An Introduction To Reinsurance

Reinsurance
Fundamentals of risk management and

reinsurance in practice
Peter Liebwein
Version 20.04.2014
2 LP (Diploma); 3 ECTS (Master of Science)
© Peter Liebwein – Risk & Insurance – Reinsurance – Summer term 2014 Slide 1
Summary
 An overview over RISK-MANAGEMENT in insurance

companies will be presented. Here, REINSURANCE will
be derived as one of the options to mitigate insurance
risks.
 In context of reinsurance according proportional and
non-proportional TYPES OF REINSURANCE
TREATIES will be studied (inter aIia); some typical
PRICING APPROACHES will be analyzed for the
respective types of treaties.
 Finally, there is an introduction into ALTERNATIVE
RISK TRANSFER.
ORGANIZATIONAL ISSUES
Prob.density
This image cannot currently be display ed.
Loss
0.1 Disclaimer and copyright
To avoid any misunderstandings:

 This lecture and these documents are based on the
personal opinion of the trainer which in turn does not
necessarily coincide with the opinion of any third party.
 This lecture and these documents are intellectual
property of the author and are protected by copyright.
Unapproved disclosure to third parties violates this
copyright. If you want to pass these documents to third
parties, please contact the author in advance.
0.2 Overview
0.2.1 Structure
Alternative
risk transfer
Reinsurance programs
Proportional Nonproportional
reinsurance reinsurance
“Traditional” reinsurance
Fundamentals of risk management
0.2 Overview
0.2.2 Outline
1 Motivation 4 Alternative risk transfer
4.1 Basics and definitions
2 Risk management for insurers
4.2 Purpose and goals
4.3 Classification of types
4.4 Insurance linked bonds
2.3 Classification of risk management
4.5 Further examples
2.4 Risk management core process
2.5 Risk management service process
2.6 Types of risk mitigation options
Appendix
3 “Traditional” reinsurance
3.4 Techniques of proportional r/i
3.5 Pricing proportional r/i
3.6 Techniques of nonproportional r/i
3.7 Pricing nonproportional r/i
0.2 Overview
0.2.2 Schedule – 15+1 blocks (I)
Mon Wed Mon Thu Fri

28.04. 30.04. 05.05. 06.05. 07.05.
08:00
Risk R/I
management nonprop. ART
process techniques
10:00
R/I
Risk mitigation
nonprop.
option R/I Discussion
Introduction techniques
introduction regarding
12:00 motivation
and goals exam
01:00
Risk Recap R/I R/I
management risk proportional nonprop.
introduction management techniques pricing
03:00
Risk R/I R/I
management introduction proportional ART
process and goals pricing
05:00
0.2 Overview
0.2.2 Schedule – 13+1 blocks (II)
 Time (irrespective of schedule): To be defined.

 Rooms (scheduled*):
Ad *): As per 20.04.2014. For updates please see website:

http://www.inriver.bwl.uni-muenchen.de/studium/sommer_2014/masterveranstaltungen/reinsurance1/index.html
0.2 Overview
0.2.2 Schedule – 13+1 blocks (III)
 Rooms (scheduled*):
Ad *): https://maps.google.com/maps?q=Fritz-Erler-Stra%C3%9Fe+30,+Munich,+Germany&hl=en&ie=UTF8&ll=48.097811,11.647494
&spn=0.000029,0.021136&sll=41.052063,-73.639351&sspn=0.29308,0.676346&hnear=Fritz-Erler-Stra%C3%9Fe+30,+
Ramersdorf-Perlach+81737+M%C3%BCnchen,+Germany&t=m&z=16&layer=c&cbll=48.097811,11.647494
&panoid=_82UIHjUWm9drhpl76MnFA&cbp=12,294.05,,0,0
0.3 Mandatory literature
0.3.1 Risk management
 Casualty Actuarial Society Enterprise Risk Management

Committee: Overview over Enterprise Risk
Management, May 2003, S. 1-26
(http://www.casact.org/research/erm/overview.pdf)
 Liebwein, Peter: Risk Models for Capital Adequacy:
Applications in the Context of Solvency II and Beyond,
in: The Geneva Papers, 2006, 31, (528–550)
0.3 Mandatory literature
0.3.2 Reinsurance
 Swiss Re:
Introduction into reinsurance, 7th edition, Zurich 2002
(English and German)
 Swiss Re:
Securitization: New opportunities for insurers and
investors, sigma 7/2006 (English and German)
0.4 Methodology
0.4.1 Learning goals
Get a deeper understanding of:

 Fundamentals of risk management
– Notion of risk and risk management process
 Purpose, techniques, and price of “traditional” r/i
– Proportional reinsurance
– Non-proportional reinsurance
 Purpose and techniques of “modern” r/i
– To some extent: Alternative risk transfer
0.4 Methodology
0.4.2 “Negative” specifications
Out of scope are:

 Aspects of risk theory and decision theory
– See “Risk and Insurance”
 Managerial aspects of a r/i company
– See standard business administrations
 Aspects of reinsurance accounting
– See “general” accounting (e.g. Prof. Ballwieser)
– See “insurance accounting “ (e.g. Rockel; Ott)
0.4 Methodology
0.4.3 Language issues
 “Broken English spoken perfectly.”

 This lecture is held in English by a non-native speaker
to (usually) non-native speakers
 The reasons are two-fold
– Most technical terms are in English anyway
– Internationalization and globalization of human
capital point at the pure necessity of knowing several
foreign languages – in addition to technical
competence
 In this lecture, our goal is to drop “shyness”, to allow for
mistakes, and to unconsciously improve…
CHAPTER 1:
Motivation
Alternative
risk transfer
1.1 Some loss events
1.1.1 Examples (I)
History’s most costly natural History’s biggest man made

catastrophe: A satellite picture catastrophe: The terrorism attacks
of Hurricane Katrina, which on Sep-11-2001 caused a loss
caused losses of USD 80.4 of USD 25.7 billion.
billion in 2005.
Losses in USD as indexed to 2013; source: sigma 1/2014, p. 43.
http://www.hurricanekatrina.com/images/hurricane-katrina-category-5.jpg
http://www.drjudywood.com/articles/why/whypics/18_wtc1heli.jpg
1.1.1 Examples (II)
Product liability Developments of capital markets
1.1.1 Examples (III)
Death Life/health
1.1.1 Examples (IV)
Financial markets turmoil … and our measures
http://blogperso.univ-rennes1.fr/arthur.charpentier/public/perso/finance.JPG
http://sahajapower.files.wordpress.com/2008/04/confidence1.jpg
1.1.2 Facts and figures (I)
 The 15 most expensive insured losses 1970-2013*
 A single loss can trigger the default/ruin case

Ad *): Losses in million USD 2013. Without liability and life; source: sigma 1/2014, p. 43. Sandy incl. flood losses (NFIP).
1.1.2 Facts and figures (II)
 Development of insured losses 1970-2013*
Ad *): Losses in million USD 2013. Without liability and life; source: sigma 1/2014, p. 5.
1.1.3 Loss filtering
 Loss analyses requires understanding of several layers
not: losses excluded

reinsured losses by reinsurance
not: losses not

insured losses
insured / “public/state”
not: unemployment or
financial losses e.g. morbidity
not: loss to “moral”

loss to economy
values
e.g. Tsunami
reality (“perils” and “values”)
increase of values
1.2 Risk management stakeholders
 Insured as stakeholder
– Competition leads to a market with buyers’ power
– Supervision: Meet liabilities sustainable
 Owner as stakeholder (stock company or mutual)
– Increasing the value of the firm
– Minimizing the risk of negative results
 Government as stakeholder
– Taxation issues
– Supervision: Solvency
Blank slide
CHAPTER 2:
Risk management for insurers
Alternative
risk transfer
2.1.1 “Finality”
 Definition
– Target: Statement of a wanted condition or state*
– Target system: Targets and their relations
– Target dimensions: content
• Target content
• Target extent target
• Time dimension
extent time
 Example: At least (!)
12% RoE for next year
Ad *): As a result of a decision.
2.1.2 Risk (I)
 Lack of information what/

whether
content
– Deficit of information
– Here: Regarding (at least) info‘
one target dimension deficit
target
 Definition of risk How much when
extent time
– Lack of information
with respect to achieving targets
(i.e. a potential deviation of targets)
 Examples
– Is the target achieved or not, and if so when or to
what extent?
2.1.2 Risk (II)
 Didactical counter examples

– Lack of uncertainty
– Lack of “relevancy” for target
 Key characteristics
– Depending on target
– Depending on individuals, e.g. due to perception
2.1.3 Risk cause/effect (risk map)
 Cause/effect relations of drivers and target variables

natural
drivers C11
C12 transformation target system
C21 areas
...
technical C22 C1j E11
target deviation
objective
...
economic
subject*
drivers C2k E21
E12 ... Ez
...
C31
...
drivers E2r
related to C32 C41 E1p
...
subjects
C3l C42
...
Social and C4m

economic drivers Ad*): Including implemented risk mitigation options.
2.2.1 Steering the risk position (I)
 Risk management – inter alia – has the task to

mitigate/change the “target distributions” and their
parameters by coordinated implementation of risk
mitigation options
 Steering the risk position depends on e.g.:
– Target deviations (“failures”) become less and less
probable
– Expected number of failures become less probable
– Expected severity of deviations become smaller
– Expected total target deviation become smaller
2.2.1 Steering the risk position (II)
 Target distributions quantify the presented notion of risk

– “x-axis”: Target variable (and extent)
– “y-axis”: Probability distribution to model uncertainty
 Target distributions
– Number/frequency of target deviations
– Severity of target deviations
– Total target deviation
2.2.1 Steering the risk position (III)
 Simplified model for risk position
severity risk
position 4
risk
risk
position 1
position 3
risk
position 2
frequency
 Why could position 4 be beneficial?
2.2.1 Steering the risk position (IV)
 Another model for risk position (see section 3*):

“downside”
uncertainty measure Discuss:
How to compare
these two?
“better”:
Same return with lower risk
“better”:
Same risk with higher return
“upside”
return measure
 Remember Markowitz…
2.2.2 Steering implemented options
 Risk management – inter alia – has the task to

mitigate/change the “target distributions” and their
parameters by coordinated implementation of risk
mitigation options
 Steering of the implemented options
– Continuously and rolling forward
• Plan risk mitigation options
(see decision theory)
• Implement risk mitigation options
• Check effectiveness of risk mitigation options and
their implementation
2.3 Classification
2.3.1 Degree of integration
 Partial risk management

– Restrict to some driving variables
(e.g. technical issues, jurisdiction (lobbying))
– Restrict to some transformation areas
(e.g. sales, investments)
– Restrict to some targets
(e.g. underwriting targets, corporate result)
 Total risk management (integrated, holistic,…)
– All drivers, transformation areas, and targets
– Respecting all inter-dependencies
2.3 Classification
2.3.2 Organization (I)
 Risk management system

– Elements: Risk management positions/functions
– Relations:
• Between risk management positions/functions
• Risk management process
• Inter-dependencies to “remaining” organization
2.3 Classification
2.3.2 Organization (II)
 Set up
– Distribution of jobs and powers (risk management
positions)
– Rights to order and to decide, degree of participation
and centralization
– Inter-dependency to “remaining” positions/functions
 Processes
– Risk management process
– Inter-dependency of risk management processes
and “remaining” processes
2.3 Classification
2.3.3 Risk management sub-process
 Risk management process and sub processes
Risk management core process

interactions
Risk management service process
 Risk management core process:*

Target focused steering of the risk position
 Risk management service/supportive process:**
Coordinating and steering of the core process
Ad *): “Primary” activities.
Ad **): “Secondary” / “supportive” activities.
2.4.1 Identify
 Structure and identify transformation areas

– e.g. underwriting / sales / investments / reinsurance
 Structure and identify driving factors
– e.g. internal / external (natural/technical/…)
 Identify inter-dependencies
– identify mutual relations (e.g. correlations)
– identify cause/effect-relations
 Outcome: (Almost) target independent cause/effect map
2.4.2 Measure/quantify
 Measure/quantify driving factors

– e.g. stochastic loss model or capital markets model
 Measure/quantify inter-dependencies
– measure correlations and measure cause/effect-
relations
 Measure/quantify transformation areas
– e.g. stochastic underwriting model or stochastic
investment model
 Outcome: Measured/quantified target independent
cause/effect map
2.4.3 Evaluate*
 Connect sub-targets and transformation areas

– Measure/quantify cause/effect-relations
 Evaluate (and filter) transformation areas
– e.g. can underwriting cause deviation from targets?
– focus on “most dangerous” transformation areas
 Evaluate (and filter) driving factors
– e.g. can inflation cause deviation from targets?
– focus on “most dangerous” driving factors
 Outcome: Measured risk** map (risk cause/effect map)
Ad *): Implicit prerequisite: Target system is identified and measured/quantified.
Ad **): Remember the notion of risk with its dependency on the targets (and possible deviations).
2.4.4 Implement risk mitigation (I)
 Identify risk mitigation options

 Analyze risk mitigation options i.e. core process as before
including risk mitigation options
 Evaluate risk mitigation options
 Select (mix of) risk mitigation options
 Implement (mix of) risk mitigation options
 Outcome
– Measured risk** map (risk cause/effect map)
including implemented risk mitigation options
– Ideal case: Risk position aligned with targets
2.4.4 Implement risk mitigation (II)
 Theoretical support: Decision theory

 Decision matrix*
target k1 target k2 evaluation

(risk
preference)
option a1 evaluated evaluated Φ(a1)
result result
X11=g(a1;k1) X12=g(a1;k2)
option a2 evaluated evaluated Φ(a2)
result result
X21=g(a2;k1) X22=g(a2;k2)
Ad *): Occasionally the matrix is set up with only one target and more discrete conditions with their occurrence probability.
2.4.4 Implement risk mitigation (III)
 Practical examples (see section 3*):

– Return on risk adjusted capital:
expected result
> hurdle rate
required risk capital
– Economic value added:
expected result before capital cost – capital cost > 0
 In general: Risk preference and risk preference

functional needs to be defined and understood
Ad *): Occasionally the matrix is set up with only one target and more discrete conditions with their occurrence probability.
2.5 Risk management
service process
 Steering and coordinating the core process

– Define of responsibilities
– (Continuously) communicate and document
– (Continuously) steer, control, and check core
process
 Interaction points of service process
– At all process steps of the core process
– At all partial results of the core process (especially
checks of the risk position and the risk mitigation
options and their implementation)
2.6.1 Risk avoidance
 Definition
– Options which avoid the “materializing of a risk”
– Deviation from targets are excluded ex ante
– Total risk avoidance versus partial risk avoidance
 Examples regarding insurance risk
– Restrictive underwriting policy
– Principle based / case related risk selection
– Underwriting related product design (e.g. nuclear
exclusion clauses)
2.6.2 Risk sharing and risk transfer
 Definition
– Split risks and jointly take/accept risks
– (Partially) Transfer the risk to other individuals
– Transfer to insured (e.g. deductibles or retentions)
– Transfer to other insurance companies
(e.g. co-insurance and reinsurance)
– Transfer to capital markets (e.g. ART)
2.6.3 Risk diversification
 Definition (risk diversification, risk compensation)

– Compensate loss potentials with potential profitable
counter potentials (also for other targets than profit)
– Resulting diversification is ideally disjoint,
respectively independent / uncorrelated
– Diversification with respect to insurance products,
lines of business, client segments, sales channels,
regions, ...
– Example: Munich RE versus Swiss Re (group)
2.6.4 Risk “equalization”
 Remark
– In general: Risk “equalization” risk compensation
– Specific role in an insurance company
 Definition (Albrecht modified)
– The aggregated risk premium increases only
digressively with increasing number of insured
entities or number of insurance periods (with
unchanged safety probability)
– Equalization with large number and/or over time
2.6.5 Risk reserve creation
 Definition
– Pooling of safety elements with high liquidity, which
are used (only) in case of target deviations
– Financial versus non-financial risk reserves
– External versus internal risk reserves
– Individual versus collective/group risk reserves
– R/I as external financial risk reserve generator
– Equity, hidden reserves, to some extent equalization
provision (Germany, Austria,… in local GAAP)
2.6.6 Target revision
 Remark
– Risk: Lack of information regarding target achieving
– Risk avoidance “negates” targets set
 Definition
– Target dimensions unchanged, preferences “relax”
– Additionally: Risk preference/appetite “relaxes”
 Examples
– Reduce targeted level or timing level
– Increase “risk appetite”
2.6.7 Risk acceptance
 Definition
– The risk position is accepted
– No risk mitigation option shall be implemented
 "Do nothing"
 Examples
– …
CHAPTER 3:
Alternative
risk transfer
CHAPTER 3:
Alternative
risk transfer
3.1.1 Definitions
 Kiln: What is reinsurance? Insuring insurers.

 German Seehandelsrecht (§ 779 Abs. 1 HGB): R/I is
the insurance of the risks/perils taken over by insurers
 EU directive (Art. 2(1)a 2005/68/EC): Taking over risks
which are transferred from a (re-) insurer
 Mack: Partially replacing uncertain loss cost by fix cost
 Economics: Production factor of an insurer which is – as
a product component – built in into the product
“insurance protection”
3.1.2 A single risk transfer (I)
 Insurer and reinsurer as demander and supplier:

insurer reinsurer
insurance insurance
company company
demander r/i product supplier

reinsured party r/i protection reinsuring party
outgoing/outwards r/i r/i incoming/inwards r/i
cedent cession cessionnaire
risk cedent risk transfer risk taker
 R/I broker as intermediary party

Ad *): Latin origin is “cedere”. Some literature and practitioners denote “cedant” which is simply wrong.
3.1.2 A single risk transfer (II)
 Classifying risk transfer
retention
retention
insurer insurer
reinsurance
co-insurance
insured insurance pools
alternative risk transfer
capital
insurer
markets
3.1.2 A single risk transfer (III)
 Splitting r/i contracts:

reinsurer
(primary)
reinsurer
insurer
risk splitting reinsurer
 One treaty is placed with several reinsurers

 same as co-insurance between (primary) insurers
3.1.3 Network of risk transfers
Building up portfolios global atomizing
r/i r/i r/i r/i r/i
insurer insurer insurer insurer insurer
insureds insureds insureds insured
“straight forward” transfer direction additional transfer direction
3.1.4 Professional r/i companies (I)
 Ranking 2011/12 (written net premium in million US-$)
Source: http://www.iii.org/commerciallines/rankings/ Rankings for 2013 are not yet available.

3.1.4 Professional r/i companies (II)
 Market shares and their development
Source: J.P. Morgan: European insurance: Solvency II: A potential game changer, in: Europe equity research, 19.01.2010, p. 49.
3.1.4 Professional r/i companies (III)
 For comparison purposes: Ranking 2012 of insurers
Source: http://www.iii.org/commerciallines/rankings/ Rankings for 2013 are not yet available.

3.2.1 Overview (I)
 Targets with taking reinsurance to support achieving all

corporate targets
meet demand
reinsurance
profit growth
target relations
safety
 R/I shows effects to the
entire target system of the insurer
 Buying r/i is motivated by various targets
3.2.1 Overview (II)
 Classifying targets when taking reinsurance
services
underwriting financial statements
target relations
further targets
3.2.2 Underwriting and safety
 Reduce and mitigate insurance risk

– Transfer of insurance risk is most important target
– Protection against large losses and catastrophes
 Support original tariff calculation (service)
– Information about tariff variables is key
– Reinsurer can provide information and support
 Increase underwriting capacity
– Capital strength and know how are limited
– R/I can take over peak risks and provide services
3.2.3 Financial statements (I)
 Stabilize performance of business

– Randomness of total loss leads to fluctuations in
results
– Reinsurance (partially) replaces uncertain losses
with fixed r/i cost
– R/I stabilizes the underwriting result
 Protect elements derived
– Protect returns, dividends, etc.
– Protect key financial indicators (e.g. loss ratio)
3.2.3 Financial statements (II)
 Thought experiment: Where would you invest?

price green dotted
return insurance company
profit
…
blue solid
insurance company
time
3.2.4 Further goals (I)
 Regulatory requirements
– Should guarantee policyholder protection (insurer
must meet their obligations)
– Capital requirements depending on risk position
– R/I is key regarding insurance risk; is always taken
into account
 R/I replaces capital (requirement)
– Approximation P&C: Equity / net premiums x%
(see workshop and discussion!)
– R/I reduces risks (net premiums) and thus capital
requirements
3.2.4 Further goals (II)
 “Financial aspects”
– Increased investment demand, e.g.
• New entity, new line of business, new region
• Acquisition cost (especially life insurance)
• Growth periods (see solvency requirements)
• Extraordinary loss development
– R/I can support significantly
– Note: Requirements regarding minimal transfer of
insurance risks have to be met
3.2.4 Further goals (III)
 “Equalizing aspects”
– International accounting standards (IAS/IFRS, US
GAAP) do not feature equalization provisions
– R/I is one of the remaining possibilities to smooth
results (equalization in time)
– Note: Requirements regarding appropriate
disclosure in financial statements have to be met
 Further perspectives
– Rating and financial analysts
– Risk management and capital cost
3.2.4 Reinsurance services
 Some examples: Consulting and supporting of

– Actuarial tasks
– Assessment and underwriting of special risks
– ´Loss research, loss prevention, loss handling
– Information regarding new markets / products
– Training of cedent’s employees
– Aspects not related underwriting (e.g. investments)
 Reinsurers can go much further than “just” providing
capacity (where to be is a strategic positioning)
3.2.5 Empirical field studies (I)
 Answers from 1 (not at all) to 5 (very much) for the goal

weights (multiple choices allowed)
Analyzed goals m s m s trend
1979 1979 1991 1991
Reduce insurance risk 4,22 1,19 4,62 0,48 +
Take over periodic extra losses 3,2 1,49 3,73 1,24 +
Increase underwriting capacity 3,58 1,41 3,51 1,13 -
Achieve a positive underwriting result 3,4 1,2 3,49 1,13 +
Transfer expected losses (negative results) 2,89 1,05 3,38 1,15 +
Maintain personal and technical relationships 3,31 1,26 3,19 1,09 -
Use services of reinsurer 2,36 1,09 3,16 1,08 +
Reduce net expenses 3,09 1,35 2,92 1,22 -
Increase ratio 'equity / net premium' 2,62 1,21 2,89 0,98 +
Meet solvency requirements 2,09 1,16 2,62 1,15 +
Meet insurance group goals 2,4 1,41 2,51 1,15 +
Avoid liquidity shortfalls 2,09 1,13 2,46 1 +
Get reprocity business 2,26 1,36 1,54 0,98 -
Total 2,54 3,07 ++
 More modern: Management of earnings volatility

(risk management)
3.2.5 Empirical field studies (II)
 German non-life premiums in million EUR
Source: J.P. Morgan: European insurance: Solvency II: A potential game changer, in: Europe equity research, 19.01.2010, p. 53.
Data source 2007.
3.3.1 Types like “original” (I)
 Cause/effect model of losses / deviations (risk map)

natural
drivers C11
C12 transformation target system
C21 areas
...
technical C22 C1j E11
target deviation
objective
...
economic
subject*
drivers C2k E21
E12 ... Ez
...
C31
...
drivers E2r
related to C32 C41 E1p
...
subjects
C3l C42
...
Social and C4m

economic drivers Ad*): Including implemented risk mitigation options.
3.3.1 Types like “original” (II)
 Insured peril, e.g.

– Earthquake, flood, storm, hail, fire, …
 Insured object or subject or insured interest, e.g.
– Building contents, industrial business, life, death, …
– Liability, legal protection, …
 Insured loss / insured compensation, e.g.
– Compensating of losses (financial; also: “natural”)
– Compensating defined sums
3.3.2 Type of agreements (I)
 Individual insured entities
 Collectives/groups of insureds
3.3.2 Type of agreements (II)
 Obligatory reinsurance (“treaty” reinsurance)

– Reference to total underwriting collectives
– Mandatory cession of insurer and mandatory
acceptance of reinsurer
 Facultative reinsurance
– Reference to individual single insured entities
– Free decision of insurer to cede and free decision of
reinsurer to accept
 Combinations (facultative/obligatory r/i)
3.3.3 “Technical” types (I)
 Proportional r/i
– R individual loss (also: Premium) of a insured entity
– Split of R into:
• (1-c) · R for account of insurer
• c·R for account of the reinsurer
– The split of obligations is key under proportional r/i
3.3.3 “Technical” types (II)
 Nonproportional r/i
– X large loss, event loss, annual total loss
– Split of X into:
• min(X;a) for account of the insurer
• max(X-a;0) for account of the reinsurer
– The split of losses for defined losses is key under
nonproportional r/i
 Combinations: In principle, proportional r/i is applied
before nonproportional r/i
Blank slide
CHAPTER 3:
Alternative
risk transfer
3.4 Techniques proportional r/i
3.4.1 Characteristics (I)
 Risk transfer per insured entity

 Risk transfer by split in a certain relation (proportion)
 Obligation of an insured entity is spilt according to sum
insured (or PML*) between insurer and reinsurer
 This split of obligations (“cession rate”) determines the
entire handling of proportional reinsurance:
– Split of premiums
– Split of partial and total losses
Ad *): PML abreviates Possible or Probable Maximum Loss. For sake of simplicity, the following paragraphs focus on sum insured.
3.4.1 Characteristics (II)
 Two basic techniques

– quota share
– surplus reinsurance
– combination (both ways)
 Ultimate target of the technique is to determine the split
of obligations per insured entity
3.4.2 Quota share (I)
 In principle, r/i participates at all insured entities with a

fixed rate (“quota share”), the “cession rate”
 Retention of insurer is a percent of the sum insured
limit
r/i
insurer
sum insured
sum insured
portfolio portfolio after quota share

3.4.2 Quota share (II)
 Simple administration
 Reducing obligations in absolute terms
 Protecting against changes or errors regarding loss
distributions
 Participating at relative stable small and medium sized
business
 Contingent protecting against random risk effects
 No equalizing the retained portfolio in terms of sum
insured
 In principle, no table of retentions possible
3.4.3 Surplus (I)
 Reinsurer participates at insured entities which

obligation exceeds the retention (“line”) of the insured
 R/I obligation is defined by a number of lines
Limit
r/i
insurer
sum insured
sum insured
line (retention)
portfolio portfolio after surplus

3.4.3 Surplus (II)
 Increasing underwriting capacity

 Equalizing retained portfolio in terms of sum insured
 Potentially protecting against large losses [rationale!]
 Additional table of retentions is possible
 Only contingent protecting against changes in “retail
business”
 Only contingent protecting against accumulation
 More complex administration relative to quota share
 R/I results subject to (significant) higher fluctuations
3.4.3 Surplus (III)
 “Layering” of surplus treaties

Limit
2nd surplus
sum insured
sum insured
Limit
1st surplus
line (retention)
portfolio portfolio after surplus

 Agreements (e.g. commission) per layer possible
 Only a few insured entities endow higher layers
(additionally: Observations on premium level)
3.4.4 Combination (I)
 Combination with surplus first (“gross surplus”)
Limit
sum insured
sum insured
line (ret.) line (retention)
portfolio after gross surplus portfolio after net quota share

 Application e.g. subsidizing quota share
3.4.4 Combination (II)
 Combination with quota share first (“gross quota share”)
Limit
sum insured
sum insured
line (retention)
portfolio after gross quota share portfolio after net surplus
 Application e.g. “forced quota share” in regulated

countries
3.5.1 Excursion: Pricing/costing (I)
 Have a guess about producer’s cost and market price…
Apple’s i-pad
http://i.i.com.com/cnwk.1d/i/tim/2011/10/18/ipad-mini-300x300.jpg
3.5.1 Excursion: Pricing/costing (II)
 Have a guess about producer’s cost and market price…
Nescafe’s Nespresso (machine and pads)

http://www1.nespresso.com/precom/goodies/wallpapers/nespresso12801024.jpg
http://www.coolhunting.com/images/Nespresso%20Romeo%20-%201.jpg
http://www.seancasey.org/wp-content/uploads/2008/10/nespresso_gc1.jpg
3.5.1 Excursion: Pricing/costing (III)
 What would you be prepared to pay for…
almost new vessel
http://www.freefoto.com/images/9906/09/9906_09_7---Tanker-vessel_web.jpg
3.5.1 Excursion: Pricing/costing (IV)
 In theory:
– Result from costing: We know what reinsurer’s costs
are to “produce” this certain r/i product.
– The price for this product is what the reinsurer and
the insurer agree upon. The determinants are e.g.:
• Market context: A “function” of demand/supply for
r/i capacity and transferred (insurance) risks.
• Individual cost versus benefit: Insurer’s “balance”
of the product’s cost (for the insurer the price is
the cost) and the product’s benefits.
 In practice: Costing/pricing is mingled and called pricing
3.5.2 Part of original premium
 Participating of r/i expenses
– Proportional split of
original premium funding part
– Split according to split of

obligations (proportional r/i) fluctuation
– Key component of r/i price
 As if system net risk
– Premium which insurer is
entitled to get
insurer reinsurer
– No transfer of operational risks according to prop. split
3.5.3 Reinsurance commission (I)
 Compensation from r/i to insurer

 Expressed in percent r/i premiums
 Different rationales
– Expense structure
(“re-funding expenses”)
– Sales argument
(“only“ price steering
component for r/i)
– Risk theory (“fair split”)
insurer reinsurer
– Price calculation of r/i
3.5.3 Reinsurance commission (II)
 Simplified* result of reinsurer:

+ r/i premium (“follow the actions”)
− r/i losses (“follow the fortunes”)
− expenses of reinsurer (production factor human capital)
− capital cost of reinsurer (production factor capital)
− r/i commission (remainder)
 R/I commission to steer the r/i result
 Idea:
– Good r/i business  high commission
– Volatile r/i business  low commission
Ad *): Without further price components and without anticipated investment income.
3.5.3 Reinsurance commission (III)
 Fix commission
– Fix height of r/i commission rate
– Simplicity versus in-flexibility
– Loss development without direct price impact
 Sliding commission (rare)
– Attaching commission to r/i result development
– Attaching to loss ratio (or combined ratio)
– Advantage for insurer and reinsurer (e.g. moral
hazard and bridging loss perception gaps)
3.5.4 Further price components
 Profit commission
– Additional ex-post compensation by reinsurer
– Prerequisites: Agreement and “r/i profit”
– Advantage for insurer and reinsurer (e.g. moral
hazard and bridging loss perception gaps)
 Loss participation
– Additional ex-post price component by insurer
– Prerequisites: Agreement and loss ratio (or
combined ratio) above a certain threshold
Blank slide
CHAPTER 3:
Alternative
risk transfer
3.6 Techniques nonproportional r/i
 It’s reasonable to view the portfolio as a “loss generator”

and to forget which individual insured entity produced
the losses. (translated from Mack)
 No ceding of proportional obligations regarding insured
entities
 Splitting and transferring of certain losses
compensations of the insurer
 Limiting of r/i coverage per loss, per event, per year
 “Three” basic techniques of nonproportional r/i

– per risk excess of loss
– per event excess of loss
– stop loss
– Combinations (usually “prop before NP” and NP like
denoted)
 Ultimate target of the technique is to determine the split
of the losses in scope between insurer and reinsurer
3.6.1 Characteristics (III)
 Theoretical “labeling”
loss definition occurrence probability or height of deductible
working XL cat XL
per risk
excess of loss
per event
excess of loss
stop loss
 “Labeling” in practice
3.6.1 Characteristics (IV)
 Splitting the losses always follows the same principle

– R/I is liable for loss exceeding a certain “deductible”
– R/I is liable at a max for the maximum “loss cover”
 Expressing the nonproportional technique
– R/I loss cover “in excess of” deductible
– R/I cover “in excess of” deductible
– R/I cover “xs” deductible
– Example: 1.000.000 xs 500.000
3.6.2 Per risk excess of loss (I)
 Definition of loss: Single (large) loss

 Applies to single losses per maximum proportional
retention
insured entity (“per risk”) = loss potential
 R/I cover limits: capacity

exemplary loss of an
– per single loss insured entity
(capacity)
loss severity
– maybe per year
– maybe per event deductible
split of losses under a working XL

exemplary loss insurer r/i
3.6.2 Per risk excess of loss (II)
 Reducing the large loss burden

 Retaining small and medium sized losses
 Equalizing out loss burden in retention
 R/I result displays significant higher fluctuations
 Only contingent protecting against accumulations
 If loss distributions change, only contingent protection
(in case above deductible, in this case reinsurer is liable
to full extent up to his cover limit)
3.6.2 Per risk excess of loss (III)
 “Time-wise and severity-wise” layering of XLs*
layered r/i program
3rd layer
loss severity
“flipped” probability density of

2nd layer
of loss severity distribution
1st layer ”time-wise”

deductible reinstatements
respectively density of
 Lower layers: Working XLs; loss severity distributions
upper layers: Cat XLs

Ad *): Per risk XLs and per event XLs; stop loss only severity layerings.
3.6.3 Per event excess of loss (I)
 Definition of loss: Event loss or accumulation loss

 Applies in case of loss events affecting more insured
entities at the same capacity
time (accumulation) event loss maximum proportional
retention in retention
 Definition of an = loss potential
event is key!
loss severity deductible
 R/I cover limits: exemplary losses of
2 insured entities
– per event (trivial)

– maybe per year
Price versus cover:
„The lack of cover when the ultimate happens
may ruin you; the higher deductible is unlikely split of losses under a cat-XL
to do so.“ (Kiln p. 196) exemplary loss insurer r/i
3.6.3 Per event excess of loss (II)
 Definition of events
– Any definition is possible
(as long as it tries to be sufficiently clear)
 Three main criteria
– “Logics” / reason / cause
– Spatial dimension
– Time dimension
3.6.3 Per event excess of loss (III)
 Effectively protecting against accumulation or events

 Protecting over more lines of business possible
 R/I result displays significant higher fluctuations;
therefore it is important
– to equalize over time
– to diversify e.g. over regions
 Only contingent protecting against changes in loss
distributions
 Determining the exposure, appropriate deductible and
capacity is not trivial
3.6.4 Stop loss (I)
 Definition of loss: Relative (annual) total loss

 Expressing deductible and
cover in relative terms; capacity
relative to business volume*
relative severity of loss

example of a relative
 Deductible to be exceeded loss burden of a year
in negative result cases

 Optimal? (Rationale in
literature is “questionable”
deductible
in some points)
split of annual loss under stop loss

exemplary loss insurer r/i
Ad *): Usually earned premium net of all inuring reinsurance.
3.6.4 Stop loss (II)
 Protecting against the total range of insurance risk (if

effects are exceeding the deductible)
 Deductible could potentially be exceeded also in case of
– Withdrawing/changing inuring r/i
– Deteriorating premium levels in original tariffs
 Limiting moral hazard, e.g.
– Applying for flood, hail, storm etc. only
– Combining with other r/i covers
– Introducing loss participations
3.7.1 Similarities to insurance pricing
Original premium r/i premium (rate)
loading for • Loadings

expense and profit
loading “rate”
[life and health:
funding premium
(dependent on time)]
fluctuation loading
• net risk premium rate
safety loading relative expected loss
capital cost
• Total: (gross) premium rate,

net risk premium so called “rate”
(expected losses) (relative to protected premium
volume)
3.7.2 Rating approaches (I)
 Calculating the expected loss of a r/i layer

– Burning cost: Based on loss experience
– Extrapolation: Based on distribution assumption also
– “Pure” model: Based almost only on assumptions
– Exposure rating: Based on split of portfolio
– Pay back: Based on loss frequency (return periods)
 Calculating the expected loss is called “rating”
3.7.2 Rating approaches (II)
 Expected loss depends on business volume (“size of

the protected portfolio”)
 Measuring usually with protected premium volume
expected loss to layer

 Relative expected loss =
protected premium volume
(“burning cost / risk rate“)
 Protected premium volume:

Usually earned premium income after deduction of all
inuring r/i, especially proportional r/i
3.7.3 Burning cost rating
 Example: Burning cost rating for per risk XL

100.000 xs 50.000
year net premiums net losses loss to layer total burning cost
01 1.000.000 30.000 0
80.000 30.000
100.000 50.000 80.000 8%
02 1.000.000 40.000 0
200.000 100.000 100.000 10%
03 1.000.000 60.000 10.000
60.000 10.000 20.000 2%
trending
04 1.000.000 110.000 60.000
130.000 80.000 140.000 14%
05 2.000.000 60.000 10.000 or
80.000 30.000
90.000 40.000
110.000 60.000 total
130.000 80.000
170.000 100.000 320.000 16% calculation
total 6.000.000 660.000 11%
3.7.4 Extrapolation rating
 Loss experience is one of the starting points, and

 Assumption regarding loss distribution to extrapolate
rel. occurrence
layer 1 layer 2
density
loss
3.7.5 Model based rating
 Assumption or partial models* for loss frequency and

loss severity distributions
rel. occurrence
layer
extreme case: E.g. only one loss event
as experience
• Assumption for frequency (number of losses)
density
• Assumption for severity (loss severity)
Ad *): Model based rating is applied often for natural catastrophe covers.
loss
The according partial models are empirically validated in many cases.
3.7.6 Exposure rating (I)
 Based on the characteristics (i.e. split) of the portfolio

 Split of the (risk adjusted) net risk premium:
ind I (30.000), ind II (20.000), comm I (25.000), ...
“1–exposure curve“ (or negotiation) Estimating the expected loss
200
180
capacity to layer:
• Ind I: 30% of 30.000
30%
10%
10%
160
loss potential
140
of future layer • Ind II: 10% of 20.000
120
• Comm I: 10% of 25.000
sum insured
100
deductible
80 • Total: 13.500
60
40 Relative expected loss
20
• Relative to protected premium
ind I ind II comm I comm II private others. volume (“as always”)
3.7.6 Exposure rating (II)
 Background: Exposure curves

(in % of total expected loss burden)
height of expected loss burden
below the deductible
height of deductible
(in % of sum insured)
Source. Swiss Re (editor) Exposure rating, Zurich 2004, p. 26

Developed to analyze retentions (deductibles) of original insureds.
3.7.7 Pay back rating (I)
 Applying as rating method

– Experiences, statistics, meteorological, geologic, or
other models retrieve expected return periods
– Question: “Within what period shall a r/i total loss* be
“paid back” by r/i premium?“
– Expected loss in amount
r/i cover
expected return period (in years)
Ad *): The most simple version focuses on r/i total losses.
3.7.7 Pay back rating (II)
 Applying as plausi-check of r/i price
– Return period
r/i cover
r/i premium in amount (with or w/o loading)
 Applying as rating methodology is possible if partial

losses are integrated as well (e.g. earthquake with
different intensities)
3.7.8 Loadings
 Determining further loadings/discounts

– Fluctuation or safety loading
– Loading for expenses and capital cost
– Maybe discount for anticipated investment income
– Maybe discount for cover limitations (reinstatements,
annual limits, etc.
– Loading for profit (usually greater than zero)
 In practice there are different “premium principles”
(however the loading as such, i.e. in amount, is key)
3.7.9 Further price components (I)
 Types of r/i premium

– Fixed amount
– Fixed rate
– Sliding rate (“sliding scale”*)
 (Excess) loss participation*
 Reinstatement premium (charged reinforcement of
“exhausted” r/i cover)
 Rare: Profit commission or no claims boni
Ad *): See short remarks on the following slide.
3.7.9 Further price components (II)
 Sliding scale
– R/I premium rate according to realized burning cost
– Reducing the forecast problem regarding the loss
burden to r/i layer
– Reducing moral hazard; bridging loss perception gap
 (Excess) loss participation
– Insurer participates at every excess loss to layer
(e.g. 5-10%)
– Reducing moral hazard; bridging loss perception gap
CHAPTER 3*:
Alternative
risk transfer
3* Excursion: R/I programs
3*.1 Types of agreements
 Reminder
– Obligatory r/i: mandatory cession and acceptance
– Facultative r/i: freedom to cede and to accept
 Combinations
– Fac/obl exist rarely; obl/fac do not exist in practice
– Any combinations possible:
• Portfolios of “regular” risks with obligatory r/i
• Single “special” risks with facultative r/i
3*.2 “Technical” types
 Combinations
– Principle 1: Proportional r/i before nonproportional r/i
– Principle 2: Per event XL after per risk XL
– Principle 3: Stop loss applying as last r/i technique
– With these principles any* combinations possible
– Examples: Quota share before nonproportional r/i,
per event XL after per risk XL
 Note
– The combination of risk mitigation options allows for
optimal, i.e. target consistent, risk management
Ad *): There are 39(!) combinations of the basic r/i techniques.
3*.3 Evaluating and optimizing (I)
 R/I changes result position and risk position

(see section 2.2.1)
return measure
How to compare
these two?
more return
“better”:
Same risk with higher return
“better”:
Same return with lower risk
risk measure
more risk
3*.3 Evaluating and optimizing (II)
 Cost and benefit of r/i

– Cost: Expected “loading“ for the reinsurer
– Benefit: Risk transfer – e.g. risk capital reduction
 Exemplary preference functionals (see section 2.4.4)
– “Relative” measure: Risk adjusted return
expected result expected result
RoRAC := =
risk adjusted capital RAC
– “Absolute” measure: Economic value added (EVA*)

EVA : expected result  cost of capital 
 expected result    RAC
Ad *): EVA is a Stern Stewart trademark.
3*.3 Evaluating and optimizing (III)
 Different views on required capital

Internal:
Economic and
risk based
Convergence with
Convergence with fair value
Solvency II and accounting and
internal models “ERM”?
External: External:
Regulatory Accounting
Rating
3*.3 Evaluating and optimizing (IV)
 Measuring of “capital efficiency” with internal models
net
mean
14m
gross gross
200 years mean
285m 29m net
200 years
91m
Ad *): Vgl. Swiss Re: Risk and capital – Ricasso (risk capital simulation software), Zurich 2005.
3*.3 Evaluating and optimizing (V)
 Targets with taking reinsurance to support achieving all

corporate targets
meet demand
reinsurance
profit growth
target relations
safety
 Buying r/i is motivated by various targets

Source: See chapter 3 (section 3.2.1): Targets when bying reinsurance.
CHAPTER 4:
Alternative risk transfer
Alternative
risk transfer
4.1 Basics and definitions (I)
 Let ART be the transfer especially of insurance risks

with “alternative” instruments, especially the ones of
traditional capital markets
 Further notions: ART is risk transfer with “alternative

components”
4.1 Basics and definitions (II)
 Per definition ART serves insurance risk transfer

 Insurer can set “synthetic r/i” with ART
risk transfer with

insurance market instruments
risk taker
insurer
in insurance market
risk taker
insurer
investors of capital market
risk transfer with

capital market instruments
4.2.1 Transfer of insurance risks (II)
 Limits of r/i capacity

– See also limits of insurability in original insurance
– Catastrophe potential e.g. earthquake PML in
California: 100-150 billion US-$
 Idea: Generate additional r/i capacity*
– traded assets 19,000 billion US-$
– daily standard deviation 133 billion US-$
– insurance industry’s equity 200 billion US-$
(r/i 20 billion US-$)
Ad *): Rough comparison of capacities; see sigma 5/1996.
4.2.2 Capital market theory (I)
 Complete capital market

– Every risky cash flow (“risk”) exists in the market and
has a (market-) price
 Perfect capital market (friction less)
– No tax, no information costs or transaction costs
– Market participant is “price taker” (prices of financial
instruments are independent of his/her actions)
– Every investor can sell or buy arbitrary parts of
financial instruments
– All investors have same market entrance
4.2.2 Capital market theory (II)
 Reality: Capital markets are neither complete (tradability

of insurance risks) nor perfect
 In this context, ART supports to complete capital
markets (or to “perfectionize” capital markets)
 Insurers and reinsurers featuring ART,
– can be seen as intermediaries between “traditional”
insurance markets and capital markets
– support efficiency of markets because (in ideal
cases) they arbitrage evaluation differences*
Ad *): With simplified focus to price only, the insurer will approach the market where the “cheaper” r/i capacity is available.
4.2.3 Non-monetary goals
 Innovative reputation (assumption in 1990ies)

 Reducing insurance risks
 Generating profits (e.g. with arbitrage profits)
generating
additional profits
(e.g. arbitrage)
example of a
strategic positioning
reduction Generating and

of insurance risks exploring know-how
4.3.1 Capital market instruments
financial instruments
originary derivatives
furher bond option furher
further
principal coupon characteristics underlying
link with insurance risks
principal coupon insurance

at risk at risk underlying
 Main classes: Insurance linked bonds and insurance

derivates
4.3.2 Types of hedges
 Starting point: Occurrence of an insurance event leads

to a loss of liquid instruments
occurrence of an insurance event
asset hedge
assets liabilities assets liabilities assets liabilities
Generating new
E
E1
E2 assets
A
A1
L A1 - e.g. traditional r/i,
L L PCS cat options*, ...
loss  A profit A2 A2
liability hedge Reducing exiting

assets liabilities assets liabilities assets liabilities
E1 E1 liabilities
E
A1 A1
-L2 - e.g. LPT, insurance
A L
L
L linked bonds
loss  A profit -L2
Ad *): Historically.
 Fixed income securities are characterized by

– Pay back of the “credit” (“principal“)
– Interest proceedings (“coupons“)
 “Insurance link“: Linking principal and/or coupons to
insurance events
– If an insurance event occurs, …
– … the principal goes default (Principal at Risk)
– … and/or the coupons (Coupon at Risk)
– … for one/more following periods
– … in total / partially / not at all
 Simple example
cash flows after issuing
cash flows
(sponsor‘s perspective)
going „default“
occurrence
of a risk event
time
cupon with part interest spread proceeding the
risk free interest in cupon principal
4.4.1 Characteristics (III)
 Empirical examples* for interest rate spreads

spread over LIBOR (bps)
Ad *): See sigma 2/2007, p. 9.
4.4.2 Trigger for “insurance link“ (I)
 Characterizing the insurance event*

– Loss (event) of the individual portfolio (“indemnity
based”) or of a virtually constructed insurance
portfolio (“modeled loss”)
– Occurrence of a “physical” event (“parametric”)
– (Simple) formulae on this basis (“parametric index”)
 Additional links
– Maybe dependent on time
– Maybe risk period different from maturity
– Different tranches for different events
Ad *): Analogous to characterizing an insurance underlying for insurance derivates.
4.4.2 Trigger for “insurance link“ (II)
 Clustering trigger types and degree of protection
Parametric Pure
index parametric
Modeled
loss
Industry
index
Indemnity
basis risk for sponsor
4.4.3 Example of a placement (I)
 Structure with a swap counterparty
Source: Sigma 4/2009, p.21.
4.4.3 Example of a placement (II)
 Structure without a swap counterparty
Source: Sigma 4/2009, p.22.
4.4.3 Example of a placement (III)
k5
r/i treaty
D risk modeling
-(P + D+ Σi ki) k1
insurer reinsurer set up
(with retention) (with retention)
k3 IL-bond
legal firm k2 LIBOR + D
special purpose
Investor
fiscal agent vehicle
k4 BB- k
6
rating agency
trust
swap counterparty
(government papers)
P swap* re-financing
LIBOR versus fixed interests of government papers; alignment of timing
Ad *): In some cases adaptions in the aftermath of financial markets turmoil.
4.5.1 Alternative capital
 Alternative capital
– (Re-) Insurance (partially also insurance linked
bonds) provides "traditional" capital for risk transfer
– Investors and fund managers continue to like
insurance risk due to diversification and still superior
returns in comparison to e.g. corporate bonds
– This additional capital which is available for bearing
insurance risks is called "alternative capital"
 This capital and its investors enhance efficiency of the
traditional reinsurance markets; in regular markets it will
stick around sustainably.
4.5.2 Headlines only…
 Insurance derivatives
– Derivatives on insurance related underlyings
(e.g. loss derivatives)
– Exchange traded only historically (e.g. PCS options)
– Over the counter (limited public disclosure)
 Risk swaps
– Mutual exchange of insurance risks
 Contingent financing
– e.g. catastrophe equity put options
(right to emit new own shares)
Blank slide
APPENDIX
Prob. density
Loss
A.1 Epilogue
 This lecture captures the basic fundamentals of risk

management with r/i only.
 In practice you will find options, which transfer
– risks of several lines of business (multi line)
– risks of several periods (multi year)
– based on several triggers, insurance and investment
driven ones, (multi trigger)
– with limitations of insurance risk transfer (finite)
– via special purpose vehicles (professional r/i)
– into capital markets (ART).
A.2 Insurance risk
A.2.1 Farny’s notion
 Accepting many single loss distributions does not lead

to a specific total loss, but to a probability distribution of
total losses
 Founded in potential deviations of the collective real
total loss from the collective expected total loss
 Insurance risk := Distribution of losses from risk
business of an insurer [measuring P(S>E(S)) ]
 Components: Random risks / risk of change / risk of
error
A.2 Insurance risk
A.2.2 Albrecht/Schwake’s notion
 Insurance risk := Potential that for a specified period the

total loss of the insured portfolio (collective) exceeds the
sum of
– collective risk premium and
– available safety capital
[measuring P(S>(S)+R) ]
 Components: Random risks, risk of error (risk of

diagnosis and risk of prognosis); note: Different notion
of terms of the components between the authors
A.2 Insurance risk
A.2.3 Helten’s notion (I)
 Insurance risk := lack of information with respect to the

true collective total loss and the resulting deviation of
targets of the insurer
– Target: Maximizing the expected profit S-E(S)
[ Farny]
– Target: Maximizing the expected safety capital
[ Albrecht/Schwake]
A.2 Insurance risk
A.2.3 Helten’s notion (II)
 Components: Risk of diagnosis / risk of prognosis
diagnostified hypothetitical prognostified

rel. occurrences probabilities probabilities
time stability:
without
with
time
0
diagnosis prognosis
(statistics) (stochastics)
A.3 Insurance as risk reserve
generator (I)
 Insurer organizes collective financial risk reserve

generation for insureds
 Insurer provides start risk reserve for guarantee
purposes
 All insureds pay fixed premiums to the risk reserve
 Insurer invests risk reserve (insurance as coupled
production)
 Risk reserve finances stochastic insurance losses of a
few insureds
 Maybe: Owners provide additional risk reserve
A.3 Insurance as risk reserve
generator (II)
 Visualizing the simplest form
“maybe” additional provision of

risk reserves
Determined deterministic: Capital for establishment
premiums of stochastic: e.g. loss participation in mutuals
all insureds
Stochastic insurance compensations
risk reserve to a few insureds
A.4 Types of risk mitigations (I)
 Heilmann
– Risk control (avoidance, reduction, limitation, split)
– Risk financing (transfer)
 Helten
– Risk avoidance, risk reduction, risk sharing, risk
transfer
– Cause-related and effect-related mitigation options
– Risk avoidance, change of targets, risk
communication, risk transfer, risk financing
A.4 Types of risk mitigations (II)
 Axiomatic approach
– Change of lack of information
– Change of targets (or level of thresholds)
A.5 Alternatives to r/i
A.5.1 Co-insurance (I)
 Co-insurance
– An insured entity is insured by more insurers
– Each insurer participates at the insurance contract
with a certain percentage
 Example
– Larger commercial or industrial clients
 Note
– Partial participation as risk mitigation option of the
insurer
A.5.1 Co-insurance (II)
 Simplified scheme of risk sharing
several
insurance contracts co-insurer
insured co-insurer
risk sharing co-insurer

(split)
A.5.2 Insurance pools (I)
 Insurance pool
– Cooperation of several insurers and/or reinsurers in
order to jointly cover insurance (peak) risks
– Pool is only “organizer” of risk sharing (pool is
characterized by a treaty of the engaged parties)
 Examples
– Nuclear pool, pharma pool, longterm care pool
– In former times: Aviation pool
– Other countries: Terrorism pools, elementary perils
pool
A.5.2 Insurance pools (II)
 Simplified scheme of risk sharing
1 insurance contract
pool-insurer
insured pool-insurer
risk sharing pool-insurer

(pool)
A.5.3 Reinsurance captives (I)
 Primary insurance captives

– Insurer established or bought/owned by insured
– Risk management option: Self insurance / internal
collective (or individual) financial risk reserve
generation
– Financial and/or tax motivations are important
– Reduction of acquisition and (parts of) administrative
costs
– “Neutral“ example: Pensionssicherungsverein
(captive to protect occupational benefit schemes)
A.5.3 Reinsurance captives (II)
 Reinsurance captives
 Analogous to primary insurance captives (owned by
large insurance groups)
 Examples:
– “Dedicated reinsurance entity” in insurance groups
– Special purpose vehicle in context of ART
– …
A.6 Examples for types of r/i
A.6.1 Quota share
Example 1 Example 2
• Insured entity R1 sum insured 100’ • Insured entity R1 sum insured 100’
• Quota share 60% (cession rate) • Quota share 60% (cession rate)
• Limit 80’
• Losses 1.000 for R1, R2, R3
• R/I cover for R1, R2, R3 600 • Losses 1.000 for R1, R2, R3
• R/I cover for R1 480
• R/I cover for R2, R3 600
• Premium 100 for R1, R2, R3
• R/I premium 60 for R1, R2, R3 • Premium analogous to losses
A.6.2 Surplus
Example
• Insured entity R1 sum insured 100.000
• Insurer’s line 20.000

• Reinsurer’s cover 3 lines
• Losses 1.000 for R1, R2, R3 Hint: (like quota share)

• R/I cover for R1 600 Calculate the
• R/I cover for R2 600 split of obligations
• R/I cover for R3 0
With this idea, the methodology
can be applied for PML also.
• Premium analogous to losses
A.6.3 Per risk excess of loss
Example
• Per risk excess of loss 500‘ xs 100‘
• Net loss x1 90‘

• Loss split x1: Insurer 90 reinsurer 0‘

A.6.4 Per event excess of loss
• Per event excess of loss 5.000‘ xs 1.000‘

(assume no other nonproportional r/i is in place)
Example 1 Example 2
• One event triggers single losses • One event triggers single losses
x1 400‘ x1 1.000‘
x2 800‘ x1 2.800‘
x2 3.000‘
• Accumulated event loss 1.200‘ • Accumulated event loss 6.800‘
• Loss split: Insurer 1.000‘ • Loss split: Insurer 1.800‘

reinsurer 200‘ reinsurer 5.000‘
A.6.5 Stop loss
• Stop loss 50% xs 75%
(relative to protected premium volume (see loss ratio)
• Plausi-check: 100% protected premium volume

(modified - 30% prop. r/i commission (proxy expenses insurer)
combined ratio) - 10% r/i premium for stop loss .
= 60% loss ratio insurer “without negative result”
• Loss ratio q1 70%: - underwriting loss insurer approx. 10%

- no r/i compensation
• Loss ratio q2 100%: - at first underwriting loss insurer approx. 40%
- r/i compensation 25%
- “usually”: loss is stopped at 15%
• Loss ratio q3 200%: - at first underwriting loss insurer approx. 140%
- r/i compensation 50%
- insurer’s retention 150%; loss approx. 90%
A.6.6 Insurance derivatives (I)
 Derivative financial instruments: Instruments derived

from an underlying with a price depending on the price
of the underlying
– Integrating insurance risk (e.g. losses) in underlying
– “Traditional” derivatives upon this underlying
– Outcome: Traditional financial instrument features a
link to insurance risks (insurance derivatives)
 Exchange traded examples (historically):
– PCS options at CBOT (www.cbot.com/)
– GCCI derivatives at BCOE (www.bcoe.bm/)
A.6.6 Insurance derivatives (II)
 Placing arbitrary derivatives on insurance underlyings

financial market
money market capital market
Terminmarkt Kassamarkt
commodities financial
unconditional conditional
instruments instruments
forwards futures caps, floors,

swaps options
(over the counter) (exchange traded) collars
over the counter exchange traded

options options
A.6.6 Insurance derivatives (III)
 Characterizing the insurance underlying* according to

the coverage of traditional r/i
– logical specification (e.g. lines of business, perils)
– geographical specification (e.g. regions, countries)
 Reference variables for insurance underlyings
– Economic versus insurance perspective
– Known versus estimated versus “expected values
– In amount versus relative variables (e.g. loss ratio)
– Market versus individual references
Ad *): Similar as the specification of the triggering event at insurance linked bonds.
A.6.6 Insurance derivatives (IV)
 Historically: PCS cat options Chicago Board of Trade

time space business
specification specification specification
insurance
cat losses PCS index
underlying
insurers’ reports investigations Transformation example

(70% market share) of PCS “on site” (truncation etc.)
estimations 6
of PCS 5
0
time
loss/risk period development period
A.6.6 Insurance derivatives (V)
• 20/50 PCS cat call spread (long position)
(50-20)·200 US $ =
= 6.000 US $ value: 1 point = 200 US-$
attachment
profit
point 20
Index as at “maturity”
Index:
0
1 point = 10 million US-$
loss
with option premium

option exit without option premium
premium point 50
• If the PCS loss is below 200 million US-$, no payout occurs
• If the PCS loss is above 500 million US-$, the maximum payout of the
option occurs, i.e. 6.000 US-$
A.7 Some further literature
A.7.1 Risk management (I)
 Happel, Elke und Liebwein, Peter:

Risikofrüherkennung in Versicherungsunternehmen:
Aspekte zur Unterstützung des Risk-Managements
nach KonTraG, in: Versicherungswirtschaft 2000, S.
228-235
 KPMG Deutsche Treuhand Gruppe:
Integriertes Risikomanagement, Berlin 1998
A.7.1 Risk management (II)
 Bernstein, Peter L:
Against the Gods: A Remarkable Story of Risk, New
York 1996
 Heilmann, Wolf-Rüdiger:
Versicherungsmathematische Methoden des Risk
Management, in: Blätter der DGVM, Band XIX 1989, S.
141-172
 Helten, Elmar; Bittl, Andreas; Liebwein, Peter:
Versichern von Risiken, in: Dörner, Dietrich; Horváth,
Peter; Kagermann, Henning (Hrsg.): Praxis des
Risikomanagements, Stuttgart 2000, S. 153-191
A.7.2 Traditional r/i (I)
 Pfeiffer, Christoph:
Einführung in die Rückversicherung, 3.(!) und 5.
Auflage, Wiesbaden 1999
 Grossmann, Marcel:
Rückversicherung: Eine Einführung, 3. Auflage,
St. Gallen 1990
 Kiln, Robert:
Reinsurance in Practice, 3. Auflage, London 1991
 Swiss Re (Hrsg.):
Reinsurance matters: A manual of the non-life
branches, Zürich 2005
A.7.2 Traditional r/i (II)
 Carter, Robert L.:

Reinsurance, Bath/Avon 2001
 Gerathewohl, Klaus:
Rückversicherung: Grundlagen und Praxis, Band I und
Band II, Karlsruhe 1976 / 1979
 Liebwein, Peter:
Klassische und moderne Formen der
Rückversicherung, 2nd edition, Karlsruhe 2009
 Schwepcke, Andreas et al.:
Rückversicherung: Grundlagen und aktuelles Wissen,
Karlsruhe 2001
A.7.2 Traditional r/i (III)
 Barile, Andrew:
A Practical Guide to Financial Reinsurance, New York
1991
 Heß, Andrea:
Financial Reinsurance, Karlsruhe 1998
 Monti, George R. und Barile, Andrew:
A Practical Guide to Finite Risk Insurance and
Reinsurance, New York 1994
 Swiss Re:
Overview: sigma 1/2003; more detailed & better: sigma
7/2006, 5/1996 (ART); sigma 5/1997 (FinRe)
A.7.3 Alternative risk transfer (I)
 Albrecht, Peter und Schradin, Heinrich R.:

Alternativer Risikotransfer: Verbriefung von
Versicherungsrisiken, in: ZVersWiss 1998, S. 573-610
 König, Markus:
Der Anleger als „Rückversicherer“: Alternativer
Risikotransfer mittels „Katastrophenanleihen“ nach
deutschem Recht, in: Versicherungsrecht 1997, S.
1042-1050
 Wagner, Fred:
Risk Securitization als alternatives Mittel des
Risikotransfers von Versicherungsunternehmen, in:
ZVersWiss 1997, S. 510-552.
A.7.3 Alternative risk transfer (II)
 Munich RE:
Risikotransfer in den Kapitalmarkt, Munich 2001
(http://www.munichre.com)
 Swiss Re: Insurance Linked Securities, Zürich 2001 und
Zurich 2005 (Print)
 Swiss Re: ART-Bestandsaufnahme, sigma 1/2003
A.8 Your trainer
 Peter Liebwein
– 1989-1991: Versicherungskaufmann
– 1991-1996: Diploma (“master”) in mathematics
– 1996-1999: PhD in insurance economics
– 2000-dato: Bavarian Re and Swiss Re
 Contact
– Default: Before and after the lectures
– Office: Peter_Liebwein@SwissRe.com
– University: Professor Dr. Andreas Richter
and Verena Jaeger

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Reinsurance

Fundamentals of risk management and

 An overview over RISK-MANAGEMENT in insurance

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To avoid any misunderstandings:

Fundamentals of risk management

Mon Wed Mon Thu Fri

 Time (irrespective of schedule): To be defined.

Ad *): As per 20.04.2014. For updates please see website:

 Casualty Actuarial Society Enterprise Risk Management

Get a deeper understanding of:

Out of scope are:

 “Broken English spoken perfectly.”

Fundamentals of risk management

History’s most costly natural History’s biggest man made

Product liability Developments of capital markets

Financial markets turmoil … and our measures

 The 15 most expensive insured losses 1970-2013*

 A single loss can trigger the default/ruin case

 Development of insured losses 1970-2013*

 Loss analyses requires understanding of several layers

not: losses excluded

not: losses not

not: loss to “moral”

Fundamentals of risk management

 Lack of information what/

 Didactical counter examples

 Cause/effect relations of drivers and target variables

technical C22 C1j E11

Social and C4m

 Risk management – inter alia – has the task to

 Target distributions quantify the presented notion of risk

 Simplified model for risk position

 Why could position 4 be beneficial?

 Another model for risk position (see section 3*):

 Risk management – inter alia – has the task to

 Partial risk management

 Risk management system

 Risk management process and sub processes

Risk management core process

Risk management service process

 Risk management core process:*

 Structure and identify transformation areas

 Outcome: (Almost) target independent cause/effect map

 Measure/quantify driving factors

 Connect sub-targets and transformation areas

 Identify risk mitigation options

 Theoretical support: Decision theory

target k1 target k2 evaluation

 Practical examples (see section 3*):

expected result before capital cost – capital cost > 0

 In general: Risk preference and risk preference

 Steering and coordinating the core process

 Definition (risk diversification, risk compensation)

Fundamentals of risk management

Fundamentals of risk management

 Kiln: What is reinsurance? Insuring insurers.

 Insurer and reinsurer as demander and supplier:

demander r/i product supplier