Risk Mitigation and the Role of Reinsurance John Finston Deputy Commissioner for Corporate and Regulatory Affairs California Department of Insurance © 2013 National Association of Insurance Commissioners All Rights Reserved 1

Reinsurance Essentially “insurance for insurance companies” An insurer issuing policies becomes a “Ceding insurer” in a reinsurance transaction when it transfers insurance risk via a reinsurance contract to the “Reinsurer.” If a Reinsurer enters into another reinsurance agreement ceding its risk, its reinsurer is called a “Retrocessionaire” and the contract is called a retrocession agreement. Reinsurance is a form of insurance, not a lending or money, that requires actual transfer of risk.

Risk Transfer Insurance risk transfer is the essential ingredient of a reinsurance contract Under U.S. statutory accounting guidance, insurance risk includes both: –Underwriting risk – uncertainties about the ultimate amount of net cash flows from premiums, commissions, claims and claim settlement expenses –Timing risk – the timing of the receipt and payment of those cash flows Various analytical methods are utilized to evaluate contracts for risk transfer 3

Advantages of Reinsurance: Risk Mitigation / Insurance Risk Transfer / Financial Credit Maximizes spreading of risk to multiple insurers Insurers generally transfer insurance risk for one or more of the following purposes: –Capacity –Catastrophe Protection –Stabilization –Financing Financial statement credit for reinsurance is generally allowed if contract meets certain requirements

Parties to a Reinsurance Contract Policyholder to insurer is direct premium Ceded premium for the insurer is assumed premium for the reinsurer Policyholder Direct writer cedes Reinsurer assumes Policyholder and insurer have a contract (policy) Insurer and reinsurer have a contract (Reinsurance contract) Policyholder and reinsurer do not have a contract

Property Casualty Reinsurance Treaty vs. Facultative Proportional –Quota Share –Surplus Share Non-Proportional –Excess of Loss Per Risk Per Occurrence (e.g., Catastrophe) Aggregate

Proportional Agreement Types Quota Share –Simplest type, reinsurer and reinsured share in premiums and losses at a fixed percentage on a first dollar basis –Example: Retention 60% / Reinsurance 40% Policy LimitRetained 60%Reinsured 40% $100,000$60,000$40,000 $200,000$120,000$80,000

Proportional Agreement Types Surplus Share –Greater flexibility, reinsured selects retention for each risk, and cedes multiples of the retention (lines) to the reinsurer –Compare ceded amount to policy limit. Create a proportion. Reinsurer shares in that proportion of losses and premiums applicable to the policy from a first dollar basis. –Example: Retention $20,000 Policy LimitReinsured’s ShareReinsurer’s Share $20,000100%0 $40,00050% $60, %66.67%

Non-Proportional Agreements Reinsured retains a predetermined dollar amount (retention). Reinsurer then indemnifies loss in excess of that retention up to a stated limit. Coverage is frequently provided in layers As the limits of the layer are exhausted, the next layer of excess reinsurance becomes available

Types of Agreements EXCESS OF LOSS REINSURANCE Type of Loss Type of Reinsurance Per Risk Excess of Loss Per Occurrence Excess of Loss Aggregate Excess of Loss Single Loss Exceeding Retention Covered Sometimes Covered Not Covered Accumulation of Losses in Single Occurrence Exceeding Retention Not CoveredCoveredNot Covered Total Net Retained Losses Over Year Exceeding Retention Not Covered Covered

Excess of Loss Contract $ 10 M $ 500 K $ 5 M $ 1 M Retention 95% of $5M xs $5M 95% of $4M xs $1M 95% $500K xs $500K

Catastrophe 2nd Excess Surplus Share Retention Quota Share Reinsurance Program Example $ Loss Proportional Non- Proportional 1st Excess

Excess of Loss Treaty Quota ShareSurplus SharePer Risk Per Occurrence Aggregate Pro Rata Semi Automatic OR Automatic Certificate Facultative Reinsurance Contracts Pro RataExcess of Loss Proportional Reinsurance Non-Proportional Reinsurance Other Considerations: Occurrence vs. Claims Made Prospective (future) vs. Retroactive (past events) Insurance Risk Transfer Reinsurance Contract Basics

Life Reinsurance Automatic vs. Facultative Proportional –Yearly Renewable Term –Co-insurance Modified Co-insurance Co-insurance with Funds Withheld Non-proportional –Yearly Renewable Term can also be non- proportional –Catastrophe –Stop Loss Indemnity vs. Assumption

Yearly Renewable Term A form of life reinsurance usually covering only mortality risk under which the ceding insurer buys coverage for the net amount at risk on the reinsured portion of the policy for a specified premium that may vary each year with the amount at risk, the duration of the policy, and the ages of the insured(s). The ceding insurer retains responsibility for establishing reserves and the payment of all surrenders, dividends, commissions, and expenses. Despite its name, YRT reinsurance contracts typically obligate the reinsurer to continue coverage throughout the life of the policy.

Coinsurance A method of reinsurance under which the reinsurer receives a proportionate share of the premiums, sets up a proportionate share of the reserves and pays its proportionate share of the benefits of the reinsured policy. The reinsurer pays the ceding commission and expense allowance to the ceding company to represent the reinsurer’s share of the acquisition and maintenance expenses.

Modified Coinsurance Indemnity life reinsurance that differs from coinsurance only in that the assets supporting the reserves are transferred back to the ceding company while the risk remains with the reinsurer. The ceding company is required to pay interest to replace that which would have been earned by the reinsurer if it had held the assets corresponding to the reserves in its own investment portfolio. Used to retain control of investments or to reduce potential credit risk.

Reinsurance Analysis Adequate reinsurance cover Quality / financial strength of reinsurers Diversification / concentration of risk Affiliated reinsurance arrangements Proper transparency / disclosure in the financial statements 18

Importance to Financial Solvency Regulation Reinsurance significantly affects reported financial results, reflected as an asset or a reduction of liability. Accounting and reporting differs significantly depending on characteristics of reinsurance agreement; Ceding insurer maintains obligation to primary policyholder regardless of whether reinsurer meets its obligations Contracts can be complex, subject to misinterpretation Successful insurance company management generally requires high degree of reinsurance understanding Comprehensive analysis of a reinsurance program requires a thorough understanding of the rights and obligations of each party under the agreements 19

Captives A special type of insurer that is set up by a parent company, trade association or group of companies in a common business that exclusively insure the risks of their owner or owners Types of Captives –Pure (single parent captive) –Group –Association –Rent-a-captive –Special Purpose

Captives - Benefits Broader coverage through underwriting flexibility Improved service through claims management (greater control) and better risk management Potential Cost Savings –Direct reinsurer access –Investment income and capture underwriting profits –Tax benefits Fewer regulatory restrictions

Captives - Risks From Company Perspective: –Lack of diversification of risk and potential risk concentration –Dependence on service providers –Internal administrative costs –Capitalization and commitment –Taxation issues –Increased cost and reduced availability of other insurance From Regulator’s Perspective: –Potential loss of consumer protection & safeguards –Lack of transparency

Reinsurance and the Capital Markets Convergence of reinsurance and capital markets has resulted in development of Hybrid Products and Financial Instruments (Insurance-Linked Securities) as alternatives or compliments to traditional reinsurance Convergence drivers: –Growth in insured values in catastrophe-prone areas –Reinsurance market inefficiencies/underwriting cycle –Advances in computing/communications technologies –Regulatory, accounting, tax and rating agency factors –Modern financial theory/deeper understanding of risk management has facilitated financial engineering

Reinsurance and the Capital Markets Property/Casualty –Catastrophe Bonds –Reinsurance Sidecars –Collateralized Reinsurance Investment –Industry Loss Warranties –Contingent Capital –Catastrophe Futures and Insurance Derivatives Life –Value in Force or Embedded Value Transaction –Reserve Funding –Extreme Mortality Bonds –Longevity Swaps

Impact of Quota Share

Impact of Excess of Loss