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Week 8: Risk Management

0 Introduction
In Chapter/Week 1, we introduced risk management and discussed the different
types of risk and described the risk management process for financial institutions.

In this chapter we consider the different tools available for managing risks. The main
risk management tool that we consider here is reinsurance. Other tools for managing
risks are also discussed briefly.

1 Issues surrounding the management of risk
When a provider is taking on liabilities for the provision of benefits on future financial
events it needs to consider how it can minimise the risks it takes on and how it will
manage the remaining risks associated with those liabilities.

For example, introducing better and stricter claims management policies in general
insurance may reduce risks from expense overrun, fraudulent claims, fraudulent
applications and poor underwriting.

In managing risk the aim is to protect the provider of benefits against adverse
experience that could result in the provider being unable to meet the liabilities that
have been taken on.
However, protection will have some disadvantages:
There may be a cost associated with obtaining the protection.
In protecting against downside risk the provider may also lose the advantages
to be gained when the risk moves in a favourable direction.

2 Tools that can be used to aid the management of risk
The following can be used to aid the management of risk:
reinsurance
diversification
underwriting
alternative risk transfer (ART)
management control systems.

3 Reinsurance terminology
Reinsurance is an insurance companys own insurance. It involves the insurance
company passing on some of its risks to another party a reinsurer.
There is quite a lot of specialist language in reinsurance. Although you will soon get
used to it, you will find it useful to be familiar with the following terms immediately:
cede pass on or give away, as in cede some risk to a reinsurer
facultative individual, as in an individually negotiated arrangement
treaty covers a group of policies the reinsurance that the reinsurer is
obliged to accept from the insurer, subject to conditions (which are set out in
the treaty)
direct writer the insurer with a direct contract with the insured (as opposed
to a reinsurer, who has a contract with the direct writer). Also called the
primary insurer or cedant.

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Facultative reinsurance
When each individual risk on which reinsurance is required is offered separately to a
reinsurer, the risk is said to be offered facultatively. There is no obligation for the
ceding office to offer the business, neither is the reinsurer obliged to accept it. Each
case is considered on its own merits and the reinsurer is free to quote whatever
terms and conditions it sees fit to impose for that risk.

Treaty reinsurance
Arranging reinsurance for each individual risk is administratively messy. Therefore
direct writers may instead set up treaties with reinsurers. This allows them to place
reinsurance automatically. The terms and conditions of the treaty are carefully laid
down so that both parties know exactly where they stand.
The treaty document sets out all the relevant details and obligations under the
arrangement, though the wording differs for different types of reinsurance.

The treaty would then be described as being on an obligatory/obligatory basis.
Occasionally, treaties may be written on a facultative/obligatory basis; these are
normally associated with reciprocal arrangements, whereby each ceding company
reinsures a block of business with the other.

4 Types of reinsurance
The two main types of reinsurance are proportional and non-proportional.

4.1 Proportional reinsurance
There are two types of proportional reinsurance: quota share and surplus.
Under proportional reinsurance, the reinsurer covers an agreed proportion of each
risk. This proportion may be:
constant for all risks covered (called quota share reinsurance), or may
vary by risk covered (called surplus reinsurance).
Both forms have to be administered automatically, and therefore require a treaty.

The ceding provider and reinsurer will have proportionately the same overall
underwriting experience on the business included in the treaty, apart from
differences in expenses and commissions. The reinsurer will therefore be concerned
at the outset to establish:
the nature of the business being offered
the ceding providers attitude to underwriting and claims settlement
any previous experience of this business.

4.2 Non-proportional reinsurance
Proportional reinsurance does not cap the cost of very large claims that may occur,
either as a single claim, or a set of claims from related incidents, or on an insurers
whole account. Large in this context means large relative to the ceding providers
solvency margin or annual premiums.

Excess of Loss (XL) reinsurance is non-proportional cover where the cost to a
ceding company of such large claims is capped with the liability above a certain level
being passed to a reinsurer. However, if the claim amount exceeds the upper limit of
the reinsurance, the excess will revert back to the ceding company. Variations of this
form of reinsurance cover exist to limit a ceding companys losses.
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Within excess of loss reinsurance:
The limit might operate on individual claims (eg to cover against large
individual risks), or on aggregations of claims (eg to cover against widespread
damage from one event).
There might be an upper limit, above which the reinsurers liability ends.
The reinsurer might pay for all claims within the limits or perhaps only a
proportion of the claims within the limits (eg 90%).
The limits might be linked to inflation to ensure cover is not eroded over time.

5 Proportional reinsurance
5.1 Quota share
Under quota share reinsurance a fixed percentage of each and every risk is
reinsured.
In other words, a constant proportion of each and every risk within the scope of the
treaty is automatically passed to the reinsurer. The treaty will specify the proportion
to be ceded to the reinsurer, R% say. This is often referred to as an R% quota share
treaty.

Use of quota share reinsurance
Quota share is widely used by ceding providers to:
spread risk
write larger portfolios of risk
encourage reciprocal business.
Depending on the regulatory environment, it may also directly improve the solvency
ratio and help the ceding provider to satisfy its statutory solvency requirement.

The main disadvantages to a provider of ceding business by quota share are:
It cedes the same proportion of low variance and high variance risks.
It cedes the same proportion of each risk, irrespective of size; the ceding
provider may, however, wish to cede a greater proportion of the larger risks
than the smaller ones, owing to their greater loss potential.
It passes a share of any profit to the reinsurer.
In summary, quota share does not allow the direct writer to tailor the amount of
reinsurance needed to each risk.

5.2 Surplus
Surplus gets round the lack of flexibility problems associated with Quota Share.
Surplus reinsurance gives the direct writer some discretion in choosing the amount
of each risk to retain. This gives the direct writer the ability to fine-tune its
experience.
For example, the direct writer might choose to retain a small proportion of the bigger,
more volatile risks and a large proportion of the smaller, less volatile risks.

The treaty specifies a retention limit and a maximum level of cover available from the
reinsurer.

For high volume business such as life assurance or personal lines general
insurance, the maximum cover and the retention limit are specified in the treaty.
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For commercial covers, such as commercial property and business interruption, the
ceding provider can select, for each individual risk, the retention and the amount to
be ceded.

The proportion of risk ceded is then calculated and used in the same way as for
quota share.

Choosing the retention limit and the maximum level of cover
For each risk covered by the surplus treaty, the direct writer estimates a maximum
loss that could occur. For life insurance, there is often no need to do any estimating,
as the claim amount (or sum assured) is known. However, for general insurance, the
size of the loss is usually unknown and an estimate must be made.

Here is a simple example of how a surplus treaty might work:
1. The direct writer chooses a retention limit for each property. The direct writer
might choose to retain a smaller proportion of the larger or more volatile risks.
2. The retention limit, together with the estimated maximum loss, is used to work
out the percentage retained by the direct writer of each risk.
3. Once the percentages have been determined, each claim that occurs on a
particular property is split entirely in those percentages, regardless of its size,
in just the same way as quota share.

Use of surplus reinsurance
Surplus cover enables a ceding provider to write larger risks, which might otherwise
be beyond its writing capacity. The main value of this type of reinsurance, however,
is to enable the ceding provider to fine-tune its experience for the class concerned.

Surplus reinsurance helps the ceding provider to diversify its risk exposure as
retaining a portion of lots of risks is better than retaining all of a few risks. It also
allows the cedant to increase its exposure by a chosen amount (within limits),
helping control overall business volumes and also potential accumulations of risk.

Providers use surplus reinsurance, rather than quota share, extensively for those
classes where a wide variation can occur in the size of risks. The administration is
more complicated, owing to the need to assess and record separately for each risk
the amount to be ceded.

The smaller risks will not reach the reinsurer, because they are within the retention.
The ceding provider and reinsurer will not therefore share the same portfolio of risks.
The risks that do reach the reinsurer will vary in the proportion of risk reinsured.
Hence the total underwriting experience of the risks to which the treaty applies will
vary between the two parties.

As with quota share, there will also be differences in expenses and commissions
between the two on their respective portions of the total portfolio.




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5.3 Reinsurance premiums under proportional arrangements
We now look at how the reinsurance premium (ie the premium required by the
reinsurer to take on the risk) may be determined. There are two main ways original
terms and risk premium.

Original terms
Original terms reinsurance involves the reinsurer accepting the agreed proportion of
all the risks under the contract. The reinsurer will be exposed to investment, claims,
and persistency risks, and will receive a proportionate share of each premium. As
the ceding company carries out all the administration, the reinsurer pays the ceding
office a commission in respect of its share of the expenses.

Both forms of proportional reinsurance can be on an original terms, or a risk
premium basis.
In general insurance, proportional reinsurance is usually written on an original terms
basis. Life reinsurance can also work on an original terms basis, however
alternatively it can be written on a risk premium basis.

Risk premium
Risk premium reinsurance is now much more common, especially for contracts with
a significant investment element that the ceding office wishes to retain. In this case
the reinsurer only covers claims risks.
The premium paid (to the reinsurer) is based on the amount at risk from year to year,
expressed as the sum insured less any accumulated reserve, for those policies in
force at the time.

This means that the reinsurer calculates the reinsurance premium itself based on its
expected claims experience plus margins for expenses and profits. Under risk
premium reinsurance, the reinsurance recovery is based on the sum at risk (ie the
sum assured less the reserve) rather than on the sum assured.

The cover provided under risk premium reinsurance is calculated on a year by year
basis; hence the reinsurer has no exposure to persistency or investment risk.

There is usually no reinsurance commission.
The distinction between risk premium and original terms is important:
In the case of risk premium, the reinsurer sets the premium rate, independent
of the premium charged by the insurer.
In the case of original terms, the insurance company sets the premium and
negotiates an amount of commission with the reinsurer.

6 Non-proportional reinsurance
6.1 Excess of loss (XL) reinsurance
The reinsurer agrees to indemnify the ceding company for the amount of any loss
above a stated excess point. More usually, the reinsurer will give cover up to a
stated upper limit, with the ceding company purchasing further layers of XL cover,
which stack on top of the primary layer, from different reinsurers. The higher layer
cover(s) come into operation on any particular loss only when the lower layer cover
has been fully used.

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The expression generally used to describe the cover provided under an excess of
loss reinsurance treaty is:
Amount of layer in excess of lower limit

So a treaty that provides cover for claim amounts between an excess point of
50,000 and an upper limit of 200,000 would be described as:
150,000 in excess of 50,000.

There are three main types of excess of loss reinsurance:
risk XL
aggregate XL
catastrophe XL.
There is also one further type of non-proportional reinsurance that we need to know
about, namely stop loss.

6.2 Risk excess of loss (Risk XL)
This is a type of excess of loss reinsurance that relates to individual losses. It affects
only one insured risk at any one time.

The direct writer pays a premium to the reinsurer in return for protection against
large individual claims on individual risks (eg a large liability claim on an individual
motor policy).

6.3 Aggregate excess of loss (Aggregate XL)
Events can occur which cause losses to several insured risks within a period of
perhaps a year. Such events could lead to an aggregation of claims.
Individually, each claim might not be of exceptional size, but collectively the
aggregate cost might be damaging to the ceding providers gross account. A winter
influenza epidemic is an example of where aggregation of losses can occur.

The aggregation of claims might be by event (eg a motorway pile up), by peril (eg
subsidence) or by class of business (eg all motor policies).

The aggregate XL reinsurance is a very simple extension of Risk XL, but rather than
operating on large individual claims, the excess point and the upper limit apply to the
aggregation of a number of claims.

6.4 Catastrophe excess of loss (Catastrophe XL)
This is a form of aggregate excess of loss reinsurance providing coverage for very
high aggregate losses arising from a single event, that may be spread over a number
of hours; 24 or 72 hours is common.

The aim of catastrophe reinsurance is to reduce the potential loss, to the ceding
company, due to any non-independence of the risks insured. The cover is usually
only available on a yearly basis and has to be renegotiated each year.

The reinsuring company will agree to pay out if a catastrophe, as defined in the
reinsurance contract, occurs. There is no standard definition of what constitutes a
catastrophe.

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The reinsurance contract will also specify how much the reinsuring company will pay
if a catastrophe occurs. Typically this might be the excess of the total claim amount
over the ceding providers catastrophe retention limit. The reinsuring companys
liability in respect of a single catastrophe claim would be subject to a maximum
amount and any amount above this would fall back on the ceding company.

6.5 Stop Loss
Sometimes a particular class of business gives rise to large variations in the levels of
total claims payable in any one year. Aggregate XL only provides cover for either
one cause over the year or one event. A ceding provider may therefore wish to
protect the class of business by a form of reinsurance that extends cover to all
causes or all events during the year. Stop loss does this by covering the total losses
for the whole account, above an agreed limit, for a 12-month period. The whole
account can be one or several classes of insurance.

The excess point and upper limit for stop loss are often expressed as a percentage
of the ceding providers premium income for that account. Cover might typically be
given from an excess point of 110% claims ratio up to an upper limit of 130% or
140%.

6.6 Use of non-proportional reinsurance
Non-proportional reinsurance enables the provider to accept risks that might give
rise to large claims.

Non-proportional reinsurance also stabilises the technical results of the ceding
provider by reducing claims fluctuations (stabilising profits & dividends).

With lower volatility of claims outgo, the ceding provider can also make more efficient
use of its capital. High volatility of claims outgo means that the company must hold
large free assets. If the volatility is reduced, lower free assets are required. This
means that the company can write the same amount of business with less capital by
using excess of loss reinsurance.

The other purpose of excess of loss reinsurance is to reduce the risk of insolvency
from a catastrophe, a large claim or an aggregation of claims.

7 Reinsurance as a risk management tool
7.1 The benefits of reinsurance
Reinsurance is a way of reducing, or removing, some of the risks.
Reinsurance reduces, or removes, risks by:
reducing claims volatility
avoiding large single losses or large losses in respect of a single event.

Another factor to note in assessing the relative costs of retaining the risk or buying
reinsurance is that the reinsurer may be able to offer very competitive terms for
administration, actuarial services and other insurance advice if a reinsurance
contract is purchased.



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This technical assistance is in itself a means of risk management because:
it reduces business risk, ie of pricing being based on inappropriate
assumptions
it can reduce operational risk by transferring certain activities to the reinsurer.

7.2 The cost of reinsurance
The reinsurer will wish to make a profit from the risks it takes on. Effectively part of
the profit from the business is passed to the reinsurer. A decision must be made
which balances risks against the costs of mitigating them.

7.3 Cost vs benefit
In assessing risks and rewards, the actuary can place a realistic estimate on the
value of the benefits that would be paid by the reinsurance provider. This is likely to
be lower than the cost of the reinsurance, as the reinsurance premium will include
loadings for profits and contingencies.
Values will also need to be placed on the range of likely benefit costs so that an
assessment of the risk can be made in comparison to the cost of the reinsurance.

7.4 The effectiveness of reinsurance
There are a variety of ways in which the liabilities arising under a contract can be
reinsured. Some types of reinsurance completely remove a risk from the provider.
Many others leave the liability with the provider but provide a payment to the provider
that is aimed at covering that liability. However, even if a liability is fully matched by a
reinsurance arrangement, the provider still bears the risk that the reinsurer is unable
to fulfil its obligations.

8 Other risk management tools
8.1 Diversification
Risk can be managed through diversification within the following:
lines of business
geographical areas of business
providers of reinsurance
investments asset classes
investments assets held within a class.
Diversification of business lines can be achieved by marketing a wide range of
contracts insuring a wide range of risks. However this would be expensive in terms
of administrative systems, staff training, etc. It also means that all companies are
generalists and there is little scope for niche players in the market.

8.2 Underwriting
Underwriting generally refers to the assessment of potential risks so that each can
be charged an appropriate premium.
Underwriting can be used to manage these risks in the following ways:
It can protect a provider from anti-selection.
It will enable a provider to identify risks for which special terms need to be
quoted. A provider may however aim to accept a large proportion of the
business it accepts at its standard rates of premium.
For substandard risks, the underwriting process will identify the most suitable
approach and level for the special terms to be offered.
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Adequate risk classification within the underwriting process will help to ensure
that all risks are rated fairly.
It will help in ensuring that claim experience does not depart too far from that
assumed in the pricing of the contracts being sold.
For larger proposals the financial underwriting procedures will help to reduce
the risk from overinsurance.

8.3 Alternative risk transfer
There is no wholly accepted definition of Alternative Risk Transfer (ART). One
definition is anything that is not traditional insurance or reinsurance. ART often uses
both banking and insurance techniques. It produces tailor-made solutions for risks
that the conventional market would regard as uninsurable.
There are many types of ART contract, common varieties include:
discounted covers
integrated risk covers
securitisation
post loss funding
insurance derivatives
swaps.

8.4 Management control systems
Good management control systems can reduce a providers exposure to risk.
These systems include:
Data recording
Accounting and auditing
Monitoring of liabilities taken on
Options and guarantees - Care needs to be taken when offering options and
guarantees, particularly those which appear to have limited value when
granted but which could become valuable if market or other conditions change.