This arrangement seems so complex and I personally don't feel that it is explained clearly in the course notes or fully by any of the previous posts on this forum. My first question is: How much insurance risk, say, is transferred to the reinsurer when the reinsurance premium is paid (before being deposited back)? My understanding is that a reinsurance premium set equal to the reserves is paid to the reinsurer. So this would suggest to me that all of the risk on these policies is transferred to the reinsurer in the first instance. The reinsurer then deposits back the reinsurance premium (in this case equal to the size of the necessary reserves from the insurers perspective) creating an asset and a liability on the insurers balance sheet (net effect 0). Now I start to get even more confused. At this stage has there been any transfer of risk back to the insurer? If not, surely the reinsurer needs to keep that money for itself. If yes, then fine... but what was the point in transferring it to the reinsurer in the first place. (Given that the whole amount deposited back becomes a liability on the insurers balance sheet I would guess that all of the risk remains with the reinsurer.) The reinsurer also adds on a contingent loan which boosts the insurers assets as the loan doesn't need to be reserved for in Peak 1. OK fine... but why not just do this in the first place i.e. the reinsurer gives a loan in return for future profits without any of this passing to and fro of the reserves \ reinsurance premium beforehand. Sorry, perhaps it is totally obvious to everyone else but I don't have much 'hands on' experience of reinsurance... I just don't get it !
Hi I'll give it a go but others feel free to chip in as appropriate. The key thing to bear in mind is the purpose of the transaction. The whole point of the arrangement for the insurer is to increase (peak 1) free surplus. My responses are as follows: 1. All of the risk is transferred to the reinsurer (hence the insurer is able to reduce their liabilities accordingly). 2. Mechanically, the insurer pays the reinsurance premium from its assets and reduces it's liabilities by the reserves released. Impact on free surplus is 0 (i.e. this doesn't improve their free surplus position). However, it has resulted in a genuine transfer of risk (which is required if the regulator is to let it through). 3. If we stopped here, the reinsurer would receive the reinsurance premium as an asset but would need to reserve for the risks it has now taken on. The insurer would have counterparty risk to the reinsurer - i.e. the risk of not receiving reinsurance recoveries when a claim event occurs and would likely hold a reinsurer default provision. 4. The insurer may not be comfortable with its credit risk with the reinsurer. It may therefore decide to enter into a deposit back arrangement with the reinsurer. The impact: The insurer receives back the reinsurance premium. As a result they add back their liabilities too. 5. The balance sheet physically therefore hasn't changed compared with the pre-reinsurance position. However, as part of the arrangement the reinsurer agrees to provide a capital advance to the insurer - based on a proportion of future surplus to emerge. 6. The future surplus is inadmissible under Peak 1, however the capital advance paid to the insurer (cash) is admissible. Therefore assets increase by the capital advanced but there is no increase to liabilities (as the future surplus is inadmissible any liabilities contingent on surplus emerging is also inadmissible). 7. It's because of 6 that free surplus increases. Key points: Point 4. above is a red-herring. Free surplus would increase without it. Its purpose is to deal with a secondary risk (i.e. the exposure to the reinsurer as a result of the transaction). I suspect the core reading adds it in to emphasise the point that the purpose of the transaction is to increase free surplus (not to take on secondary risks). The insurer wants the capitalise future surplus so as to convert an inadmissible asset (peak 1) to an admissible one (cash)- this is the point. However, they know that the regulator wouldn't let it through and so they create a structure that seems like a genuine transfer of risk has been made. Hope that helps
Mugono, many thanks for your comprehensive reply. I certainly understand it a lot better now and I certainly understand enough to be able to explain it in an exam. Even though the aim of the arrangement is to capitalise on future profits, it seems to me that under this arrangement all of the risk to the insurer in respect of these contracts has been genuinely, and pretty much entirely, transferred to the reinsurer. My original difficulty in understanding this arrangement was: why couldn't the deal solely consist of a contingent loan to the insurer in return for future profits (with no other arrangements in place). My understanding now is that this does not involve a transfer of risk and this is a requirement of the regulator. My second difficulty in understanding was: following reinsurance of the business (i.e transfer of risk to keep the regulator happy) and a contingent loan passed back in return for future profits (this what we really want) why did the deposit back of the reinsurance premium have to take place. My understanding now is that this issue of credit risk that is another sticking point with the regulator and that they wouldn't let the deal through without it. Presumably the deposit back of the reinsurance premium (which is just a straightforward loan) addresses the issue of credit risk arising from the reinsurance transaction in the following way: if the reinsurer defaults on its obligations to the reinsured policies, the insurer has already in place the reinsurance premium deposited back (i.e. assets it can use to cover this event) and the liability (loan repayment) to the reinsurer w.r.t. deposit back arrangement could be written off. I hope this is correct. Many thanks, Christopher
1. Correct 2. The depositing back of the reinsurance premium removes the credit risk issue. This is something the insurer may want to do. The regulator wouldn't object to the deal (in principle; because there is no deposit agreement in place). 3. I think you're over complicating. The insurer will meet claims as before. By definition, the reinsurer 'can't default' - that's why depositing back eliminates credit risk. The insurer will pay the reinsurer as surplus emerges in exchange for the capital originally advanced. Hope that helps.
Hi both, Thank you for your discussion above. It is really helpful. However, I still have one question. The arrangement described above appears to be too good for direct insurer. What is in it for re-insurer to agree to such terms in the first place? Thank you! Regards, XS
This question is really old and is no longer relevant (in Europe) since the regulatory regime switched to Solvency 2. Putting the above aside, what is “in it” for the reinsurer is the profit loading it would charge the cedant.
Thank you mugono for replying (I did note the date). Just in terms of your list 1-7, where does profit loading occur, please? And how? Many thanks.
The profit loading would typically be reflected within the reinsurance premium; which would be set at a level in excess of the best estimate. If the subsequent experience was in line with the best estimate, the difference would accrue to the reinsurer as profit. Conceptually, you can think of this (in a S2 context) as the risk margin.
