalisation' or something. If they really don't like the way things work, blame those who maintain and regulate the systems, i.e. governments, not those who operate in a manner entirely consistent with the incentives and principles of the system.