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ICP 19B: Reinsurance

Basic-level Module

A Core Curriculum for Insurance Supervisors

Copyright © 2006 International Association of Insurance Supervisors (IAIS).All rights reserved.

The material in this module is copyrighted. It may be used for the purpose of training by competent organizations with permission. Please contact the IAIS to seek permission.

This paper has been prepared by Mr. Julian D. Gribble. Julian Gribble qualified as an actuary in 1991, holding qualifica-tions from the Society of Actuaries (FSA), the Canadian Institute of Actuaries (FCIA), and the Institute of Actuaries of Australia (FIAA). He has more than 25 years of business experience in the private sector in insurance and funds man-agement. Since 1993, he has been a consulting actuary and is director of his own consulting practice. He was instrumen-tal in implementing the capacity-building program for regulators—Managing Regulatory Change in Life Insurance and Pensions Program (MRC), which was endorsed by the Asia Pacific Economic Cooperation (APEC) finance ministers. His professional activities with the Institute of Actuaries of Australia include chairing a review of the actuarial control cycle syllabus and sitting on the International Relations Committee.

This paper has been reviewed by Mr. Ken Westover and Mr. Nigel Davies. Ken Westover is a Senior Advisor with the Office of the Superintendent of Financial Institutions in Canada, based in Toronto, Canada. Mr. Westover prepares guidance for supervisory reviews of Canadian conglomerate life insurers and banks as well as serving as a member of the supervisory teams performing onsite reviews of these institutions. He is an actuary and a chartered financial ana-lyst with 25 years experience with life insurance and trust companies in Canada, specializing in the risk management, reinsurance, asset/liability management, and investment areas. He was a contributor to the development of the IAIS Guidance Paper on Investment Risk Management. Nigel Davies is a U.K. chartered accountant with more than 20 years in the insurance industry in professional, managerial, and regulatory roles. From 2002 to February 2006, he worked at the International Monetary Fund in Washington, D.C., as a technical assistance advisor in the field of insurance. This involved organizing and providing technical assistance and assessing the strength and stability of the insurance sec-tor as part of the Financial Sector Assessment Program. The role also involved liaising with standard-setting bodies, providing input where appropriate. He has contributed to several major publications. Prior to this, he worked at the Financial Services Authority in the United Kingdom for seven years, supervising the London insurance market. He also represented the United Kingdom at International Association of Insurance Supervisors (IAIS) meetings and at the Eu-ropean Union Commission and Council of Ministers. Previous roles included being a director at Marsh and McLennan and an insurance specialist at Ernst and Young.

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Contents

About the Core Curriculum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

Note to Learner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii

A. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

B. Purpose and benefits of reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

C. Types of reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

D. Levels of retention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

E. Impact of reinsurance and risk transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

F. Monitoring of the reinsurance programs of primary insurers . . . . . . . . . . . . . . . . . . 27

G. Security of reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

H. Failures and reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

I. Abuses of reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

J. Reinsurance contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

Insurance Supervision Core Curriculum

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K. Supervision of reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

L. Broader context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

M. References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

Appendix I. ICP 19: Insurance Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Appendix II. Answer key . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

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About theCore Curriculum

A financially sound insurance sector contributes to economic growth and well-being by supporting the management of risk, allocation of resources, and mobilization of long-term savings. The insurance core principles (ICPs), developed by the International As-sociation of Insurance Supervisors (IAIS), are key international standards relevant for sound financial systems.

Effective implementation of the ICPs requires skilled and knowledgeable insurance supervisors. Recognizing this need, the World Bank and the IAIS partnered in 2002 to develop a “core curriculum” for insurance supervisors. The Core Curriculum Project, funded and supported by various sources, accelerates the learning process of both new and experienced supervisors. The ICPs provide the structure for the core curriculum, which consists of a set of modules that summarize the most relevant aspects of each topic, focus on the practical application of supervisory concepts, and cross-reference existing literature.

The core curriculum is designed to help those studying it to:

• Recognize the risks that arise from insurance operations• Know the techniques and tools used by private and public sector professionals

to identify, measure, and manage these risks• Operate effectively within a supervisory organization• Understand the ICPs and other IAIS principles, standards, and guidance• Recommend techniques and tools to help a particular jurisdiction observe the

ICPs and other IAIS principles, standards, and guidance• Identify the constraints and identify and prioritize supervisory techniques and

tools to best manage the existing risks in light of these constraints.

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Note to Learner

Welcome to ICP 19B: Reinsurance module. This is a basic-level module on reinsurance that does not require specific prior knowledge of the topic. The module should be use-ful to either new insurance supervisors or experienced supervisors who have not dealt extensively with the topic or are simply seeking to refresh and update their knowledge.

Start by reviewing the objectives, which will give you an idea of what a person will learn as a result of studying the module. Then proceed to study the module either on an independent, self-study basis or in the context of a seminar or workshop. The amount of time required to study the module on a self-study basis will vary, but it is best to address it over a short period of time, broken into a session on each section if desired.

To help you engage and involve yourself in the topic, we have interspersed the module with a number of hands-on activities for you to complete. These are intended to provide a checkpoint from time to time so that you can absorb and understand the material more readily and to help you to relate the principles to practices in your juris-diction. If you are working with others on this module, develop the answers through discussion and cooperative work methods.

As a result of studying the material in this module, you will be able to do the fol-lowing:

1. Explain the functions of reinsurance2. Demonstrate the potential benefits of reinsurance3. Explain the various types of reinsurance and comparable risk transfer instru-

ments and relate them to the specific needs of insurers4. Describe the typical clauses and the appropriate documentation of a reinsur-

ance contract


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5. Interpret reinsurance contracts, including the allocation of premiums and losses

6. Evaluate the appropriateness of the accounting used by an insurer for a particu-lar reinsurance contract or risk transfer instrument

7. Analyze the effect of reinsurance on an insurer’s financial position8. Monitor the reinsurance programs of primary insurers9. Estimate reasonable levels of retention and limits, including catastrophic

exposure10. Justify a reasonable minimum level of retention11. Evaluate the appropriateness of a particular insurer’s reinsurance strategy and

program12. Explain proper and improper uses of finite risk transfer13. Describe the available methods and tools for evaluating the security of

reinsurance14. Describe potential abuses of reinsurance and corresponding supervisory

concerns15. Recommend appropriate laws and regulations to assure proper supervision of

reinsurance, including credit for reinsurance, contract provisions, supervisory intervention, and liquidation or winding-up proceedings

16. Summarize the requirements of ICP 19, focusing on essential criteria d, e, and f.

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ICP 19B: Reinsurance

Basic-level Module

A. Introduction

ICP 19 on insurance activity includes criteria relating to the use of reinsurance as a risk management tool. This module provides an introduction to reinsurance and some of the issues that, particularly from a supervisory perspective, may arise in the course of supervising both life and non-life insurers who use reinsurance. It discusses the follow-ing issues with regard to reinsurance:

• Purpose and role• Financial impact• Monitoring and security• Insurer failures• Contracts and supervision• Broader context and references.

Several points are relevant when reading this module. First, reinsurance is as broad and as complex as the insurance industry itself. As a result, in some cases, this module raises questions rather than providing answers. Second, the area of reinsurance and risk transfer is continually evolving. For these reasons, supervisors should seek further review before making judgments or decisions based solely on information contained in this module.

Different jurisdictions may have different arrangements for the regulation and su-pervision of their insurance and reinsurance industries. The module does not consider reinsurance in the context of a specific supervisory regime. In some cases, points raised


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may need interpretation to reflect the particular environment. If there is a conflict be-tween this document and a local regulation, the local regulation takes precedence.

Definition of reinsurance

Reinsurance refers to a mechanism that an insurer uses to obtain protection against some or all risks associated with the insurance policies it issues. Typically, this process involves an assuming reinsurer who, for a consideration, indemnifies the ceding or di-rect insurer against some or all of the loss it may incur under a policy or policies it has issued. From here on, the term “insurer” is used to mean the direct or ceding insurer, and the term reinsurer is self-explanatory.

Several important consequences flow from this definition:

• Direct insurer liability to policyholder. The direct insurer remains fully liable to the policyholder to whom policies were issued. In general, policyholders are unaware of any reinsurance arrangements. If the direct insurer defaults or fails, policyholders do not have a direct claim on reinsurers.

• Risk transfer. Reinsurance transfers risk undertaken by the direct insurer. Estab-lishing whether the risk is transferred properly requires identifying the risk(s) transferred, quantifying the risk(s) transferred, quantifying the considerations and benefits involved, and assessing whether the risk(s) transferred and consid-erations involved are appropriate to each other. The term reinsurance does not include specific insurance that an insurer may take out to address risks it has not underwritten, such as workers’ compensation insurance taken out by the insur-er to cover injuries to employees. It is also possible that the insurer may choose to “self-insure” such risks if doing so is legally permitted and if the appropriate expertise, controls, and processes are in place. Issues relating to self-insurance are not pursued here.

• Retrocession. A reinsurer may transfer to other reinsurers some of the risk as-sumed. This is a common occurrence. Conceptually there is little difference between a retrocession by a reinsurer to another reinsurer and reinsurance be-tween a direct insurer and a reinsurer, except that the retrocession is a transac-tion between “peers.”

• Alternative processes. The risk transfer process does not necessarily require the involvement of another (re)insurer. Other risk transfer approaches may serve the same purpose as reinsurance in certain circumstances. This module focuses on reinsurance, although some alternatives are mentioned.

• Process risks. The implementation of reinsurance arrangements contains a num-ber of risks that need to be considered. Reinsurance basis risk is the risk that the reinsurance cover might prove insufficient for the risk in question because the need for reinsurance has not been precisely identified. This may occur if the

ICP �9B: Reinsurance

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insurer incorrectly identifies the need for reinsurance or incorrectly describes the need to reinsurers. This might occur if relevant clauses in the reinsurance contract are inappropriate or omitted. Also, the wording of reinsurance con-tracts may be incompatible with the underlying insurance contracts, particu-larly in harder reinsurance markets when greater exclusions may be applied. Operational risk is the risk that the people, process, or systems on which the management and execution of the reinsurance process depend will fail or be in-adequate. Outsourcing risk may also arise. Reinsurance arrangements are subject to the same risks as other outsourced functions. These risks may be exacerbated when a reinsurer is domiciled outside the supervisor’s (and, most likely, the di-rect insurer’s) jurisdiction.

• Reinsurance credit risk. While the insurer may pass risk to the reinsurer, the in-surer takes on some risks, of a different nature, as a consequence. In particular, the insurer takes on the risk that its reinsurer might fail and so void the reinsur-ance coverage.

• Specialization. A given insurer may be a direct insurer for certain risks, but a reinsurer for other risks. This gives rise to the use of the terms outward rein-surance and inward reinsurance (sometimes called reinsurance assumed) to describe the two directions in which the reinsurance arrangement may flow. While insurers may be specialist reinsurers or specialist insurers, it is not un-common for insurance entities to be involved with both outward and inward reinsurance. From a supervisory perspective, it is important to recognize the different issues relating to whether the entity is seeking or providing reinsur-ance to other insurers.1

Many definitions of reinsurance are available, including one in the IAIS glossary of terms (IAIS 2005a). While the precise words and emphases may vary, they all embrace the key elements of risk transfer in return for a consideration.

Other commonly used terms

Many terms take on specific meanings in the context of insurance and reinsurance. Moreover, while some terms used in reinsurance are recognized internationally, other meanings may vary from one country to another. The following terms specifically relat-ing to reinsurance are from the IAIS glossary of terms (IAIS 2005a); other definitions given in the text are taken from the glossary agent of the American Council of Life Insurers.

1. Available at http://www.insurancetranslation.com/Glossary_Agent/reinsurance.htm. Glossary agent provides a number of glossaries, including the reinsurance glossary consulted here, produced in several countries and covering both life and non-life insurance.


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• Automatic treaty. A reinsurance contract under which risks written by the rein-sured are automatically assumed (accepted) by the reinsurer subject only to the terms and conditions of the treaty

• Ceding company. The company that places reinsurance as distinguished from the company that accepts reinsurance

• Direct writer. In reinsurance, the company that originally writes the business• Excess-of-loss reinsurance. A form of reinsurance whereby the reinsuring com-

pany reimburses the ceding company for the amount and only the amount of loss the ceding company suffers over and above an agreed aggregate sum in any one loss or in a number of losses arising out of any one event

• Facultative reinsurance. Reinsurance effected item by item and accepted or de-clined by the reinsuring company after scrutiny as opposed to reinsurance ef-fected by treaty

• Quota share reinsurance. A contract that reinsures an agreed fraction of every risk of the kind described in the contract, which the ceding company writes

• Reinsurance. Insurance placed by an underwriter in another company to reduce the amount of risk assumed under the original insurance

• Reinsurance basis risk. The risk that the amount of reinsurance might prove in-sufficient to cover the risk in question because reinsurance needs have not been identified precisely, with the result that relevant clauses of the reinsurance con-tract might be inappropriate

• Reinsurance credit risk. The risk that a reinsurer might prove unable or unwilling to pay its part of the liabilities or the claims incurred, which can put the insurer’s liquidity at risk and even cause its bankruptcy

• Reinsurance risk. The risk that reinsurance coverage will be insufficient or that reinsurers will fail to pay their part of the overall liabilities (or incurred claims) evaluated on a gross basis; this risk can be separated further between reinsur-ance basis risk and reinsurance credit risk

• Retention. The act of retaining an exposure to loss; also that part of the exposure that is retained

• Retrocession. The amount of risk that a reinsurance company reinsures and the amount of a cession that the reinsurer passes on.


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B. Purpose and benefits of reinsurance

Insurers can be expected to undertake overall risk management programs. Within this, a key technical aspect is the control and management of underwriting risk. Underwrit-ing is the process by which an insurance company determines whether or not and on what basis it will accept an application for insurance, thus offering coverage against the specific risks identified.

In general, insurance can be viewed as an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) that would exist if it were not for the insurance contract. That is, the basic purpose of insurance is to provide individual policyholders with a means to spread or diversify risk that might otherwise be unacceptable or unmanage-able to the individual. The mathematical justification as to why this can work in practice lies in the law of large numbers.

The law of large numbers concludes that, when statistically identical risks are pooled together, the larger the pool of risks becomes, the smaller the relative variability in results becomes. That is, the larger the pool, the more likely it is that the total amount of claims will converge to expectations (presuming no errors in underlying assump-tions). Mathematically, the coefficient of variation, defined as the standard deviation divided by the mean, provides a measure of the relative variability of a statistical dis-tribution—in this case, the distribution of claims results. It can be shown that the coef-ficient of variation of a sum of independent, identically distributed random variables is inversely proportional to the square root of the number of variables in the sum. This mathematical result is what makes insurance viable: by pooling large numbers of statis-tically similar risks, the individual, large coefficients of variation combine to provide a sufficiently small coefficient of variation for the pool.

Several key observations follow:

• Capital. The variability of results is reduced, because capital typically must be held to provide support in the case of adverse results—that is, adverse variations from expected results. In practice, capital is in limited supply for insurers and re-insurers. The pooling effect of reducing variability of results translates to reduc-ing the capital requirements, when measured on a per policy basis. Reinsurance can reduce the probability of occasional large losses, reducing the variability of results, thereby potentially reducing the minimum capital that the insurer is re-quired to hold. Alternatively, the need for capital increases at a slower rate than the growth rate of an insurance portfolio (assuming statistically independent and identical risks).

• Homogeneous risks. In practice most pools of insured risks are not homoge-neous. While homogeneity is a useful assumption for demonstrating the valid-ity of the insurance concept and may be assisted by appropriate underwriting, it does not hold in practice. To the extent that risks are not homogeneous in


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type, severity, or frequency, the theoretical results are weakened. This highlights the importance of insurers and reinsurers understanding the structure of their insured pools and subpools of risks. In the case of reinsurers who rely, perhaps entirely, on the underwriting of the ceding insurer, there is the added risk of underwriting error or bias of the insurer to consider.

• Independence of risks. The justification for pooling presumes that risks are in-dependent of each other. Again this is rarely true in practice, and there may be correlations, albeit of varying strengths. A clear example of correlations is the level of geographic concentration of risk for, say, hailstone damage to motor vehicles.

• Pooling in reality. Despite the warnings in the prior two points, the pooling ef-fect is strong, and it is generally held that, for similarly distributed variables that are not strongly correlated, the law of large numbers, which provides the basis for insurance, will continue to hold.

From the supervisory perspective, the level of understanding that supervised enti-ties have with regard to the risk profiles of their pools and portfolios before and, espe-cially, after the application of any reinsurance is a significant issue.

In summary, the traditional justification for reinsurance is the same as for insur-ance. The pooling of (similar) risks reduces the variability of the overall outcome. In the same way that insurance provides a means for policyholders to manage their risks, rein-surance provides a means for insurers to manage their risks. In particular, reinsurance offers an opportunity for ceding companies to cede risks or portions of risks that are outliers, thus increasing the homogeneity of their retained (net) insurance portfolios. Hence reinsured risks are typically large or concentrated in some way.

Most non-life reinsurance contracts last for one year and cover only a specified line of business. Life reinsurance contracts, in contrast, usually cover indefinite periods and commonly contain a termination condition for new business only.

The structure of a typical non-life reinsurance contract provides the opportunity for additional levels of pooling, such as covering an extended period, multiple product lines, or both. While commensurately harder to price and manage, the additional pro-tection provided by increased pooling is a compensating advantage. This is one aspect of finite risk reinsurance and blended reinsurance covers.

Reinsurance provides an insurer with the opportunity to diversify certain risks, typically those that may reduce the homogeneity of the insured pool for some reason. Moreover, the insurer may not have the desire or sufficient capital to hold a full insur-ance portfolio and so may seek to share the risk with a reinsurer. In each of these situ-ations, the transfer of risk is the key to supporting the adequacy of the insurer’s capital position. From an accounting and supervisory perspective, it is important to ensure that sufficient risk is transferred for the arrangement to qualify as reinsurance.

A number of advantages generally accompany the implementation of reinsurance programs. According to Tiller and Tiller (1995), these include, for example:


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• Diversification of underwritten risk, which limits catastrophic risks, total claims, and the variability of total claims in various ways.

• Increase in new business capacity, which provides the insurer with the ability to take on larger risks than it might prudently consider on a “stand-alone” basis.

• Access to expertise, which provides product advice, especially in the case of new or innovative products, underwriting advice, especially in the case of products new to the insurer, and claims advice, especially in the case of long-term and emerging-industry experience.

• Opportunity to divest a product line, for example, when an insurer plans to exit a certain business or product, perhaps in a given geographic area. In some cases, this may be via an assumption reinsurance arrangement where, in principle, the policyholders are notified that liabilities will be transferred permanently to the reinsurer and that all future premiums and claims will become the direct responsibility of the reinsurer. However, it is important to recognize specific national legal issues regarding the details of the transfer. Alternatively, a more standard indemnity reinsurance arrangement, contractually binding between the insurer and reinsurer (but leaving the policyholder’s direct contractual rela-tionship with the insurer only), may be put in place.

• Financial results management, which allows insurers to use the financial report-ing implications of reinsurance agreements to change their reported results. Specifically, reinsurance may enable insurers to stabilize annual earnings over time, improve capital efficiency, reduce strains from undiscounted technical provisions, spread or improve income tax effects, and provide financial lever-age. In all cases, changes to reported profitability occur even if they are only changes in timing. An example is that of relief from front-end strain, particular-ly in life insurance. The accounting and income tax treatments of reinsurance-related items may also have a significant impact. While such arrangements may be subject to abuse, they also have a legitimate role in business development and support: for example, they may relieve the financial strain on the insurer arising


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from the issue of capital-intensive products. Abuses include the manipulation of financial results without significant transfer of risk.

• Transfer of investment risk, most commonly in life insurance with regard to inter-est-sensitive life and annuity products, either to take advantage of the reinsurer’s asset management capabilities or to avoid undue concentration of assets.

Exercises

1. Outlinethebenefitsthatmaybeachievedbyaninsurerimplementinganeffectivereinsuranceprogram.

2. Thelawoflargenumbersjustifiestheuseofinsurancetopoolrisks.Extendthistojustifytheuseofreinsurance,despitetheneedforreinsurerstoholdcapital.


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C. Types of reinsurance

From a procedural perspective, there are two basic forms of reinsurance: obligatory reinsurance and facultative reinsurance.

In the case of obligatory reinsurance, the insurer and reinsurer have in place a for-mal treaty or agreement for the cession of risks. Key to the treaty is that the insurer is obliged to cede risk to the reinsurer and the reinsurer is obliged to accept those risks from the insurer consistent with the terms of the treaty. Such insurance is sometimes also referred to as automatic or treaty reinsurance. In the non-life context, such trea-ties are typically annual, whereas in life insurance they may be for longer or indefinite periods.

With facultative reinsurance, the ceding insurer is free to choose whether or not to offer an individual policy to a reinsurer for reinsurance and the reinsurer is free to choose whether or not to accept the risk. This approach is useful when either the insurer has a sum insured remaining after obligatory reinsurance is exercised or the policy cov-ers risk not included under obligatory reinsurance. Facultative reinsurance is typically used only for larger or more complex risks.

In some cases, combinations or variations on these basic forms may appear, such as automatic facultative reinsurance. In this case, a reinsurer accepts certain risks that con-form to agreed underwriting criteria. The agreement may require the sharing of such risks by one or both parties or make such risk sharing voluntary. Such arrangements are most commonly seen in the context of life insurance.

From a structural perspective, reinsurance may be either proportional or nonpro-portional. Both structures may occur in either an obligatory or a facultative context. With proportional reinsurance, the insurer and reinsurer share the risk in accordance with a formula that is defined prior to the contingency occurring. The insurer and re-insurer share both the premiums and claims in a way predetermined by a reinsurance treaty. So, for each reinsured risk, the ratio between the risk retained and the risk ceded determines the split of premiums, technical provisions, and claims. Typically, the rein-surer pays reinsurance commissions to reimburse the insurer for agent commissions and other incurred costs.

There are two basic forms of proportional reinsurance: quota share reinsurance and surplus reinsurance. In the case of quota share reinsurance, each risk is split be-tween the insurer and reinsurer in a fixed proportion (the quota) of the premiums. In the case of surplus reinsurance, the risk in excess of a specified level, or surplus retention limit, of risks underwritten is taken up by the reinsurer (in full).

For life insurance, within the context of proportional reinsurance, there are several common approaches, including:

• (Traditional) co-insurance, in which the reinsurer receives a proportionate share of all of the risks and cash flows of the policy. Often the policy fee remains with the ceding company. The reinsurer receives its share of the premiums and ben-


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efits and sets up its share of the technical provisions. The reinsurer usually pays an allowance (reinsurance commission) to the ceding company to represent the reinsurer’s share of the acquisition and maintenance expenses.

• Modified co-insurance, which differs from traditional co-insurance in that the assets supporting the technical provisions are held by the ceding company, in-cluding the assets supporting the portion of the risk assumed by the reinsurer. The ceding company is required to pay interest that the reinsurer would have earned if it had held the assets corresponding to the technical provisions in its own investment portfolio.

• Yearly renewable term, in which the insurer reinsures a specific risk, in exchange for premiums that change from year to year, based on amounts at risk and ages of the policyholders from year to year.

Nonproportional reinsurance provides protection to the insurer, but the amount of protection depends on the claim amounts on a block of polices rather than on a specific predetermined amount of claims on individual policies. The reinsurer reimburses the insurer for claims in excess of a predefined amount. Nonproportional reinsurance is normally arranged under a treaty, with the premium being expressed as a percentage of the direct premium.

In some cases, profit-sharing arrangements may be built into the policy, such as is common with group life reinsurance.

There are several forms of nonproportional reinsurance. In all cases, the insurer retains the cost of claims up to a certain limit, commonly called the deductible or reten-tion limit:

• Excess-of-loss reinsurance covers claims arising from a single event, treating sep-arately each policy affected. Some care may be needed in the case where a single policy provides cover for multiple claims (such as in liability insurance). Such reinsurance is often termed working excess-of-loss reinsurance.

• Catastrophe reinsurance covers large claims arising from a single infrequent event, but the claims amount is the aggregate over the group of policies affect-ed.

• Stop-loss reinsurance covers all claims arising in a specified period, with the claims amount being the aggregate over the group of policies affected. Stop-loss insurance is rare in practice.

In the context of non-life insurance, the term co-insurance is typically used to mean an arrangement in which a risk is split into separate parts and each part is insured, on identical terms, by separate insurers. Such co-insurance may be arranged by brokers or through an ongoing arrangement between a group of insurers.

McIsaac and Babel (1995) provide specific examples of both proportional and non-proportional reinsurance. In practice, not all risks in excess of a defined retention level


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are passed from the insurer to a reinsurer, and risks not passed to the reinsurer remain with the insurer. Moreover, insurers may combine different types of reinsurance to ad-dress combinations of risks. Usually insurers have a reinsurance program made up of a number of treaties to cover a variety of risks. Such a program may also be supplemented by facultative placements for the more exceptional risks. This introduces a level of com-plexity into the reinsurance program, as different policies may cover different groups of risks over varying lines of business. It also introduces a risk that there may be inadver-tent gaps in the reinsurance cover.

For non-life reinsurance, reinsurance coverage is usually applied in the following order:

• Facultative reinsurance• Proportional reinsurance (surplus and quota share, but may apply after excess-

of-loss or after catastrophe insurance)• Nonproportional reinsurance, in the following order: excess-of-loss (on net cost

of claims after surplus recoveries), catastrophe (on event costs net of surplus and excess-of-loss recoveries), and stop-loss (on net cost of claims after all other recoveries).

For life insurance, reinsurance coverage is usually applied in the following order:

• Obligatory treaties, typically including proportional reinsurance• Facultative reinsurance• Nonproportional reinsurance.

However, in particular circumstances, the details of policy wording should be re-viewed.

In terms of the reinsurance coverage that may be expected to occur in practice, McIsaac and Babel (1995) state,

Stop-loss treaties are not very common, and automatic facultative treaties are rare in the property-casualty business. These unusual types of treaties may be effective in special circumstances, but the most common treaties are proportional and per occurrence excess treaties. For normal casualty lines, small companies will com-bine quota share treaties (to increase the number of exposures) with per occur-rence excess treaties in various layers. Large companies will forgo the quota share treaties. For property insurance, surplus share treaties and catastrophe covers are the usual ones.

Patterns in the choice of reinsurance covers will change over time and be affected by the state of the reinsurance market. For example, nonproportional contracts give


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reinsurers greater capacity to manage risk and so can be a feature of hard reinsurance markets.

Lines and layers

Particularly in non-life reinsurance, where the claim amount may vary significantly and may not be “capped” by a specified amount (for example, liability insurance, asbestos claims, and public liability claims), it is common to express the extent of coverage pro-vided under a reinsurance treaty in terms of “lines” of coverage. Usually a line is a mul-tiple of the retention limit. So, for example, a surplus reinsurance treaty of five lines over a retention limit of $50,000 provides coverage of $250,000 over the retention limit. If the claims exceed $300,000 (the sum of the retention limit for the insurance and the five lines covered by the reinsurer), then the claim amounts in excess of $300,000 become the responsibility of the insurer. If a claim may exceed the amount covered by the lines, then the insurer should consider either a further surplus reinsurance treaty, perhaps with another reinsurer, or facultative reinsurance to cover the risk.

Limits on reinsurance coverage provided by a single reinsurer under a particular reinsurance treaty introduce the potential need for insurers to develop more complex reinsurance programs, involving more than one reinsurer, to cover their needs. Dif-ferent treaties may then cover different “layers” of reinsurance. The reinsurance treaty covering the initial amounts in excess of the retention limit would be called the first layer, and then subsequent treaties would be the second and subsequent layers of rein-surance. The pricing of different layers of reinsurance typically varies due to changes in the underlying profile of the risks insured (as they move toward the tails of the overall risk distributions) and on whether reinsurance markets are hard or soft.

A reinsurance program for a particular insurer may become quite complex and difficult to manage. This highlights the importance of insurers having adequate internal controls on the design and management of their reinsurance programs. The structure of the reinsurance program may vary, depending on the particular lines of business considered.

For life insurance, reinsurance treaties may only cover claims for lives insured with names starting with certain letters of the alphabet (for example, A–K) as a further risk-spreading mechanism. Generally, life reinsurance programs are less complex than non-life ones.

Other risk transfer instruments

Some alternate risk transfer mechanisms also have emerged. The most notable are in-surance-linked securities, financial reinsurance, alternative risk transfer, and alternative risk carriers.


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Insurance-linked securities (ILSs) provide a means of transferring (usually cata-strophic) risk to the capital markets via issuing bonds. If the defined catastrophic risk occurs (a specified trigger criteria is met), then bondholders forfeit the interest and cap-ital of the bond to the bond issuer. Insurers and reinsurers typically use ILSs to provide cover for natural catastrophes, hence the name CAT (catastrophe) bonds. They have been issued to provide cover for earthquakes and hurricanes in Japan and the United States. Some life insurance bonds have been issued in the United States to securitize premium payments on traditional life insurance policies. Unlike traditional reinsur-ance, there is no credit risk for these bonds, as they are set up via a separate arm’s-length special-purpose vehicle.

Conceptually, other insurance and reinsurance risks may be securitized, and provi-sion of this service is not restricted to insurers. An advantage of ILSs is the lack of cor-relation between the capital markets and the insurance risk.

Financial reinsurance is a broad term that can be used to describe a variety of trans-actions. It is often used to describe transactions that are structured to have the appear-ance of reinsurance but that do not transfer any or a significant enough amount of risk to justify being treated as reinsurance in the financial statements of the ceding insurer. As a consequence of some high-profile failures, the term “financial reinsurance” not only is ill-defined but also may have a pejorative connotation. The term may also be used to describe products that cover financial exposures, such as credit risk and changes in currency or commodity prices.

Financial reinsurance may be hard to recognize in practice, so supervisors should persist in their inquiries until they are comfortable that they have received full and frank disclosure from the insurers and reinsurers they supervise. A key issue to address is the level of risk transfer. In supervising financial reinsurance arrangements, supervi-sors should take a balanced approach to assessing and recognizing the positive aspects as well as guarding against potential abuses.

Alternative risk transfer covers a range of risk transfer mechanisms that, for some reason, are not considered to be traditional reinsurance. Several types of alternative risk transfer products have emerged, including:

• Finite risk reinsurance, which is discussed in the next section. • Contingent or committed capital, in which a contractual commitment is made to

provide capital, in the form of senior debt, preferred shares, and so forth, after a specified adverse event triggers the option. The expectation is that the cost of capital will be lower before the contingent event than after. Although potentially a useful means of managing risk, this is not an insurance product.

• Multiyear or multiline products or multi-trigger products, in which the users can consolidate risk and combine uncorrelated risks, thus allowing more efficient risk transfer to insurers or reinsurers. The multi-trigger aspect is designed to


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prevent moral hazard and requires a second event, highly correlated with the insured’s financial circumstances, to trigger payments.

• Structured finance or credit enhancement, in which the (re)insurer provides some form of financial guarantee to the borrowing institution, lowering its credit costs.

• Weather derivatives.

With the exception of finite risk insurance, these products are not considered further here.

Risk may also be transferred to alternate risk carriers, such as captives and self-in-surance. “Captive” insurers or reinsurers are the primary alternate risk carriers. These entities may be (and often are) domiciled in jurisdictions different from those of the parent company or insurer. Traditionally, a captive (re)insurer has been established by a corporation or group not involved in insurance and only caters to risks from this par-ent. More recently, use of the term has broadened to cover risks coming from restricted sources, such as risks from a particular industry, or a single-parent captive may accept some risks from other sources. Significant premium incomes flow though captive insur-ers and reinsurers. The market for self-insurance is predominantly, but not only, found in the United States. To be permitted to self-insure, an entity is usually required to sat-isfy specific size and financial requirements and to receive and retain permission from the appropriate supervisor, often an insurance supervisor.

Insurers and reinsurers can consider alternative risk transfer (ART) products in place of, or in combination with, more traditional reinsurance or retrocessions. Su-pervisors should be aware of the evolving ART market, both in the context of rein-surance and, more generally, in the context of when, and if, such products fall under the definition of insurance and so into the domain of insurance supervisors. The ART marketplace is growing, both in absolute and in relative size, compared with traditional reinsurance markets and may now have a 10 percent share of the global commercial insurance market.2

Other aspects of the broader reinsurance market, in addition to traditional ap-proaches involving independent reinsurers, include pooling, either among affiliated insurers and specific industry groups or involuntary pools established for all insurers sharing a high-risk business; Lloyds, a system of syndicates of independent individuals or firms often having unlimited liability; and insurance exchanges, which facilitate the sharing of risks between participating entities.

2. For more information on ART, see the Artemis website (www.artemis.bm).


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Finite risk reinsurance

Finite risk reinsurance (a subset of financial reinsurance) has evolved over time, es-sentially in the non-life context (see IAIS 2005b; see also Swiss Re 1997a and Hochberg 2002).

Finite risk is based on the same instruments as traditional reinsurance. It has the following characteristics:

• Timing risk. The transfer of underwriting risk and the transfer of timing risk, with emphasis on the time value of money

• Limited assumption. Limited assumption of risk by the reinsurer, capping the potential economic downside for the reinsurer

• Multiyear. Multiyear period of contracts, providing some smoothing of experi-ence

• Investment income. Explicit inclusion of investment income in the contract• Profit sharing. The sharing of results between the insurer and reinsurer.

An issue that arises in some jurisdictions is whether there is sufficient risk transfer for finite risk to be accounted for as reinsurance. For example, the September 11, 2001, terrorist attack in New York City, major accounting scandals, and the weakened state of several high-profile insurers and reinsurers raised concerns about finite risk and its ac-counting treatment. These concerns have been reduced, although treatments may vary among jurisdictions. In some cases, “blended” reinsurance covers emerged, combining traditional and finite risk reinsurance. This has the advantage of reinforcing the transfer of risk and of providing more cost-effective reinsurance coverage by pooling over both product lines and multiple years.

Swiss Re (1997a), which provides specific numerical examples of finite risk rein-surance, identifies four main forms of finite risk:

• Loss portfolio transfer (LPT), in which the insurer transfers an existing loss port-folio and associated reserves to the reinsurer. This reinsures the timing risk of the claims being settled too quickly. LPTs also improve the balance sheet posi-tion, especially in the year of writing. By permitting insurers to exit particular lines of business, LPTs can facilitate mergers and acquisitions.

• Adverse development cover (ADC), which protects the insurer against unex-pected adverse development of claims provisions that remain with the insurer. This provides protection against adverse incurred but not reported (IBNR) and incurred but not enough reported (IBNER) events. ADCs also improve balance sheet position, facilitate mergers and acquisitions, and may improve access to traditional excess covers.

• Finite quota share (FQS), which is similar to traditional quota share but address-es the insurer’s financial needs more effectively. The insurer cedes part of its


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unearned premium provision and in return receives a reinsurance commission. This provides smoother financial results for the insurer, increased and stabilized underwriting capacity, and assistance with solvency requirements.

• Spread loss treaty (SLT), which provides the insurer with more stable capacities and prices due to the multiyear nature of the contract. The insurer pays a speci-fied premium into an “experience” account held by the reinsurer. At the end of the term, the experience account is settled. This smoothes results for the insurer, reduces variability in underwriting, transfers timing risk, and stabilizes reinsur-ance.

Some commentators have suggested that interest in finite risk insurance has in-creased following the September 11 terrorist attacks in New York and the subsequent reduction in worldwide reinsurance capacity and hardening of insurance and reinsur-ance markets.

In general, supervisors should also be aware of the possible impact of changes in accounting and other relevant standards on reinsurance and risk transfer products. For example, the upcoming phase 1 of the international financial reporting standards for insurance contracts may prohibit a reinsurance transaction that immediately improves an insurer’s position. This may have a significant impact on the financial reinsurance market. See Standard & Poor’s (2003).

Retrocessions

A reinsurer may itself choose to spread risk further to other reinsurers. Such a process is called retrocession. In principle, retrocessions further diversify risk.

However, in practice, some issues can make retrocession less beneficial. It is of-ten the case that reinsurance arrangements are not “look through” in the sense that a reinsurer may not disclose to an insurer where its retrocessions may be placed. As a consequence there is the possibility of a risk going though a “spiral” among a group of reinsurers and, ultimately, at least in part, unknowingly being passed back to the origi-nal insurer. A well-known example of a reinsurance spiral is the London market excess spiral of the 1980s, which either caused or contributed to the failure of several reinsur-ance companies in the early 1990s.

Although it may be difficult to assess the risk of reinsurance spirals, this suggests that an assessment of immediate reinsurers alone may not be adequate. Some under-standing of the retrocession policies of reinsurers, as well as an assessment of the breadth of retrocession markets, can be helpful. In markets where the number of reinsurers is limited, the risk of reinsurance spirals may be increased. Supervisors should periodi-cally review the wording typically included in contracts, as market solutions may also assist in preventing spirals and other inappropriate uses of reinsurance.


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Similarly, for an insurer dealing with both inward and outward reinsurance, in-ward reinsurance can bring the risk of retaking on its own risk without intending to: the insurer sells the initial business, keeps the retention, reinsures, and then gets back some of the reinsured risk, either directly from the reinsurer or indirectly through a more complex loop.

Government (anti-)terrorism pools

The September 11 terrorist attacks raised concern about the impact of terrorism on in-surance and reinsurance. The consequences of this are still working their way through the insurance system worldwide.

However, one impact of terrorism on insurance and reinsurance is clear: acts of terrorism are not typical of other risks. They may be extremely severe and extremely infrequent; in some cases, there is no precedent. They may not have the random nature typical of other risks, being subject to the deliberate choice and targeting for maximal impact. Consequently, in some senses, such risks are difficult to insure using standard insurance principles. Some countries, recognizing these differences, have established national insurance pools to address the risks of terrorism. Examples include PoolRe in the United Kingdom, the Australian Reinsurance Pool Corporation, and the U.S. Terrorism Risk Insurance Act (due to expire on December 31, 2005). In effect, these governments have become an insurer or reinsurer of last resort in order to stabilize the international reinsurance industry.

The difficulties with the development of private sector insurance and reinsurance products to address the risk of long-term terrorism pose a challenge to the industry, supervisors, and governments. Responses to this challenge are an evolving area of im-portance in both the insurance and reinsurance industries.

Exercises

3. Identifyandexplainthedifferencesbetweenproportionalandnonproportionalreinsuranceandthemaintypesofreinsuranceineachofthesecategories.

4. Explainhowfiniteriskreinsurancemaydifferfromtraditionalreinsurance.


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D. Levels of retention

In general, insurers do not seek to transfer more risk to reinsurers than is efficient. The decision regarding the efficient or optimal level of retention for an insurer is often com-plex and subject to judgment; it can change over time as business objectives and condi-tions vary. There is a balance to be drawn between the cost of the reinsurance cover and the capital required to support the portfolio.

On the one hand, the desirable amount of retention depends on three elements: (a) the insurer’s current level of risk aversion (usually measured by a certain probability of failure, over a fixed time period, that the board of the insurer approves as acceptable, such as a probability of failure of 0.1 percent over one year), (b) the amount of capital the insurer is prepared to put at risk to support the portfolio, and (c) the variability of claims results expected from the portfolio, in terms of both size and time of occur-rence.

On the other hand, the desired level of retention needs to be balanced against (a) the cost of the reinsurance cover considered desirable, (b) the availability of the desired cover, (c) practical issues in implementing the desired cover, and (d) any minimum retention criteria.

Insurers and reinsurers may set “per risk” and “per event” risk retention limits as well as consider blocks of business in aggregate. For example, Stenhouse (2002) gives the long-standing position of the Australian supervisor in this regard:

• Per risk retention. Not more than 5 percent of net tangible assts, with a maxi-mum of 3 percent considered more prudent, especially as the size of the insurer grows

• Per event retention. Not to exceed the amount of net tangible assets over the insurer’s statutory minimum solvency. This seeks to ensure that the insurer can withstand extreme claims without breaching statutory solvency. This is shown in the discussion of maximum event retentions.

Ideally, risk retention should also be related to the ability of the insurer to access relatively liquid funds (noting that tangible assets may include illiquid assets).

A standard approach is to assess the level of retention required for a “typical” insur-er—the “base” retention—and then to adjust this to apply to different classes of business and to determine more appropriate retention levels for a particular insurer.

Theoretical approaches to assessing retention levels generally depend on the math-ematics of risk theory and are based on established actuarial models. The mathematics involved can get complex quickly and are outside the scope of this module. An intro-duction, including a numerical example, is given in Swiss Re (1997b). A mathematical derivation, using risk theory, of (approximate) excess-of-loss retention covers is given in Hart, Buchanan, and Howe (1996).


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In practice it is not always possible to apply theoretical approaches—for example, due to inadequate data, particularly in the case of reinsurers. Approximations, experi-ence, established practice, and judgment can all play a major role in the assessment and pricing of reinsurance cover.

Prices quoted for reinsurance cover may vary for a number of reasons, including:

• The reinsurer’s willingness to do business with a particular insured• The reinsurer’s willingness to offer a particular type of coverage• The general reinsurance marketplace and competitive issues• The amount of claims variation cover inherent in the reinsurance risk transfer.

Reinsurers are generally reluctant to provide unlimited coverage, except for statu-tory classes of business, such as workers’ compensation and motor bodily injury, where the insurer is required to provide unlimited cover. Unless additional layers of cover are put in place, risks in excess of the reinsurance limit are the responsibility of the insurer.

For the main classes of reinsurance, the following limits generally apply:

• Quota share. Limits are seldom imposed.• Surplus. The overall limit is often a matter of administrative convenience, based

on the business the insurer expects to write, and may be coupled with facultative cover.

• Excess of loss. The overall limit is driven by the maximum sum insured or the probable maximum loss (PML), which may be assessed by the insurer or based on industry data and discussions. An understanding of the assumptions and processes used to set the probable maximum loss is usually central to the super-visor’s understanding of reinsurance programs.

• Catastrophe. The limits may be based either on industry practice and analyses or on rules of thumb. A pragmatic approach given in Hart, Buchanan, and Howe (1996) is that the catastrophe limit is between two and four times the probable maximum loss for a catastrophe zone.

In all cases, depending on the size of the portfolios and other insurer-specific needs, comparing the limits of retention and reinsurance cover with industry practice is a useful starting point for reviewing a particular insurer’s retention limits. Supervisors are well placed to assess (and perhaps promulgate) industry practices and may also use information collected by industry bodies and professional groups such as actuaries.

A supervisor should expect an insurer to provide documentation of, and give clear explanations supporting its decisions with regard to, levels of retention and reasons for changes from year to year. Moreover, reinsurance policies, and so related risk appetites, often must be considered and approved by the insurer’s board of directors. Such pro-cesses should generate appropriate documentation for review. In jurisdictions where


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a responsible actuary regime is in place—more commonly for life insurers—annual financial condition reports are required, and copies of these confidential documents must be provided to the supervisor. Supervisors should expect financial condition re-ports to contain a discussion of reinsurance arrangements, specifically their adequacy and appropriateness from an actuarial perspective. Such information and analysis are potentially valuable sources of information when provided in accordance with profes-sional guidelines.

IAIS (2003c) provides guidance for the use of actuaries as part of a supervisory model. This guidance also considers the role of internal auditors and their relationship with external auditors, and this can be extrapolated to other independent professionals. Such considerations are as relevant for reinsurers and reinsurance as for insurers and direct insurance.

Catastrophic exposures

The theoretical approach to setting catastrophe retentions is the same as that used to set excess-of-loss retentions. However, since the risks involved are in the (extreme) tails of the claims distributions and these distributions are poorly understood, it is com-mon to rely on judgment and assumptions regarding experience in setting catastrophe retentions. A rough rule of thumb given in Hart, Buchanan, and Howe (1996) is that catastrophe retentions are often set at two to five times the basic excess-of-loss retention level, with the lower multiple usually being associated with higher basic retentions.

Catastrophe covers generally have quite tight definitions of what constitutes an event, particularly regarding the time frame of an event; they clearly specify the number of claims required before the cover is triggered. As with other insurance and reinsur-ance cover, catastrophe covers may contain limits to their continuity or the number of events claimable before the cover ceases.

Because the reinsurer is taking on the more extreme variability of result in the typi-cally poorly understood tails of claims distributions, catastrophe cover may be relatively expensive.

In some countries there is a direct link between the insurer’s management of ca-tastrophe risk and capital requirements and its holding of catastrophe reinsurance. For example, in Australia, non-life insurers are required to hold a specific maximum event retention (MER) component in their minimum capital requirements (see APRA 2002a). The MER is the largest loss an insurer will be exposed to (taking into account the prob-ability of that loss) due to a concentration of policies, after netting out any reinsurance recoveries. The MER must also include the cost of one reinstatement premium for the insurer’s catastrophe reinsurance.


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Minimum levels of retention

The reinsurer must consider not only the ongoing business objectives of the insurer but also the question of “moral hazard” if the insurer retains only a small portion of the risk. See the discussion of “fronting.” Consequently it is common for reinsurers to insist, as a matter of prudence, that insurers retain a “reasonable” amount of their underwritten risks. There are no fixed rules regarding appropriate minimum retention levels, and these may vary depending on the circumstances of the individual insurer. However, supervisors have some tools for assessing reasonable levels of risk.

• Industry information. From statistical information collected on an ongoing ba-sis, industry norms by line of business should be available. Insurers who deviate far from these norms, especially toward lower retention limits, are likely to be reviewed in some detail.

• Specified minimums. Supervisors may set minimum levels of retention with varying degrees of rigidity. For example, the Australian supervisor, APRA, would normally allow a non-life insurer to cede up to 60 percent of the insurer’s total business written (and in the case of captive insurers, up to 90 percent). See APRA (2002a).

• External information. According to Swiss Re (2003), retention limits for non-life reinsurance worldwide are about 80 percent, with some variance depending on line of business and in some cases allowance being made for the needs of small companies. McIsaac and Babel (1995) recommend that minimum reten-tion rates, on average, be set at no less than 25 percent, which in aggregate is consistent with the results in Swiss Re (2003).

• Life insurers. Given the typically higher retention limits for life insurance, mini-mum retention limits might be considerably higher for life insurance before taking into account any particular circumstances.

Exercise

5. Whattypesofreinsurancearemostcommonlyusedinyourjurisdiction,andwhataretheaveragelevelsofretentionoverthelastfiveyears?


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E. Impact of reinsurance and risk transfer

The accounting treatment applied is of crucial importance to assessing the financial im-pact of reinsurance. Different accounting treatments may lead to significantly different reported financial results. Further, the accounting treatment of reinsurance arrange-ments may well flow through and affect income tax calculations.

Accounting standards may lead to the development of products specifically de-signed to take advantage of specified accounting treatments. As an example, U.S. statutory accounting does not allow immediate recognition of the equity in unearned premium provisions. Consequently, some insurers purchase proportional reinsurance treaties with ceding commissions as a surplus relief mechanism. See McIsaac and Babel (1995). Also, U.S. statutory accounting does not allow discounting of claims provisions, which creates an incentive to achieve the effect of discounting indirectly through the purchase of claims portfolio transfers.

There is an argument that insurance business, especially long-tailed business, which remains in place over a number of years and accounting periods and has significantly uncertain cash flows, is not always well served by accounting practices that presume that all transactions are short term and have a measure of certainty. The issues around matching and spreading or smoothing transactions over a number of years can be sig-nificant and generate material issues.

In general, accounting standards must be followed, and insurers and supervisors rely both on the financial results provided and on the external audit typically required. Given the importance and extent of this reliance on external auditors, some supervisors require specific approval of “approved” auditors. Accounting standards should evolve over time to reflect changes in environment and practice, and there may be significant changes with the introduction of international financial reporting standards in 2005–07. It is an ongoing responsibility of insurers, reinsurers, and supervisors to remain abreast of supervisory developments and current professional standards. While these issues are just as relevant for insurers as for reinsurers, the issues may be heightened for reinsurers domiciled offshore, which may increase the difficulty of obtaining information.

Supervisors therefore need to understand the accounting regime in their own ju-risdiction and, if needed, have the power to require additional statistical and other in-formation from insurers and reinsurers they regulate. In the context of reinsurance (as in general insurance), it is useful to require gross rather than net data. That is, even if amounts may be offset against each other, they should be reported separately. It should be expected that the accountants and actuaries will interact with one another when reporting information to supervisors. In some cases, accounting entries may be used to record items directly; in others, actuaries may include provisions in their calculations (report items indirectly).

In the context of insurance and reinsurance, the underlying accounting principles can be listed as follows (see Stenhouse 2002, which was prepared as a result of the in-vestigation of the HIH failure):


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• Premiums. Premiums are recognized from the risk attachment date, and the rev-enue earned is measured over the period of insurance in accordance with the incidence of the risk.

• Expenses. Premiums ceded to reinsurers are recognized as an outward reinsur-ance expense in accord with the pattern of reinsurance service.

• Gross reporting. Accounting for insurance and reinsurance transactions should be on a gross basis.

• Liability recognition. Technical provisions for outstanding claims are recognized for direct and inward reinsurance business and are measured as the present val-ue of expected future payments.

• Claims recoveries. Anticipated claims recoveries from reinsurers are recognized as assets where the amounts can be measured reliably and calculated as the pres-ent value of the expected future receipts.

Recognition generally is on an accrued basis for premiums, on a policy or claim admitted basis for technical provisions, and on a received basis for claim payments. There is inherent uncertainty in the assessment of future claims, and this uncertainty increases the further into the future the finalization of the claim is likely to be.

In order to apply these principles to an insurance transaction, the purported rein-surance arrangement needs to satisfy a test that a significant transfer of risk has been involved in the transaction. It is generally accepted that risk in this context includes both underwriting and timing risks, but it may not include investment risks. Risk also implies an expectation of a reasonable range of outcomes, which cannot be biased by the affected participants, from the transaction. The key to the test is the meaning or interpretation of the word significant.

Some jurisdictions (for example, the United States) have taken a more black-letter-law approach and established a specific benchmark to determine whether significant risk is transferred. This test indicates that significant, or material, risk transfer has taken place if there is at least a 10 percent probability of at least a 10 percent loss by the rein-surer, with specific consideration of catastrophe risk, which does not have a 10 percent probability of occurrence. No matter what rules are in place, it is hard to sustain a posi-tion that 10 percent of 10 percent—namely, 1 percent—of a risk is a significant transfer of risk. A further potential difficulty is that such an approach creates an arbitrage point for players to move around and seek to subvert, in intent if not in form. Also, the assess-ment of such probabilities from the actuarial perspective cannot be exact, as they reflect the impact of future experience, which can be estimated but not known.

Other countries may take a more principles-based approach aimed at assessing the intent and economic outcomes of the transaction (a “look through” approach). Also, in some countries supervisors may have to approve reinsurance arrangements before they are put in place and should at least reserve the right to vary or void an arrangement after its inception. In principle, while valid arguments may be advanced in favor of such an approach, it may carry an element of moral hazard for the supervisor. If there is an


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adverse outcome, the supervisor may be blamed for a decision that should have been made by the insurer’s board and management.

If a transaction is not treated as reinsurance, it will be treated as a “funding” con-tract, meaning, effectively, as a loan. Ideally, a zero result should then be achieved, im-plying that discounting is being applied to the future claim recovery payments. The importance of allowing a transaction to be treated as reinsurance can be seen in the following example regarding non-life insurance, which is relevant to a jurisdiction that does not permit the use of discounting when calculating technical provisions. If a de-posit is paid in return for a sequence of future payments derived from the invested premium, then, if properly accounted for in terms of present values, the contract should achieve essentially a zero result on the balance sheet at inception. However, treating the premium as reinsurance and the future “recovery” payments, at face value, as recovery payments leads to an apparent immediate increase in the insurer’s solvency position. This occurs because premium income, net of reinsurance, is reduced, but net outstand-ing claims are reduced at the significantly higher undiscounted face value of the future recoveries.

The issues around whether a proposed arrangement may be treated and accounted for as reinsurance have been highlighted by the growing prevalence of financial rein-surance and some recent incidents in which reinsurance contributed to the failure of the insurer. In many cases, the insurer and reinsurer entered into a reinsurance ar-rangement in order to engage in a form of regulatory arbitrage, with the transaction being viewed as a transfer of risk and providing the associated accounting relief in the insurer’s jurisdiction, but with the reinsurer’s jurisdiction not viewing the transaction as involving a transfer of risk. As a result, no liability or capital requirements are ultimately created. The Accountants and Actuaries Liaison Committee (2002) discusses account-ing treatment in the context of finite risk transfer, with a summary of the positions in a number of countries (Australia, Canada, United Kingdom, and the United States) as of 2002, drawing the following conclusion:

ART [alternative risk transfer] is a legitimate risk and capital management tool available to insurers and should not be banned. ART is a natural part of financial markets and can be expected to continue under other names even if “banned” in insurance markets.

A useful supervisory approach for dealing with ART is to require full disclosure to the supervisor and, as part of ongoing reporting and analysis requirements, to require insurers and reinsurers to provide full detail and quantification of ART contracts and their impacts. Where available, the most appropriate vehicle for this is the actuarial financial condition report.


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As insurance and reinsurance are generally accounted for under the same prin-ciples, most of the issues discussed here for reinsurance also arise in the context of standard insurance.

Effect on insurer’s financial position

Reinsurance, and other risk transfer mechanisms, can affect an insurer’s reported finan-cial results and capital management. Indeed, reinsurance arrangements provide capital adequacy assistance to an insurer’s financial position.

Supervisors should consider several issues when assessing the impact of reinsur-ance. Using the returns and other information that insurers are required to submit, supervisors can analyze the insurer’s financial position, including the impact of reinsur-ance, at various levels (business line, region, overall), on the insurer. Approaches taken may include, but are not limited to:

• Ratios. It is common to use ratios to provide a foundation for this analysis and resulting conclusions. The module on ICP 12, non-life ratios, includes specific ratios for reinsurance: cession and retention rates (the proportion of gross pre-miums ceded or retained by the insurer), maximum event ratios (the extent to which the insurer holds capital to cover such events; if not, the insurer may be at risk, which puts the appropriateness of the reinsurance program in question), and reinsurance recoveries (expected claims recoveries relative to net technical provisions).

• Trends. Insight can be gained from examining the trends in an insurer’s results over time.

• Assessment of position excluding reinsurance. Using reinsurance-related infor-mation explicitly provided, ratios and other analyses are recomputed removing the impact of the reinsurance entries. Comparison of the ratios, including and excluding reinsurance, may, particularly if results “straddle” minimum or key values (for example, whether operating profits are positive or negative), provide focus for further investigation of the insurer.

• Reflection of credit risk assessment. To reflect the possible impact of credit risk of a reinsurer, ratios may be recomputed to reflect the potential default by the reinsurer on some expected claims obligations.

When the impact of reinsurance has been assessed, supervisors need to consider the specific circumstances of the insurer. For example, small and newly established in-surers face different challenges than larger and better established insurers. Different product lines have different risk characteristics, and, particularly for new products (ei-ther to the insurer in particular or to the market overall), high levels of reinsurance may


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be appropriate. These comments apply equally to reinsurers when assessing the impact of retrocessions.

Appropriateness of a reinsurance strategy and program

The insurer is responsible for establishing its reinsurance program. The supervisor is responsible for ensuring that such responsibilities are properly executed.

Supervisors may provide guidance to insurers on issues to consider regarding re-insurance programs. See, for example, APRA (2002b, 2002c). Both the insurer and the supervisor should consider a number of issues in assessing the appropriateness of a reinsurance strategy:

• Insurer’s position. Following Hart, Buchanan, and Howe (1996), it is important to consider issues such as the insurer’s risk profile, business, exposure, retention level, and structure. This means considering the insurer’s risk profile, risk toler-ance, and available capital, the nature and extent of its gross business (such as the spread of business by geography and business class, which may be particu-larly important in the context of catastrophe covers), and the distribution of its exposure to identify large potential claims. Regarding retention level, this means considering the optimization of retention levels for reinsurance programs in terms of costs and benefits, which is generally a complex matter in practice even if theoretically possible. Practical constraints, which imply that judgment is re-quired in determining a good reinsurance program, include matters such as the need to work within the context of an established program, maintain continuity and long-term relationships with reinsurers, obtain sufficient detailed pricing information from reinsurers, and consider the impact of reinsurance pricing cy-cles and availability. Considering the structure of reinsurance programs means considering matters such as the choice of reinsurer, type of reinsurance, and diversification of reinsurance business among reinsurers.

• Insurer’s reinsurance governance processes. The board of directors and senior management are responsible for governance (see IAIS 2002b). The board of di-rectors reviews and approves the insurer’s reinsurance strategy in the context of its risk profile, capital, and business plans. This should include strategies for (a) managing and monitoring the reinsurance program, (b) ensuring compliance with relevant legal and supervisory requirements, and (c) setting appropriate risk limits. Senior management implements the reinsurance strategy, including matters such as (a) ensuring that clear policies, procedures, and internal con-trols are established and maintained, (b) setting and approving specific program structures and limits, (c) ensuring appropriate, accurate, and timely reporting, and (d) ensuring the presence of appropriate systems and processes of internal


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control to govern the interaction of the insurer with the reinsurer(s) with regard to reinsurance transactions. Such systems should be regularly reviewed.

• Impact of external standards. External standards affect the reported financial position and business management of insurers. Issues to consider include, but are not limited to, accounting standards and income tax. Accounting standards evolve over time and may not support long-term risk transfer. Such issues may be of heightened interest once the new international accounting standards are introduced, as expected in many countries over the next few years. For exam-ple, the proposal to prohibit equalization and catastrophe reserves may be sig-nificant, especially for reinsurers. See Standard & Poor’s (2003). The treatment of items for income tax purposes can significantly affect the insurer’s manage-ment decisions. In the context of reinsurance, it may affect the levels and types of reinsurance covers put in place. Supervisors need to be aware of such issues as potential drivers for change in the behavior and risk transfer strategies of insurers.

Finally, changes in reinsurance capacity can also affect the capacity of direct insur-ers. That is, insurers may assume incorrectly that consistent reinsurance capacity will always be available; they need to ensure they are not overly exposed to the impact of a sudden reduction in reinsurance capacity. In an extreme, as happened after the Sep-tember 11 terrorist attacks, this may result in a significant withdrawal of capacity from direct markets. More recently, a similar result occurred in the United States when major reinsurers withdrew from the variable annuity market in the bear market of 2000–02, leaving direct companies to retain the risks. See Bieluch and Mueller (2004).

Exercise

6. Confirmhowreinsurancearrangementsaretreatedforaccountingpurposesinyourjurisdiction.Explainwhyitmaybetothedisadvantageofaninsurerifapurportedreinsurancearrangementisnotaccountedforasreinsurance.


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F. Monitoring of the reinsurance programs of primary insurers

IAIS provides guidance on monitoring. Additionally, supervisors typically prepare their own criteria for assessing reinsurance programs.

A key principle is that the primary insurer must take responsibility for its reinsur-ance program as well as assess the soundness of the reinsurance companies with which it does business. The supervisor must ensure that such responsibilities are properly car-ried out. In the process of monitoring an insurer’s reinsurance program, the supervisor should consider the following issues:

• Strategic framework. Verify that the board of the insurer has approved and regularly reviews its reinsurance strategy and that this reinsurance strategy is consistent with the insurer’s business plan and risk profile. This may include the supervisor retaining the right to approve the insurer’s reinsurance strategy. However, the supervisor should recognize that the choice of reinsurance cover is a business decision of the insurer within the context of its overall reinsurance strategy.

• Insurer implementation. Obtain assurance that senior management has imple-mented the reinsurance policies and procedures in compliance with the reinsur-ance strategy and has sufficient controls in place to demonstrate compliance.

• Data. Receive sufficient financial and statistical information to be able to evalu-ate the impact of the insurer’s reinsurance program. Such information should be of sufficient quality to permit the supervisor to assess its integrity and quality.

• Appropriateness of regular analysis of reinsurance. For example, regimes using a responsible actuary approach, including an annual financial condition report, require that an actuarial analysis of the reinsurance program and experience be provided.

• Continuous coverage. Be assured that the insurer maintains adequate reinsur-ance cover at all times. In particular, this may be relevant at times when the insurer is establishing new or reestablishing prior reinsurance covers.

• Confidentiality of insurer information. Verify that confidential information ob-tained by the insurer on its policyholders remains confidential.

• Remedial powers. Have appropriate remedial powers to address deficiencies identified in the reinsurance program. This may include a requirement that in-surers inform the supervisor if material problems arise with its reinsurance pro-gram.


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G. Security of reinsurance

Security can be considered from several points of view: that of the supervisor or that of the insurer. It can also be considered with regard to outsourcing and operational risks.

Supervisor’s perspective

For the supervisor, security of reinsurance can be considered from several perspectives, including the security and licensing of the reinsurers and the security of insurers’ rein-surance programs. Various matters should be considered.

Direct assessment

The supervisor should apply its standard criteria for granting and maintaining an in-surance license to reinsurers applying for a license in the jurisdiction. Some additional considerations may be applied to reinsurers. At a high level, the process for assessing a reinsurer’s risk profile includes gathering background information, examining recent compliance issues, conducting financial analysis and comparing the industry and per-formance indicators over a recent period (for example, three or five years), assessing the reinsurer’s current business strategy, assessing the various risks inherent in the re-insurer (in particular, corporate governance matters and “fit and proper” consideration for board and senior management), and judging the effectiveness of risk mitigators, control functions, and capital availability.

Issues relating to the choice of branch structures versus subsidiary structures for foreign reinsurers are not considered here. ICP 6 specifies that all insurers, including reinsurers, should be licensed in a jurisdiction before being permitted to operate in it, except for foreign insurers operating on a service basis only. However, it may not be possible to achieve this objective in all cases, and it may be necessary to focus on re-taining sufficient assets in the jurisdiction to support the reinsurance liabilities in that jurisdiction. See ICPs 6–10.

appropriate powers in regarD to insurers’ reinsurance programs

Appropriate powers include matters such as the ability of the supervisor to require (a) reinsurance arrangements (changes both in the coverage desired by the insurer and in the treaty conditions for a given coverage), (b) reinsurance providers (changes in providers, including the power to prohibit a particular reinsurance arrangement), (c) capital (the power to require the provision of additional capital, technical provisions, or collateral), (d) information and analysis (regular provision of information regarding re-


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insurance programs, for example, the power to require reporting and analysis through financial condition reports), and (e) independent reviews (independent third-party re-views of matters relating to reinsurance and its administration).

It may be useful for supervisors to establish known “triggers” for intervention with regard to reinsurance programs. This may be by precedent, specific regulation, or other means. In doing so, it should be borne in mind that the reinsurance environment will change and evolve, so care should be taken not to entrench particular positions too deeply.

other (home) supervisors

For foreign reinsurers, a key source of information and insight should be the home su-pervisor in the jurisdiction in which the reinsurer is headquartered. Input from other supervisors in the region may also be valuable. To access this information, preferably on a bilateral basis, the supervisor may put in place appropriate memorandums of un-derstanding and related processes. See ICP 5.

other inDepenDent sources

There may be other reputable independent sources of information on the reinsurer and other members of any conglomerate to which it may belong. In particular, ratings agen-cies may be able to provide measures of financial strength and other business criteria.

policyholDer protection schemes

As noted, policyholders of an insurer do not have a direct claim on reinsurers. As a con-sequence of this, if reinsurers fail, it is unlikely that government-authorized protection schemes will be in place to support affected insurers.

Exercise

7. Doanyinsurersinyourjurisdictionhaveinplacereinsurancearrangementswithreinsurerswhoarenotsupervisedwithinyourjurisdiction?Ifso,howarethesearrangementstreatedintheinsurer’sbalancesheet?


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Insurer’s perspective

From the perspective of an insurer, security of reinsurance can be viewed in terms of the ap-propriateness of placing business with the reinsurer. As noted, the insurer is responsible for conducting appropriate risk assessment and assuring itself of the financial soundness of the reinsurer. The supervisor is responsible for ensuring that such responsibilities are properly carried out. Issues to consider in this process include the following (see also OECD 1998):

• Consistency of approach. Appropriate and up-to-date board and senior manage-ment reinsurance policies must be consistent with the insurer’s risk appetite and approach and be reflected in reinsurance contracts.

• Legal and statutory framework. Understanding the framework is especially im-portant if the reinsurer is not domiciled in the same jurisdiction as the insurer.

• Financial assessment. Appropriate and documented criteria are needed to assess the financial condition and credit risk of reinsurers.

• Business practices. It is important to understand the reinsurer’s underwriting and claims practices (understanding the underwriting and claims policies and procedures of the reinsurer and how they will integrate with the insurer’s prac-tices and reporting), the use of alternative risk transfer tools, and the investment policy, including the use of derivatives.

• Management. It is important to evaluate the expertise, quality, and stability of management of the reinsurer.

• Structural indicators. Indicators of importance include ownership structures, af-filiates, and group (assessment of any affiliated companies and other members of any group to which the reinsurer belongs).

Reinsurers should apply similar criteria when considering retrocessions.

outsourcing

The general issues involved with the management and assessment of outsourcing apply in the case of reinsurance as well. Supervisors are starting to develop guidelines regard-ing specific outsourcing, and these will be applicable to reinsurance arrangements. See, for example, APRA (2001). Typically, reinsurance treaties seek to cover many of the issues involved with outsourcing in the context of reinsurance.

Exercise

8. Whatconsiderationsshouldbetakenintoaccountandprocessesputinplacebyinsurers(andsoconsideredbysupervisors)tomanagereinsurancearrangementsfromtheperspectiveofconsideringreinsuranceasanoutsourcedservice?


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operational risks

It is not uncommon for insurers to give the management of reinsurance matters a rela-tively low priority. Symptoms of the low priority accorded reinsurance matters include delays in the completion and signing of reinsurance treaties, poor administrative prac-tices, and weak systems for reinsurance (for example, poor or manual reporting pro-cesses).

Although board or other high-level approval or consideration may be needed for reinsurance matters and policies, it is a separate matter to ensure that the approved poli-cies are implemented adequately and appropriately.


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H. Failures and reinsurance

Insurers and reinsurers can, and do, fail for a variety of reasons. At a summary level, perhaps 5–10 percent of insurer failures can be attributed to the failure of reinsurance in some form, and perhaps up to a further 5–10 percent can be attributed to causes (in particular, catastrophes) that could, or perhaps should in retrospect, have been re-insured. It is also possible that insurers or reinsurers near failure may be “rescued” in some way—for example, through being acquired—and it is difficult to obtain informa-tion on the impact of reinsurance in such cases.

Work has been done in the European Union on the causes of failures and near fail-ures of insurers (see MacDonnell 2002; Sharma and others 2002). From the reinsurance perspective, a couple of comments are relevant. First, the primary causes of insurer fail-ures are inadequate management and inadequate internal controls in the great majority of cases. Moreover, reinsurance risk is a common trigger for problems. From a supervi-sory perspective this suggests that monitoring the insurer’s reinsurance programs and the quality of the reinsurers is important.

From the reinsurer perspective, Swiss Re (2003) identifies 24 mostly European and U.S. reinsurers that went bankrupt in the period 1980–2003. The causes of these failures include the following (some failures were attributed to multiple causes):

• Insufficient capital (in eight, or a third, of the cases) • Insufficient IBNR or other technical provisions (four cases)• Fraud (for cases) • Catastrophic events (four cases) • Poor underwriting (three cases)• London market excess (LMX) losses (three cases)• Over exposure to a high-risk (London) market (two cases)• Risky assets (one case)• Mismanagement (one case) • Default of retrocessionaire (one case).

The great majority of these causes were internal to the reinsurers and so subject to influence by the reinsurer and also, potentially, by their supervisor. Other reinsur-ers—some of them significant players—went out of business for various reasons not included in this list.

In the context of credit risk in reinsurance failure, Swiss Re (2003) offers the fol-lowing comment:

Whereas in life insurance (with the exception of the United States) reinsurance is not a big credit risk, in non-life insurance it is significantly higher. As the primary insurers have generally diversified their reinsurance cessions, even the share of a big reinsurer ought not to come to more than 4 percent of the non-life insurance


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balance sheet. So the possible bankruptcy of an individual reinsurer does not hold any systemic risk.

Thus, in assessing the reinsurance programs of insurers, supervisors should con-sider the level of diversification of the reinsurance program.


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I. Abuses of reinsurance

An example of an abuse of reinsurance is “fronting,” where an insurer, often with mini-mal capital of its own, is established with a view to reinsuring the great bulk of the risks underwritten. This type of arrangement poses several significant problems:

• No incentive for the direct insurer. There is moral hazard in that the direct insurer has no or little incentive to underwrite or administer claims properly, as rein-surance commissions probably outweigh any losses that may arise from the low level of retention.

• Inappropriate ownership structure. Major problems may arise when the reinsurer also owns the fronting company or vice versa.

An incentive for fronting may be an agent or broker seeking to capture not only commissions but also reinsurance profits, without the usual capital requirements or skills and experience to deal with adverse experience. In the event of a failure by the reinsurer, the full obligation for the direct insurance contracts reverts back to the in-surer.

A review of retention levels is the key to detecting and addressing fronting. In gen-eral, reinsurers expect insurers to retain a significant amount of risk in order to provide an incentive to manage their insured business well, and there may also be supervisory constraints on the level of retention required.

In general, insurers tend to seek to develop long-term relationships with their re-insurers. If a supervisor finds that a particular insurer does not seem to do this, further investigation may be warranted.

Reinsurance issues have been involved in a number of high-profile failures, and some are noted here:

• HIH Group in Australia. The HIH Royal Commission has established the role of abuses of reinsurance and financial reinsurance agreements in the failure of HIH Group in 2001. The situation was compounded by the existence of “side letters,” unknown to the supervisor and other parties, that voided some of the terms of the treaty. Also, the directors of the company may have been unaware of the side letters, calling into question the quality of the overall corporate gov-ernance of HIH.3

• Gerling in the United States. Gerling’s U.S. subsidiaries failed due to credit loss-es, the September 11 terrorist attacks, and asbestos losses. Gerling’s other re-insurance subsidiaries provided support, which, in turn, caused them to fail, even though they raised additional capital. This illustrates the risk of group contagion.

3. See http://www.hihroyalcom.gov.au.


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• Independent Insurance Company Limited in the United Kingdom. This significant and fast-growing non-life insurer closed to new business in June 2001 and went into receivership. While the major cause of its demise appears to be underre-serving, some of the company’s reinsurance arrangements appear to have been questionable.

• Reliance National in the United States. This insurer fronted large amounts of workers’ compensation carve-out business. A reinsurance spiral behind it col-lapsed, leaving the company unable to pay claims. The subsequent loss of repu-tation then caused healthy non-U.S. companies in the group to fail.

• Cardinal Insurance in the United States. This insurer obtained stop-loss cover at very low premium rates, virtually ensuring that it made a profit no matter how bad the business experience. The reinsurer argued that the reinsurance cover was obtained in a fraudulent way and did not pay the claims. Cardinal was liq-uidated.

Exercise

9. Explainwhy“fronting”hasthepotentialtoleadtoabuseofreinsurancearrangements.


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J. Reinsurance contracts

Reinsurance treaties should satisfy the standard requirements of contracts as well as ad-dress the particular needs of the specific reinsurance arrangement under consideration. This includes immediate matters such as having good records of treaties and ensuring that all current treaties are properly signed and executed. Supervisors can check these items relatively easily.

At a summary level, reinsurance treaties should address the following broad areas:

• The details of parties• Business line(s) covered, including limits and exclusions• Premiums and commissions• Management of changes in policies covered, such as changes in sums insured

under inflation clauses• Reporting between the parties• Claims requirements and processes• Profit-sharing arrangements, where applicable• Arbitration in case of dispute, for example, through differing interpretations of

a treaty or omission of information in a treaty• Governing laws• Accounting criteria• Termination conditions, ensuring that the conditions of termination are clear

because, particularly in the case of life insurance, they may refer only to new business or may involve the recapture of existing business previously placed with the reinsurer.

Some template reinsurance contracts are publicly available (see, for example, Ca-nadian Reinsurance Conference 2003; Swiss Re n.d.). A review of these templates shows some of the complexities involved in establishing clear and comprehensive reinsurance arrangements.

Especially when insurers or reinsurers are in difficulty or have failed, the clarity and completeness of documentation supporting reinsurance arrangements become in-creasingly important. However, in general business practice, clear and complete docu-mentation is considered good practice and should emerge as a result of good corporate governance processes.

Supervisors should consider requesting insurers and reinsurers to provide all per-tinent documentation. Such an approach puts the responsibility of disclosure onto the supervised entities and, at least in principle, requires the disclosure of side letters and any other documentation that may alter the impact of formal reinsurance arrange-ments. Both the HIH case in Australia and Equitable Life in the United Kingdom il-lustrate the problems created by side letters (see FSA 2004; HIH Royal Commission, Australia 2003). Supervisors may review the specific items relating to the complete-


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ness and consistency of documentation, the adequacy of processes, and the supervisory powers in place.

• Completeness and consistency of documentation. Supervisors should review cur-rent and historical documentation and treaties (a) to verify the consistency of treaties with information presented in other formats, checking for policy consis-tency of reinsurance arrangements and policies reported by boards, by actuar-ies, and in financial condition (or similar) reports, (b) to ensure that treaties are signed and fully executed in a timely manner by the appropriately authorized personnel, (c) to ensure that interim cover and procedures are in place, espe-cially for non-life reinsurance, where treaties typically renew annually and is-sues may arise in the periods between the expiry of a reinsurance treaty and the completion of its replacement (in practice, appropriate cover notes, signed by all of the affected parties, should be in place to deal with the interim), and (d) to verify that reinsurance intermediaries and providers are appropriately licensed and in good standing in the jurisdiction.

• Adequacy of processes. Reinsurance contracts and arrangements can be com-plex. Generally, appropriate process reviews and checks should be in place. Su-pervisors should review both the processes and the evidence that the processes have been complied with. In particular, expert reviews and signoffs cover the following internal matters for the insurer: (a) ensure that the wording of con-tracts is appropriate and that other legal matters are dealt with properly, (b) ensure that the insurer’s staff are trained to handle the intended processes and requirements and are reporting efficiently, (c) ensure that the insurer’s systems can reflect intended processes and reporting requirements, and (d) ensure that documentation, testing, and signoff of change control processes are in place and demonstrate the ongoing correctness of policies, procedures, and systems when, for example, the terms and conditions of policies or reinsurers change.

• Supervisory powers. Supervisors should clarify their powers, policies, and pro-cedures in the event that the reinsurance documentation requirements and pro-cesses are not complied with. This could include the power to (a) impose fines, (b) prohibit particular reinsurance treaties or arrangements, and (c) require changes to reinsurance treaties or arrangements.


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K. Supervision of reinsurance

Reinsurance checklists are useful for helping supervisors to review the reinsurance pro-grams of insurers. Checklists typically include review of the following items:

• Reinsurance program • Retention levels • Security of reinsurance • Specific reinsurance contracts • Credit taken for reinsurance.

Some other issues that may warrant further consideration are considered below.

Mandated coverage and prior approval

Some jurisdictions have national reinsurers and require all insurers to take out a certain minimal amount of reinsurance cover with these national reinsurers. Independent of the reasons for establishing national reinsurers, this approach may carry a number of risks, including market concentration risk and capability risk (adequate skills, resourc-es, and experience) for the national reinsurer. This issue may be especially significant in jurisdictions with limited competition among reinsurers. Commonly, the national reinsurer is a state-owned or related entity. As such, although it may formally be under the same supervisory regime as other reinsurers, there is a risk that the supervisor’s influence and powers will be diminished.

In some jurisdictions, approval of reinsurance arrangements is subject to the prior approval of the supervisor. In principle, this raises the question of moral hazard for the supervisor, in that insurers may become dependent on and rely on the supervisor’s as-sessment of the proposed reinsurance arrangements when it is more appropriate for the insurer (in particular, its senior management) to take responsibility for them. There is also the implication that the supervisor has sufficient in-house expertise and sufficient detailed knowledge of the insurer’s business objectives, position, systems, and products to be able to fully assess the proposed reinsurance arrangement. These conditions may be hard to fulfill in practice.

From the perspective of prudential risk management, leaving aside other criteria, it is preferable to have a competitive reinsurance market in which insurers can choose where to place their reinsurance business.


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Other parties

Supervisors can use other parties to support their assessment of reinsurance and rein-surers, just as they can in the broader context of supervision.

Independent professionals—in particular, actuaries operating under a strong pro-fessional code of conduct—should be able to provide independent assessments of re-insurance arrangements and solvency, both of insurers and reinsurers. In jurisdictions where the actuarial profession is well developed, the use of the responsible actuary concept can deliver this assistance. Supervisors can use actuaries who are independent of both the supervisor and the entity in question to perform assessments of reinsur-ance arrangements, provided the supervisor has the legal power to demand such as-sessments. Other professionals, such as accountants, independent underwriters, legal experts, and so on may also provide valuable input regarding the assessment of reinsur-ance arrangements.

Ratings agencies may also be useful sources of information. While the primary role of ratings agencies is not to provide a supervisory or pseudo-supervisory service, the fact that a consistent set of evaluation criteria is applied to both insurers and reinsurers suggests that there is value in considering the relative ratings assigned to insurers and reinsurers, as well as noting the trends in the ratings attained by entities. There is some evidence, put forward by some of the ratings agencies, that the movement in insurer and reinsurer ratings has an element of predictability with regard to entities becoming distressed. Access to the causes of movements in the ratings of insurers and reinsurers may provide valuable insights for supervisors in addition to access to the ratings them-selves.

Supervision of reinsurance companies

IAIS provides guidance on the supervision of reinsurers (see IAIS 2002a, 2003b). As an overall approach, IAIS (2003a, para. 7) states:

The principles apply to the supervision of insurers and reinsurers, whether private or government-controlled insurers that compete with private enterprises, wher-ever their business is conducted, including through e-commerce. The term insurer refers to both insurers and reinsurers. Where the principles do not apply to rein-surers (such as consumer protection), this is indicated in the text.

From the reinsurer’s perspective, doing business with the ceding insurer is essen-tially analogous to an insurer doing business with its policyholders. As such, essentially, the same supervisory regime should apply.

In particular, IAIS (2002a) provides two principles.


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• Principle 1. The supervision of reinsurers should reflect the distinct characteris-tics of the reinsurance business in four areas: (a) technical provisions, in which reinsurers may need to address specific issues in the development of technical reserves, (b) investments and liquidity, in which reinsurers may need to empha-size the management of currency risk and liquidity to reflect their operations in multiple countries and the size of potential claims, (c) capital requirements, in which reinsurers may need to hold higher levels of capital to address diversifica-tion and underwriting risk, investment issues, retrocessions, taxation, opera-tional risk particular to reinsurers, and increased volatility of results, and (d) corporate governance, in which, given the increased risks of reinsurance, rein-surers should have commensurately stronger risk management and corporate governance in place.

• Principle 2. Except as noted in principle 1, reinsurers should be supervised in the same way as insurers.

These minimum requirements for the supervision of reinsurers anticipate the de-velopment of a global approach to the supervision of reinsurers, placing the onus on the home supervisor of the reinsurer. The typical cross-border operations of reinsurers make the effective supervision of reinsurers more difficult.

Supervisors should acknowledge some specific practical issues for reinsurers, par-ticularly those that write non-life reinsurance:

• Pricing. Pricing can be more difficult for reinsurers than for insurers due to lim-ited availability of data and the impact of complicated layers of reinsurance.

• Volatility. Reinsurers price in the tails of claims distributions, and these may be longer tailed, more volatile, and less homogeneous than in regular insur-ance; consequently the payment patterns of nonproportional reinsurance may be considerably different than the payment patterns of the underlying direct insurance.

• Time frame. There may be lengthy time delays between the occurrence, report-ing, and settlement of any covered loss events, placing more importance on the estimation of IBNR and IBNER provisions.

• Insurer risks. The reinsurer may be exposed to flaws in the insurer’s underwrit-ing and claims processes and pricing policies (for example, for co-insurance and other situations where the reinsurer “follows the fortunes” of the insurer), with less ability to influence them.

• Credit ranking. Reinsurers may find that they rank below other creditors in the case of bankruptcy of an insurer, and they may not be able to offset funds owed against funds due in the liquidation process.


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These issues suggest that reinsurers may encounter some issues not encountered by insurers, and so it may be prudent for them to hold higher levels of capital for adverse experience.

Where insurers or reinsurers are part of a larger group—for example, captives—the insurance supervisor should consider the risk of contagion from other members of the group. See ICP 17.

Many aspects of reinsurance, from the perspectives of both the insurer and the re-insurer, are not covered in this module but are covered in other modules. For example, the determination of liabilities and capital adequacy are covered in ICPs 20 and 23, and the behavior and supervision of reinsurance intermediaries are covered in ICP 24.

Credit for reinsurance

Typically, a ceding insurer can take credit for reinsurance, either by reducing its li-abilities or by recognizing an asset, only when the reinsurer meets certain requirements. Generally, the assuming reinsurer is required to be licensed in the jurisdiction of the ceding insurer (the jurisdiction of the relevant lead supervisor), to be accredited in some way, or to satisfy certain other specific conditions, such as being a registered rein-surer in certain other countries.

It may also be that the conditions of registration in the local jurisdiction for a re-insurer are stronger than those for a direct insurer. For example, there may be higher capital requirements. When dealing with a reinsurer not licensed and so not subject to full local supervisory control, the supervisor has to assess the long-term claims-paying ability (and the enforcement of this ability should it be needed) in the local jurisdiction. Various options are open to achieve some confidence in the level of financial security for insurers associated with the reinsurance contract:

• Prohibit reinsurance with unregistered reinsurers. This may be counterproduc-tive, especially in smaller jurisdictions, as some major reinsurers may choose not to register in all jurisdictions. The supervisor could impose this route by refusing to allow credit for reinsurance unless the reinsurer is registered in the local jurisdiction.

• Impose additional capital requirements. Subject to any permitted reductions in capital requirements due to the transfer of risk to the reinsurer, the supervi-sor may impose additional credit risk–based capital requirements, based on the credit status of the insurer.

• Recognize credit-risk mitigants. For example, these could include funds held by the reinsurer for the exclusive benefit of the ceding insurer, funds held in trust exclusively on behalf of the ceding insurer, or appropriately strong letters of credit.


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• Conduct reviews. The supervisor may review both the unregistered reinsurer itself and the perceived strength of the supervisory regime in the jurisdiction in which the reinsurer is based. Reinsurers registered in jurisdictions with weak supervisory regimes may be barred or restricted in their activities. The natural tool for this is the level of reinsurance credit allowed.

• Impose maximum percentages. The supervisor may prohibit more than a certain proportion of the insurer’s total premiums being ceded to an unregistered rein-surer.

• Information requirements. Require the ceding insurer to file with the supervisor relevant information about the unregistered reinsurer.

See the NAIC website (www.naic.org) for the principles in the United States and the module on ICP 12B (non-life insurance ratios) for the Canadian treatment of un-registered reinsurance.

Other issues to be considered in this context may include the potential impact of globalization (increasing globalization of the insurance and, in particular, reinsurance industries), memorandums of understanding (effective memorandums of understand-ing with supervisors in the home country of unregistered reinsurers allowed to operate in the local jurisdiction), and global initiatives (such as the World Trade Organization and international financial reporting standards).

Contract provisions

As a general rule, subject to standard legal requirements specifying required clauses in contracts and subject to developing practice and precedent in the industry, insurance supervisors rarely require the inclusion of specific clauses in reinsurance contracts. This reflects the trend toward prudential regulation, although it may vary by specific juris-diction.

Supervisory intervention

As noted, the regulation and supervision of reinsurers are expected to follow the same principles as the regulation and supervision of direct insurers. The international and global nature of major reinsurers may introduce complications for both home and host supervisors in practice, as does the overall supervision of international groups involved in financial services. See ICPs 5, 14, and 15.


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Liquidation or winding-up proceedings

See ICPs 5 and 16.

Exercises

10.Whatinformationdoesyoursupervisoryagencyrequireinsurerstosubmit,andwithwhatfrequency,tojustifytheirreinsurancestrategy?Whatanalysisisdonewithinyoursupervisoryagencyofthisinformation?

11.Whendeficienciesareidentified,whatactionsaretaken?


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L. Broader context

IAIS updated its insurance core principles and methodology in October 2003 (IAIS 2003a). The 28 core principles are intended to cover all aspects of a supervisory frame-work and need to be considered as an integrated body of work. In particular, ICP 19 addresses reinsurance:

Since insurance is a risk-taking activity, the supervisory authority requires in-surers to evaluate and manage the risks they underwrite, in particular through reinsurance.

Several essential criteria support ICP 19. In relation to reinsurance, the essential criteria are the following:

• Insurers have strategic underwriting and pricing policies in place, and these policies are approved and reviewed regularly by the board of directors. The in-surer’s reinsurance strategy is part of its underwriting strategy [criterion a].

• The supervisory authority requires the insurer to have a clear strategy to miti-gate and diversify risks by defining limits on the amount of risk retained, in particular, by taking out appropriate reinsurance or other risk transfer arrange-ments consistent with the insurer’s capital position. The risk mitigation and di-versification strategy is an integral part of the insurer’s underwriting strategy and thus subject to essential criterion a [criterion d].

• The supervisory authority reviews reinsurance arrangements for their adequacy and recoverability from reinsurers. In particular, the reinsurance program pro-vides coverage appropriate to the insurer’s capital position, recognizing (a) the profile and reality of transfer of the risks underwritten and (b) the security of the reinsurer’s financial position [criterion e].

• The supervisory authority checks that risk transfer instruments are properly ac-counted in order to give a “true and fair” view of the insurer’s risk exposure [criterion f].

In order for a supervisory authority to achieve “observed” status with regard to ICP 19, and in particular the reinsurance aspects of ICP 19, the appropriate supervisory environment needs to be in place. In particular,

• Powers. The relevant supervisory powers, via legislation or other means, to per-mit the supervisory authority to enforce the reporting and access requirements of insurers to permit full and complete judgments to be made

• Expertise. Sufficient expertise and knowledge to be able to make and support the required judgments


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• Independence and will. The independence and will to be able to make and en-force the appropriate judgments.

This module focuses on criteria d, e, and f. For further discussion of criteria a, b, and c, see the module on ICP 19A (insurance activity).

To support the core principles, IAIS provides further principles, standards, and guidance papers. While these documents should be considered as an integrated body of work, several of these documents focus specifically on reinsurance (IAIS 2002a, 2002b, 2003b).

Academic literature and other sources of information

There is significant literature in the academic world regarding reinsurance. While some-times considering reinsurance issues in an abstract and idealized setting, academic re-search may provide supervisors with some theoretical insight into reinsurance matters, without necessarily considering commercial and practical realities. For example, aca-demic research suggests that, for a given net premium, a stop-loss contract will produce the most reduction in the variance of the aggregate claim distribution for the ceding company (see McIsaac and Babel 1995). While this may be to the advantage of the ced-ing company, it is unlikely to be to the advantage of the reinsurer, which helps to explain why stop-loss reinsurance is rare in practice and may be expensive when it does occur. It is beyond the scope of this module to consider this literature in detail.

Many sources of further information regarding reinsurance are publicly available. These include, for example:

• Actuarial bodies, both national and international • Major reinsurers (see Swiss Re 2002)• Industry bodies and associations• Consultants and rating agencies• National supervisory websites• IAIS reinsurers database (available to members only).

Life and non-life reinsurance

The discussions in this module are applicable to both life and non-life insurance unless specifically indicated otherwise. Several differences have been noted:

• Reinsurance program structure. Life reinsurance treaties tend to cover indefinite periods, and the termination conditions affect new business only, whereas non-


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life reinsurance arrangements traditionally last for one year and cover only a specific line of business. This increases the importance, for non-life reinsurance, of ensuring that proper documentation, such as cover notes, is in place. Faculta-tive reinsurance is more common for life insurance. The term “co-insurance” has very different meanings in the context of life and non-life reinsurance, as may the usual order of application of reinsurance cover. The use of layers is com-mon in non-life insurance, but not in life insurance.

• Product structure. Many life insurance products, especially traditional whole-of-life and endowment products, have high initial expenses that are expected to be recouped over the later years of the contract. This can lead to initial capi-tal strain for life insurers. Reinsurance may alleviate some of this initial capi-tal strain. This phenomenon is not as pronounced with non-life insurance, in which one-year insurance contracts predominate.

• Finite risk and alternative risk transfer. While more recent developments in re-insurance can be used in the context of life insurance, they have developed pri-marily in the non-life context.

• Supervisory regimes and practices. Legislative requirements, actuarial approach-es, and industry practices vary between life and non-life insurance and hence are reflected in reinsurance considerations. This is not surprising given the na-ture of the risks covered.

• Retention levels. Industry retention levels, in general, are significantly higher in life insurance than in non-life insurance. This reflects the increased heterogene-ity of non-life insurance risks as well as the increased volatility of non-life insur-ance risks.

• Credit risk. Reinsurance failures of some type are a significant, although not the most likely, cause of failures of insurers, particularly for non-life insurance.

• Complexity, volatility, and change. As a general comment, the role of reinsurance is more important, more complex, and more subject to change and volatility in the non-life than in the life insurance industry. The non-life insurance, and so reinsurance, industry is more subject to changes in expectation, legislation, and volatility in potential claims than the life insurance industry. As a specific example, consider the ongoing risks and issues relating to the past use of asbes-tos.

Reinsurance marketplace

A number of the sources listed in the reference section provide overviews of various aspects of the reinsurance marketplace. Discussion of more advanced issues lies beyond the scope of this module. However, Swiss Re (2003) discusses whether the reinsurance


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industry poses a systemic risk to financial services and concludes that the answer is no. This issue is of particular interest to supervisors.

The potential concentration risk—the top five reinsurance groups worldwide took 57 percent of net premiums written and the top 20 reinsurance groups took 93 percent of net premiums written in 2001—is mitigated by a number of factors, including:

• The assertion that the level of concentration is comparatively low in relation to other sectors of the financial services industry

• Reportedly wide diversification of risk by the large reinsurers• Small number of direct bankruptcies of reinsurers over the last 20-odd years

supported, despite some recent declines (likely attributable to the September 11 terrorist attacks), by strong credit ratings for the large reinsurers

• Generally fairly wide diversification of reinsurers by insurers, especially for non-life insurers.


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M. References

Accountants and Actuaries Liaison Committee. 2002. “Submission to HIH Royal Com-mission.” September 27. See www.hihroyalcom.gov.au.

APRA (Australian Prudential Regulatory Authority). 2001. “Outsourcing: Issues and Risk Management.” APRA Insights (4th quarter). Canberra. Available at www.apra.gov.au.

———. 2002a. Guidance Note GCN 110.5: Concentration Risk Capital Charge. Canber-ra, July. Available at www.apra.gov.au.

———. 2002b. Guidance Note GCN 230.1: Reinsurance Management Strategy. Canberra, July. Available at www.apra.gov.au.

———. 2002c. Prudential Standard GPS 230: Reinsurance Arrangements for General In-surers. July. Available at www.apra.gov.au.

Bieluch, Philip, and Hubert Mueller. 2004. “Managing the Risks from Variable An-nuities: The Next Phase.” the actuary, Newsletter of the Society of Actuaries 38 (3, March): 1, 4–5, 16.

Canadian Reinsurance Conference. 2003. Canadian Reinsurance Guidelines: Template Treaties. Available at www.crconline.ca/guidelines.htm.

FSA (Financial Services Authority). 2004. “FSA Bans Former Equitable Chief Execu-tive.” FSA press release FSA/PN/049/2004. London, June 3. Available at www.fsa.gov.uk/pubs/press/2004/049.html.

Hart, D. G., R. A. Buchanan, and B. A. Howe. 1996. Actuarial Practice of General Insur-ance. Canberra: Institute of Actuaries of Australia.

HIH Royal Commission, Australia. 2003. The Failure of HIH Insurance, 3 vols. Can-berra: Commonwealth of Australia. Available at www.hihroyalcom.gov.au.

Hochberg, E. S. 2002. “Finite Risk in the Post-Enron Environment.” Journal of Reinsur-ance 9 (Fall, 1):1. Available at www.irua.com.

IAIS (International Association of Insurance Supervisors). 2002a. Principles 6: Princi-ples on Minimum Requirements for Supervision of Reinsurers. Basel, October. Avail-able at www.iaisweb.org.

———. 2002b. Standard 7: Supervisory Standard on the Evaluation of Reinsurance Cov-er. Basel, January. Available at www.iaisweb.org.

———. 2003a. Principles 1: Insurance Core Principles and Methodology. Basel, October. Available at www.iaisweb.org.

———. 2003b. Standard 8: Supervisory Standard on Supervision of Reinsurers. Basel, October. Available at www.iaisweb.org.

———. 2003c. The Use of Actuaries as Part of a Supervisory Model. Guidance Paper 7. Basel, October. Available at www.iaisweb.org.

———. 2005a. Glossary of Terms. Basel, February. Available at www.iaisweb.org.———. 2005b. Risk Transfer, Disclosure, and Analysis of Finite Reinsurance. Guidance

Paper 11. Basel, October. Available at www.iaisweb.org.


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MacDonnell, W. 2002. Managing Risk: Practical Lessons from Recent “Failures” of EU Insurers. FSA Occasional Paper 20. London, December.

McIsaac, D. A., and D. F. Babel. 1995. “The World Bank Primer on Reinsurance.” Policy Research Working Paper 1512. World Bank, Washington, D.C., September. Avail-able at www.worldbank.org.

OECD (Organisation for Economic Co-operation and Development). 1998. “Recom-mendations of the Council on the Assessment of Reinsurance Companies.” Paris.

OSFI (Office of the Superintendent of Financial Institutions). 1997. Unregistered Rein-surance Guideline B-3. Ottawa, Canada, February. Available at www.osfi-bsif.gc.ca/eng/documents/guidance/docs/belife.pdf.

Sharma, Paul, and others. 2002. Prudential Supervision of Insurance Undertakings: Re-port of the London Working Group on Solvency II. Conference of the Insurance Supervisory Services of the Member States of the European Union, December.

Standard & Poor’s. 2003. International Accounting Standards: Threat or Opportunity? Standard & Poor’s ClassicDirect, September 8. Available to subscribers at www.eclassicdirect.com.

Stenhouse, Russell. 2002. “Submission to HIH Royal Commission: Background Pa-per—Reinsurance.” Canberra, January. Available at www.hihroyalcom.gov.au.

Swiss Re. 1997a. “Finite Risk Insurance.” Sigma Insurance Research 5/1997. Zurich. Available at www.swissre.com.

———. 1997b. “Setting Retentions: Theoretical Considerations.” Zurich. Available at www.swissre.com.

———. 2002. “An Introduction to Reinsurance.” Zurich. Available at www.swissre.com.

———. 2003. “Reinsurance: A Systemic Risk?” Sigma 5. Zurich. Available at www.swissre.com.

Swiss Re Australia. n.d. “General Conditions for Facultative Reinsurance.” Document 001. Available at www.swissre.com.

Tiller, John E. Jr., and Denise F. Tiller. 1995. Life, Health, and Annuity Reinsurance, 2d ed. Actex Publications.


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Appendix I. ICP 19: Insurance Activity

Explanatory note

19.1. Insurers take on risks and manage them through a range of techniques including pooling and diversification. Every insurer should have an underwriting policy that is approved and monitored by the board of directors.

19.2. Insurers use actuarial, statistical, or financial methods for estimating liabilities and determining premiums. If these amounts are materially understated, the conse-quences for the insurer can be significant and in some cases fatal. In particular, premi-ums charged could be inadequate to cover the risk and costs, insurers may pursue lines of business that are not profitable, and liabilities may be understated, masking the true financial state of the insurer. There is a need to ensure that embedded options have been identified, properly priced and an appropriate reserve has been established.

19.3. Insurers use a number of tools to mitigate and diversify the risks they assume. The most important tool to transfer risk is reinsurance. An insurer should have a reinsur-ance strategy, approved by its board, that is appropriate to its overall risk profile and its capital. The reinsurance strategy will be part of the insurer’s overall underwriting strategy.

Essential criteria

a. The supervisory authority requires insurers to have in place strategic underwriting and pricing policies approved and reviewed regularly by the board of directors.

b. The supervisory authority checks that insurers evaluate the risks that they underwrite and establish and maintain an adequate level of premiums. For this purpose, insur-ers should have systems in place to control their expenses related to premiums and claims, including claims handling and administration expenses. These expenses should be monitored by management on an ongoing basis.

c. The supervisory authority is able to review the methodology used by the insurer to set premiums to determine that they are established on reasonable assumptions to enable the insurer to meet its commitments.

ICP 19: Insurance activity

Since insurance is a risk taking activity, the supervisory authority requires insurers to

evaluate and manage the risks that they underwrite, in particular through reinsurance,

and to have the tools to establish an adequate level of premiums.


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d. The supervisory authority requires that the insurer has a clear strategy to mitigate and diversify risks by defining limits on the amount of risk retained and taking out ap-propriate reinsurance cover or using other risk transfer arrangements consistent with its capital position. This strategy is an integral part of the insurer’s underwriting policy and must be approved and regularly monitored and reviewed by the board of directors.

e. The supervisory authority reviews reinsurance arrangements to check that they are adequate and that the claims held by insurers on their reinsurers are recoverable. This includes that:

• The reinsurance program provides coverage appropriate to the level of capital of the insurer (taking into account the real transfer of risk) and the profile of the risks it underwrites

• The reinsurer’s protection is secure. This might be addressed through different means, such as relying on a system of direct supervision of reinsurers or obtain-ing collateral (including trusts, letters of credit, or funds withheld).

f. The supervisory authority checks that risk transfer instruments are properly account-ed for in order to give a true and fair view of the insurer’s risk exposure.


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Appendix II. Answer key

Exercises

1. Outline the benefits that may be achieved by an insurer implementing an effective reinsurance program.

Possible benefits of a reinsurance program include diversification of underwrit-ten risk, increase in new business capacity, access to expertise, opportunity to divest a product line, ability to manage financial results, and transfer of invest-ment risk.

2. The law of large numbers justifies the use of insurance to pool risks. Extend this to justify the use of reinsurance, despite the need for reinsurers to hold capital.

The pooling of (similar) risks reduces the variability of the overall outcome. In the same way that insurance provides a means for policyholders to manage their risks, reinsurance provides a means for insurers to manage their risks. In particular, reinsurance offers an opportunity for ceding companies to cede risks or portions of risks that are outliers, thus increasing the homogeneity of their retained (net) insurance portfolios.

3. Identify and explain the differences between proportional and nonproportional reinsurance and the main types of reinsurance in each of these categories.

With proportional reinsurance, the insurer and reinsurer share the risk in ac-cordance with a formula that is defined prior to the contingency occurring. The main types of proportional reinsurance are (traditional) co-insurance, modified co-insurance, and yearly renewable term. Nonproportional reinsurance pro-vides protection to the insurer, but the amount of protection depends on the claim amounts on a block of polices rather than on a predetermined amount of claims on individual policies. The main types of nonproportional reinsurance are excess-of-loss, catastrophe, and stop-loss reinsurance.

4. Explain how finite risk reinsurance may differ from traditional reinsurance.

Finite risk is based on the same instruments as traditional reinsurance, but may differ with respect to the following factors: timing risk (the transfer of under-writing risk and the transfer of timing risk, with emphasis on the time value of money); limited assumption of risk by the reinsurer (caps on the potential economic downside for the reinsurer); multiyear period of contracts (provision of some smoothing of experience); investment income (explicit inclusion of in-


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vestment income in the contract); and profit sharing (the sharing of results be-tween the insurer and reinsurer).

5. What types of reinsurance are most commonly used in your jurisdiction, and what are the average levels of retention over the last five years?

Consult with colleagues regarding the types of reinsurance most commonly used in your jurisdiction and the levels of retention (information may also be collected through regulatory returns or other reports).

6. Confirm how reinsurance arrangements are treated for accounting purposes in your jurisdiction. Explain why it may be to the disadvantage of an insurer if a purported reinsurance arrangement is not accounted for as reinsurance.

Consult with colleagues or review local accounting standards to determine how reinsurance arrangements are treated for accounting purposes in your jurisdic-tion. The accounting treatment applied is of crucial importance to assessing the financial impact of reinsurance. Different accounting treatments may lead to significantly different reported financial results. Further, the accounting treat-ment of reinsurance arrangements may well flow through and affect income tax calculations. Accordingly, an insurer’s financial results may appear unfavorable, or the insurer may need to pay higher income tax if a purported reinsurance ar-rangement is not accounted for as reinsurance.

7. Do any insurers in your jurisdiction have in place reinsurance arrangements with reinsurers who are not supervised within your jurisdiction? If so, how are these ar-rangements treated in the insurer’s balance sheet?

Consult with colleagues or review regulatory returns to determine if any insur-ers in your jurisdiction have in place reinsurance arrangements with reinsurers who are not supervised within your jurisdiction. Consult with colleagues or re-view regulations or guidelines to determine how these arrangements are treated in an insurer’s balance sheet in your jurisdiction.

8. What considerations should be taken into account and processes put in place by insurers (and so considered by supervisors) to manage reinsurance arrangements from the perspective of considering reinsurance as an outsourced service?

The general issues involved with the management and assessment of outsourc-ing apply in the case of reinsurance as well. An insurer remains responsible for meeting its obligations to policyholders, even where it has outsourced functions to others. Adequate controls should exist to ensure that the functions are per-


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formed properly. Contingency plans should be in place to deal with the poten-tial failure of the service provider. Typically, reinsurance treaties seek to cover many of the issues involved with outsourcing in the context of reinsurance.

9. Explain why “fronting” has the potential to lead to abuse of reinsurance arrange-ments.

Fronting can lead to significant problems because the direct insurer may have no or little incentive to underwrite or administer claims properly, as reinsurance commissions probably outweigh any losses that may arise from the low level of retention. Fronting is often accompanied by an inappropriate ownership struc-ture, for example, where the reinsurer also owns the fronting company or vice versa. In such cases, the control on risk taking that arises from the independent evaluation of risk by the parties to an arm’s-length business transaction will be absent.

10. What information does your supervisory agency require insurers to submit, and with what frequency, to justify their reinsurance strategy? What analysis is done within your supervisory agency of this information?

Consult with colleagues or review regulatory requirements to determine what information your supervisory agency requires insurers to submit, and with what frequency, to justify their reinsurance strategy. Consult with colleagues to de-termine what analysis is done within your supervisory agency of this informa-tion.

11. When deficiencies are identified, what actions are taken?

Consult with colleagues to determine what actions are taken when deficiencies in an insurer’s reinsurance strategy are identified.

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