This document discusses reinsurance contracts that life insurance companies can use to mitigate risk. It describes different types of reinsurance contracts, including quota share reinsurance where claims are shared proportionally, and surplus reinsurance where the reinsurer pays claims above an agreed amount. The document also discusses how reinsurance allows insurers to comply with solvency regulations by reducing risk exposure, and how diversifying reinsurance among multiple companies can help mitigate the risk of a single reinsurer defaulting, though reinsurers still face common risks.

1. INSURINGTHE INSURER
Eber, Jason | HERIOT-WATT UNIVERSITY March 2016
Insuring the
Insurers
Jason Eber discusses the reinsurance
market and how life offices can mitigate
risk using these contracts.
Reinsurance isaninsurance policypurchased
by an insurance company.Life reinsurance
allowsthe life office toreduce uncertainty
aboutfuture liabilitiesandmortalityrisk,
thoughwe can unfortunately never
completelyexpunge the risk.
Life reinsurance isacontract betweentwo
insurers.The company receivingthe insurance
coverage isknownas the cedingcompany,
and the companywhichassumesthe
insurance riskisthe reinsurer.The only
difference fromotherinsurance business,is
that the bodyderiskingisaninsurance
companyinsteadof a consumer.
“Just as the consumer, the
life office must first
understand the risk”
Life reinsurance isinnature similartoother
typesof reinsurance,howeverthe key
differenceslieinthe type of underlyingrisk.
Propertyinsurance tendstobe shortterm
business comparedtolife insurance,andthe
riskof propertydamage due tonatural
disastersfollowsamuchdifferentdistribution
than the rate of claimsina groupof
policyholdersof alife insurance contract.
Reinsuringtheirbusinessallowsalife officeto
write a greatervolume andvarietyof
contracts. It reducesthe company’sexposure
to risksof mortalityassumptions beingtoo
light.If more policyholderswere todie than
expectedthiswouldputstrainonthe insurers
free assets;reinsurance lessensthatstrainin
a varietyof waysdependingonthe type of
contract.
There are multipletypesof reinsurance that
the companymay consider,howevereach
wayreplacesor reducesuncertainclaim
amountswitha setpremiumtothe reinsurer.
Two maintypesof policy are quota share and
surplusreinsurance.
Sharing is caring
Quota share reinsurance isdefinedasapolicy
inwhichthe reinsurerandcedingcompany
agree to pay proportionsof the claim
amountseachyear. Thisspreadsthe riskof
large paymentsbetweenthe twocompanies
howeverdoesnotaffectthe volatilityof
incomingclaimstothe cedinginsurer.This

2. INSURINGTHE INSURER
Eber, Jason | HERIOT-WATT UNIVERSITY March 2016
freesupcapital by reducingthe companies
reserve forthe product,allowingthe company
to investinnewbusinesssuchasopeningupa
newproductto the market.
Surplusreinsurance iswhenthe reinsurer
agreesto payall of the claimsabove an
agreedvalue atoutset.There isoften an
agreedmaximumvalue forthe reinsurer;in
the case that the claimamountsexceedthis
limit,the liabilitypaymentfallsbacktothe
original insurance company.The company
may wantto take out a furtherreinsurance or
holdmore free assetsif theythinkthisisa
likelyevent.Thiscanlimitthe maximum
reserve thata companywill be requiredto
holdand therefore will remove uncertaintyof
loss.
Finite riskreinsurance isthatwhichis
characterizedbyreducingthe exposure of risk
to the reinsurer.The assumingreinsureris
protectedbyan aggregate limittowhatthey
will pay.Thislimitisone of a few qualities
that define financial reinsurance.
Financial reinsuranceoffersthe reinsurerthe
abilitytoreceive alow riskmargin,however
alsohave the abilitytocancel the agreement
througha commutationprovision.Other
features of these contractsinclude the use of
profitcommissionstothe reinsurer,and the
reinsurercreditingestimatedinvestment
income frompremiumstothe ceding
company. Thistype of reinsurance hasproved
popularwithreinsurersownedbyhedge
fundsas theyare able to reduce riskand earn
a margin fromprofitcommissions.
Risky Business
Like any otherinsurance policy,the life office
mustconsidermultipleaspectsbefore
enteringintoagreement;consumerspurchase
life insurance policiestoprotecttheir
dependentsagainstfinancial straininthe
eventof theirdeath,buyvehicle insurance to
coverany costs of repairor damage,removing
an unknownpaymentwithafixedpremium
(andin thiscase due to a statuaryobligation
inmany countries).Justasthe consumer, the
life office mustfirstunderstandthe riskthat
theyare tryingto transferandwhat method
wouldbe bestsuitedtothat risk.
The main riskthat the life office will face is
that of mortalityrisk.The riskis thatthe
assumptionsmade whenwritingthe policy
were an inaccurate estimatorof actual
experience.Thisisthe eventthat agroup of
policyholders were quotedagenerous
premiumunderthe assumption of acertain
life expectancy,andthe experiencedmortality
rate washeavierthanprovisionsweremade
for,leadingtothe life office makingaloss
afterpayingout the sumassuredfor a large
numberof policies.
If the Life Office were toworrythatthe policy
grouphad a lowerlife expectancythan
expectedtheywouldwanttolimittheir
exposure toyearsof large claims.Thismight
0
200
400
600
800
1000
1200
1 2 3 4 5 6 7 8 9 10
Quota Share
Reinsurance
Insurer Reinsurer
0
200
400
600
800
1000
1200
1 2 3 4 5 6 7 8 9 10
Surplus Reinsurance
Insurer Reinsurer

3. INSURINGTHE INSURER
Eber, Jason | HERIOT-WATT UNIVERSITY March 2016
leadthemto the conclusionthattheyshould
‘cap’ theirlosseswithasurplusreinsurance.
The amount woulddependonhow volatile
theythinkthe groupsmortalitymightbe.If
theyare confidentthatthe amountof claims
will notexceedacertainamount,thenthey
shouldsetthe reinsurance nearthatvalue.
New Rules
SolvencyIIhasbeenloomingoverthe
insurance and financial industryformany
years,butnow has finallyarrivedon1 January
2016. Focussingonthree pillars –
quantitative,qualitativeanddisclosure
requirements –SolvencyIIisinplace to
ensure thatcompanieshave enoughcapital to
coverany and all claimstheyare likelyto
receive atanygiventime.
If a companywant’sto relievefundstoset-up
newbusinessrevenues,toensure thatthey
are complyingwiththislegislationata given
risklevel,the companywillhave toreduce
theirexposure toriskthroughreinsurance.
The solvencycapital requirementforthe
cedentcompanyisreducedastheyhave
transferredtheirunderwritingrisktothe
reinsurer.
Diversification
The questionof reliabilityof reinsurance must
be posedby the life office.The Financial
ServicesAuthority(FSA) inpolicystatement
04/16, triedto coverthisissue.If the
reinsurerwere togobust or wasunable to
meetthe agreedliabilitypromisedtothe
insurer,the policyholderwouldregardlessbe
owedtheirfull claimbythe cedinginsurer.
The FSA wouldencourage companiesto
diversifytheirreinsurance overmultiple
companies.Thisseemslike agoodinitial idea;
if one of yourportfoliogoesbust,youare still
coveredbyyour otherarrangements.
Lookingcloserat thisa problememerges;the
reinsurersare all exposedtocommon risk
factors.Life insurance riskshave significant
interdependenciessuchasepidemics,
changesinmortalitytrends and
natural/terroristdisasters. Overthe pastfew
yearswe have seendiseasessuchasH1N1 flu
(2009), Ebola(2014) and the Zikavirus(2016)
that have threatenedthe lifesof manypeople
across the world.There have alsobeena
growthin terrorattacks cumulatingfearful
endto 2015. These eventswill addahuge
increase inlife insurance claimsandtherefore
reinsurersthatabsolve the mortalityrisk.
Diversificationmaybe one methodtolowera
life officesexposure tothe riskof the
reinsurerdefaulting,howevertheyshould
make otherprovisionssuchasretaining
excesscapital tocushionthe consequencesof
a reinsurance marketmeltdown.
ReinFuture
It islikelythatthe Reinsurance marketwill
continue togrow rapidlywiththe stricter
regulationof SolvencyII,andcompanies
lookingtoincrease theirsecurity.Itisalso
likelythatwe will see anincrease inthe
amountof small tomediumreinsurersand
companiestryto diversifytheirportfolios. The
increase inthe marketwill leadtomore
competitivechoicesforinsurers.

4. INSURINGTHE INSURER
Eber, Jason | HERIOT-WATT UNIVERSITY March 2016
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