Risk transfer from an insurance company to a reinsurer can be achieved through reinsurance. The manner in which reinsurance is carried out has over the years expanded from the traditional forms such as quota share, surplus and excess of loss to Alternative Risk Transfer Methods such as Catastrophe Bonds, Industry loss warranties and even swaps.
Just like traditional reinsurance, the alternative market offers a whole different spectrum of ways in which reinsurance can be arranged or carried out. From the early 1990’s, as insurers found themselves exposed to bigger and complicated risks whose loses and effects were quite substantial, the cost of purchasing capacity the traditional way become quite expensive. insurers were pushed to look for alternative methods of protection. This lead to the development of Alternative Risk Transfer Methods and products that were easily affordable and yet could still offer the required protection sought after.
The Transfer of risk via the alternative markets is principally done in two ways. These are;
In this article, we shall be looking at the use of alternative risk products focusing mainly on the application and use of finite reinsurance.
What is Finite Reinsurance?
The word finite comes from a Latin word “finitum“which means “to limit”. When something is referred to as finite, then such a thing is limited in either size or number or even extent. Something that is finite is limited by set parameters or has a boundary or even an ending. for example, at the end of the month you earn a salary, the amount that you will earn is capped at a set amount and as such is finite. Natural resources such as oil and gas are finite because they have a definite end. When an insurance company takes on risk, it passes on this risk to another (The reinsurer). Traditionally, there would be an agreed structure/arrangement on how each individual risk is transferred. Basically what happens is that under that agreed arrangement, the cedant knows how much of its capital it is willing to put at stake for any single loss. This is the retention of the cedant. For risks that are greater than what it can retain, the cedant obtains reinsurance support through purchasing additional capacity. There is an arrangement in which the reinsurer can limit/cap his exposure to a maximum value- this arrangement is what is known as finite reinsurance.
In as much the cedant has reinsurance support, it is also weary of the fundamental risks that it is exposed to. Two of these fundamental risks that concern insurers are (i) underwriting risk and (ii) timing risk.
Underwriting Risk” is the risk of losses resulting from poor underwriting practices. Whereas;
Timing Risk on the other hand is simply the risk that the actual losses occur a lot faster than expected and the reserves set aside are not sufficient enough to meet these claims.
Both these risks in addition to others such as credit risk could have an effect on the profitability and solvency margin of the cedant.
(The Solvency margin is the ratio of assets of an insurance company exceed it’s liabilities)
If an insurer is paying more claims than the premiums it is writing then the profitability pf the insurer will be affected. In a similar way if it is paying out more claims than the premiums being written, then the premiums it would have invested to generate more assets, will be limited hence affecting it’s solvency margin. Even though the underwriting risk and timing risk are key elements of insurance risk, the cedant is more concerned about the timing risk. Consider the example below,
ABC insurance companies insurers various buildings within a given radius for flood insurance. It knows that with the change in the seasons as a result of climate change, it would most likely have a catastrophic flood claim within the next three years. Now If is to go through traditional reinsurance, it is likely that the cost will be significantly high with coverage restricted to only one year. ABC’s preferable option would be to set aside reserves its cash flows to meet the expected loss when it occurs. You should note however that ABC is not certain as to when exactly the event may happen. It could be sooner or later. This is what brings about the element of timing risk into the equation. If the event happens before the reserves have been built up to a substantial level to meet the loss, ABC would be in a dire position. To mitigate this, ABC can take up a finite reinsurance product to ensure that the company is able to finance the cost of losses from the flood when it occurs by spreading this cost over a period of time. This is what is referred to as risk financing.
Finite Reinsurance enables the cedant protect its bottom line by ceding those risks that have a significant element of timing risk to a reinsurer. The reinsures liability for the amount of risk that is transferred is capped at a maximum limit hence the term “finite”.
Finite Reinsurance contract involves two key elements. I.e. Risk financing and Risk Transfer. The contracts are multiyear contracts and usually run for between 3- 5 years. In determining the premium paid by the cedant for the risk transferred to the reinsurer, the investment income that would be earned by the cedant is incorporated in the pricing hence incorporating an element of the time value of money which is not there in traditional reinsurance. The premiums are paid over the period of the contract or upfront into what is known as an experience account. At the end of the contract, both the cedant and the reinsurer share in the end results of the arrangement whether positive or negative.
Finite Reinsurance can be classified under two main categories. These are; (a) (post loss funding)/Retrospective Finite Reinsurance and (b) (pre-loss funding)/Prospective Finite Reinsurance.
Retrospective Finite-Re looks at losses that occurred before the contract came into effect but have not been settled yet.
Its counterpart prospective reinsurance focuses on liabilities that are incurred and settled after the contract has come into effect.
Under the these two categories, we can find the four main types of finite reinsurance products; These are (i) The Financial Quota Share (ii) The Spread Loss cover (Carpenter cover) and (iii) Loss Portfolio Transfers (iv) the Adverse Development Cover.
Key features of Finite Reinsurance.
Some of the key features of finite reinsurance include the following;
In the subsequent articles to come, I will be looking at each of the finite reinsurance products in detail beginning with the finite Quota Share Reinsurance and Spread Loss Covers.