Reinsurance Session 2

Reinsurance Session 2 Finite Reinsurance Life Reinsurance Securitization / Alternative Capital Sources Reinsurance Failures Session 2

Reinsurance 1. Finite Reinsurance

Finite Reinsurance Multi-year Multi-class (mostly) Limited indemnity risk transfer, mainly timing risk Side letters to contract which serve to conceal the limited indemnity risk transfer Dampens fluctuation of profit over term of contract.

Where would you most likely find Finite Reinsurance? High level catastrophe XL cover Likely location for Finite Reinsurance Cover for fairly high claims whose level is predictable over 5-8 years Low level QS cover

Finite Reinsurance Dampens fluctuation of profit over term of contract. Net asset value increases over time Net asset value decreases over time No Finite Re. With Finite Re. Little effect Net asset value Conceals serious problems Time (years)

Finite Reinsurance Loss Portfolio Transfer (LPT) Transfers loss portfolio to reinsurer, plus assets and plus premium. Protects against timing risk Adverse Development Cover (ADC) Losses stay with insurer but reinsurer smoothes any adverse development. Post-loss funding? Message: Please don’t be “blinded by science” Spread Loss Treaty (SLT) Pays “premium” into an “experience account” at reinsurer which is used to smooth results of cedant. Finite Quota Share (FQS) Transfers unearned premium in return for a reinsurance commission. Counter-cyclical tool to smooth profits. Source: Swiss Re. Sigma 1997, & Core Curriculum Module

Finite Reinsurance Side letters to contract which serve to conceal the limited indemnity risk transfer SEC vs. General Re & AIG (USA) – February 2008 A finite re contract to inflate AIG’s loss reserves by US$500million in 2001. (an immaterial amount for the AIG Group). Securities Fraud, Conspiracy, False Statements to Regulators 4 Gen Re & 1 AIG executives guilty and each face up to a US$48million fine & between 150 and 200 years in prison. SFO vs. Independent Insurance (UK) – October 2007 Jail sentences for CEO, CFO and In-house Counsel for conspiracy to defraud. Dampens fluctuation of profit over term of contract.

Reinsurance 2. Life Reinsurance

Life Reinsurance Usually, transfers mortality and morbidity risk. Each life company establishes a “retention per life” e.g. TT$300,000. The more volatile the underwriting results the smaller the retention should be The smaller the policy base the smaller the retention should be The less homogeneous the policy base the smaller the retention should be The lower the capital base the smaller the retention should be

Risk Transfer – Mortality & Morbidity Life Reinsurance Risk Transfer – Mortality & Morbidity Little need to reinsure savings / unit linked products!! Some anti-cyclical “finite reinsurance” transfers timing risk. Main Types Reinsurance Contracts Coinsurance Modified Coinsurance Yearly Renewable Term (YRT) And Treaty (large bundles of policies) Facultative (individual policies) Some contracts transfer timing risk to alleviate front-end strain.

Life Reinsurance -Types of Contract YRT Reinsurer assumes mortality and morbidity risk only, & annual premiums based on amount at risk. Premiums increase with age of insured. Investment risks and returns remain with primary insurer. (Quota Share or Excess of Loss) Coinsurance Reinsurer shares a percentage of business including cash flows and reserves. Investment risks and returns are shared in proportion to the risk transfer. Modified Coinsurance As above, but ceding company retains assets and reserves and, therefore, investment risks and returns. Primary insurer pays a fixed rate of interest to reinsurer for the investments it “holds” in relation to the risk transferred. Reference material: American Council of Life Insurers (ACLI). Reinsurance Treaty Sourcebook http://www.acli.com/ACLI/Issues/GR02-216.htm GLOC has YRT to reinsure mortality and morbidity in XS of $30k per life. Discuss how life reinsurers make their money. Point towards the treaty sourcebook.

3. Securitization / Alternative Capital Sources Reinsurance 3. Securitization / Alternative Capital Sources

Insurance Securitization Transfers insurance risk to capital markets Mechanism is same as for non-insurance securitization Securitization is suited to catastrophe risk; most of the deals are in this line of business. Reference: www.artemis.bm See the Deal Directory The website is up to date now. History of securitization is well-known. Started with credit card receivables. Applied to insurance, but never formed a mass market. Only a way for the top reinsurers to fine tune their enormous capital needs. This technique became widely used to transfer credit risk between banks, enabling them to diversify. It was the means of systemic transmission of the sub-prime problem to banks worldwide.

Insurance Securitization - Basics Insurance Market Capital Market Insurer Investor Investor Insurer Reinsurer Risk gatherer & transferor Special Purpose Vehicle Risk converter & bond issuer Investor Insurer Investor Insurer Insurer Investor Conventional reinsurance contracts Conventional bond issuance See next slide for: Risk transfer SPV

Insurance Securitization - Basics Risk Transfer from Reinsurer to SPV Defined risk is transferred to SPV Reinsurer is reimbursed by triggering a claim: Indemnity-based (like a conventional claim) Not popular with investors and now uncommon – too much moral hazard Parametric trigger Defined events at defined locations – quake of specified magnitude in specified location Cash flow criterion – variance from pre-agreed cash flow budget The Special Purpose Vehicle Receives funds from Transferor – reinsurance premium Investors – purchase of bonds If risk transfer claim is triggered, a payment is made to reinsurer. If no payment to reinsurer, then on maturity the bondholders receive all cash in SPV: Reinsurance premium Refund of bond purchase price Investment income on the above Risk transfer SPV Cash flow criteria facilitate non-cat securitizations SPVs in tax havens, because the accrual of tax free investment income improves the yield to investors.

Insurance Securitization - Basics Investor Investor Reinsurer Risk gatherer & transferor Special Purpose Vehicle Risk converter & bond issuer Investor Investor Parametric trigger gives rise to basis risk, sometimes covered by a secondary reinsurer A claim made before bond matures may upset investment profile, sometimes covered by a liquidity provider Investor

Reinsurance Sidecars Sidecar – a financial entity created to allow investors to take the risk & return (for a limited period) of a small and limited category of policies, usually property catastrophe. Sidecars do not take the longer term investment risk associated in buying shares whose value is affected by the entire book of business. Source: AM Best

Reinsurance 4. Reinsurance Failures Insolvency of a reinsurer BUT, before that happens….. Cashflow problems in a reinsurer will quickly become the problem of the reinsured Failure of Reliance National, a large US insurer caused by failure of reinsurers for whom it was fronting – “WORKERS’ COMPENSATION CARVE-OUT” Even without failures, the biggest & best reinsurers are not immune to problems ….. Munich Re in 2002 … Too heavily invested in equities during a stock market crash. Munich Re in 2008 … Hurricanes Gustav & Ike in the Caribbean wipe out 3Q profits.

Are failures likely? Catastrophe risk seems to be the major threat! Reinsurance Are failures likely? Catastrophe risk seems to be the major threat! Source: Guy Carpenter LLC, 2008 Reinsurance Market Review