Reinsurance: The Nuts and Bolts InsuranceWITHERBY Witherby Insurance and Legal A Division of Witherby Publishing Group Ltd 4 Dunlop Square, Livingston, Edinburgh, EH54 8SB, Scotland, UK Tel No: +44(0)1506 463 227 - Fax No: +44(0)1506 468 999 Email: info@emailws.com - Web: www.witherbyinsurance.com iii Introduction When I first wrote this book I had no idea if it would ever be published. The idea came when I was working at Sedgwick and my colleague, Margo Black, asked me to prepare some training workshops for the Brazilian market that was preparing to ease its long-standing state monopoly by allowing Brazilian insurers to purchase reinsurance from other sources than the state reinsurer, IRB. At first, I thought that I would just be preparing a few slides for Margo to present on her next trip, but it soon became clear that I was going to have to prepare enough material for a course lasting 5 days and deliver the entire programme myself to an audience, some of whom spoke little or no English. As I spoke no Portuguese at the time, it was agreed that I would prepare my slides and deliver the workshops in Spanish. The similarity of the two languages, plus the abilities of English and Spanish speakers in the audience, we reckoned, would carry me through. Altogether, I gave five workshops; two in Rio, two in São Paulo and one in Curitiba. It was during one of these courses, attended by around 35 people, that somebody asked me for a copy of my notes. Half jokingly, I replied that the book would be out shortly and to my surprise, everybody gave me a business card and asked me to let them know how to purchase the book. Immediately on my return home, I set about translating my own notes back into English and within a few weeks the Nuts and Bolts was ready to offer to the publisher. Incredibly, it was accepted immediately and publication followed very quickly. I have been greatly encouraged by the reception this book has received. It has made it onto the recommended reading list of the Chartered Insurance Institute and many people have commented that it is used to settle technical questions, both within an organisation and in the context of discussions between reinsurers and their clients or brokers. It is also used as a training manual within several prominent organisations. One of the questions I am often asked by foreign readers is the meaning of the title. To a native English speaker, it requires no explanation, but it does not translate at all well into other languages. I have tried to explain that nuts and bolts are basic pieces used Reinsurance: The Nuts and Bolts iv in the construction of machines, but the explanation has often left people bewildered. In 2009 my Brazilian friend Nicolau Daudt offered to translate the book into Portuguese for the Brazilian market. The title was an obvious concern and I proposed that rather than use an engineering metaphor, we should use a jigsaw puzzle to suggest the fitting together of various pieces of knowledge to form an overall picture. The Brazilian title “O Quebra Cabeça do Resseguro” was born, and a book of that title was published by the Brazilian National Insurance School, “FUNENSEG”. It has been almost 12 years since the last English revision of this title and a great deal has happened in the London market in that period. Regulation of both banking and insurance is now under the control of the Financial Services Authority and this has led to tighter controls over how insurance institutions in the UK conduct their business. In tandem with these changes, the London market has reformed itself considerably and the three organisations that formerly handled many back-office functions on behalf of their members, LPSO (Lloyd’s), LIRMA (London Non-Marine market) and ILU (London Marine market) have been brought together under the umbrella of XChanging-Insure Services. This has led to the introduction of the Market Reform Contract; a document that replaces the traditional broker’s slip with a standard form of contract, designed to incorporate the entire terms and thereby provide contract certainty at the inception of the insurance or reinsurance. This has had an enormous impact on the working practices of reinsurance brokers. The traditional slip that could, in the past have been just a few pages, is now a full contract including the contract wording (a document that was previously signed after the contract came into force; sometimes, in fact, so long after inception that it may already have expired before it was signed!). This change in practice is responsible for the main revisions in this edition, although I have introduced some other new material in response to suggestions I have received over the years. I hope that Nuts and Bolts shall continue to be a significant reference work for all reinsurance practitioners and that its conversational style still hits the right balance between informative and readable. Reinsurance: The Nuts and Bolts v Contents Introduction iii Chapter 1 What is Reinsurance and Why do we Need It? 1 Chapter 2 Types of Reinsurance 5 2.1 Facultative 6 2.1.1 Pro-rata (or proportional) 7 2.1.2 Excess of Loss (non-proportional) 11 2.2 Ultimate Net Loss Clause 15 2.3 Treaties 16 2.3.1 Pro-rata Treaties 17 2.3.2 Facultative Obligatory Covers 22 2.4 Cessions to Treaties 24 2.4.1 Special Considerations 25 2.5 Distribution of Premiums and Claims over a Proportional Programme 29 Chapter 3 Treaty Reinsurance – Financial Aspects 33 3.1 Premiums 34 3.2 Commission 36 3.3 Tax 38 3.4 Premium Reserves 38 3.5 Loss Reserves 40 3.6 Interest on Reserves 41 3.7 How Reserves are Accounted 41 3.8 Losses 43 3.9 Cash Loss Refunds 44 3.10 Premium and Loss Portfolio Transfers 46 3.10.1 Clean-Cut versus Underwriting Year Basis 46 3.10.2 Clean-Cut Basis 48 3.10.3 Calculation of Unexpired Premiums 48 3.10.4 Special Circumstances 52 3.10.5 Example 54 3.11 Profit Commission 56 3.11.1 Deficit Carry Forward 59 3.11.2 Underwriting Year Basis 60 3.11.3 Special Circumstances 63 Chapter 4 Proportional Treaty Wordings and Clauses 65 4.1 Period and Termination 65 4.2 Special Termination and Reinsurer Downgrade 67 4.3 Errors and Omissions 68 4.4 Self Insured Obligations 69 4.5 Inspection of Records 69 4.6 Arbitration 70 4.7 Bordereau 71 Reinsurance: The Nuts and Bolts vi Chapter 5 Designing a Property Reinsurance Programme from Historical Data 73 5.1 Data 77 5.2 Constructing a Spreadsheet 80 Chapter 6 Excess of Loss Covers 81 Chapter 7 Excess of Loss Reinsurance – Financial Aspects 91 7.1 Premium 91 7.2 Loss Payments 95 7.2.1 ‘Hours Clause’ 95 7.3 Reinstatement Premiums 100 7.4 Burning Cost Rating 103 Chapter 8 Excess of Loss Rating 109 8.1 Exposure Rating 109 8.1.1 Reinstatements 109 8.1.2 Differing Values 110 8.2 Constructing a Property Risk Excess Rating Model 113 8.3 Catastrophe Rating 113 8.4 Constructing a Catastrophe Rating Model 117 Chapter 9 Market Evolution 119 Chapter 10 Miscellaneous 123 10.1 Retrocession Treaties 123 10.2 Reinstatement Premium Protections 124 10.3 Additional Reinstatement Covers 125 10.4 Alternative Reinsurance 126 10.5 Thinking Things Through 126 10.6 The Market Reform Contract (MRC) 129 Appendix 1 Answers to Practical Exercise 1 135 Appendix 2 Answers to Practical Exercise 2 137 Appendix 3 Answers to Practical Exercise 3 141 Appendix 4 Specimen Scale of Property First Loss Rates 145 Appendix 5 Specimen Treaty Wordings 147 Appendix 6 Example Spreadsheet for designing a Proportional Treaty Programme 217 Appendix 7 Sample Burning Cost Spreadsheet Model 227 Appendix 8 Constructing a Property Risk XL Rating Model 231 Appendix 9 Constructing a Catastrophe Rating Model 245 Appendix 10 Contract Notes and Example of an MRC Compliant Placing Document 249 Index 263 About the Author 269 91 Chapter 7 Excess of Loss Reinsurance – Financial Aspects An excess of loss contract is far simpler, in an accounting sense, than a proportional treaty because there are usually only three types of financial transaction, premium, loss payments and reinstatement premiums. 7.1 Premium A proportional treaty accepts percentage cessions of individual policies and therefore receives the same percentages of the premiums for those policies. An excess of loss contract is different because it protects the reinsured against losses over a certain size. We have already seen that for facultative excess of loss reinsurances the premium is disproportionate because most losses are only partial. In fact, losses of 40% or less of the full value at risk may amount to 80% of the total of all losses. The premium for an excess of loss contract is based upon the reinsurer’s assessment of the risk he is assuming and this will depend upon a number of factors, such as: • The maximum amount being protected (ie the reinsured’s retained ‘line’) • the profile of the protected account (numbers of risks within bands of values) • loss history • catastrophe exposure (increasingly estimated by specialist catastrophe modelling tools) • original premium income • the limit and deductible of the cover. Rate The rating calculations that the reinsurer performs will enable him to fix a premium for the contract. This premium, expressed as a Reinsurance: The Nuts and Bolts 92 Chapter 7 Excess of Loss Reinsurance – Financial Aspects percentage of the contract limit, is known as the ‘rate on line’, which is often used by reinsurers in their premium calculations. The rate on line is important to reinsurers as it gives a quick indication of the payback period should the contract suffer a total loss. For example, if a contract has a limit of $10,000,000 and the annual contract premium is $2,000,000, the reinsurers would need to collect $2,000,000 per year for 5 years in order to pay for a single loss of $10,000,000. Having formed an opinion as to the amount of premium he requires to protect the reinsured, the reinsurer will usually express the premium as a percentage rate, applied to some variable component of the business he is protecting. This variability is necessary in order to ensure that, if the reinsured’s business grows, he will receive more premium for the increased exposure under the reinsurance contract. Premium Income The most common variable to which a rate may be applied is the protected premium income. Ignoring changes in the reinsured’s original premium rates, growth in the premium income usually indicates that more risks are being accepted, leading to an increase in the reinsurers’ exposure under the excess of loss contract. The term most frequently used to describe the premium income is ‘gross net premium income’ or ‘GNPI’. A typical definition of GNPI may be found in the specimen wordings in the Appendices, but essentially ‘gross’ means the premiums booked by the reinsured during the contract period, without any deduction for brokerages, taxes or other expenses. ‘Net’ means net of the cost of any other reinsurances that have the effect of reducing the exposure to reinsurers under the excess of loss contract. In other words, we are rating the contract based upon the protected portion of the original gross premiums. Premiums paid for facultative and proportional treaty reinsurances may, therefore, be deducted from the gross booked premium to arrive at the GNPI. However, premiums paid for other excess of loss contracts should not be deducted. Reinsurance: The Nuts and BoltsChapter 7 Excess of Loss Reinsurance – Financial Aspects 93 This is so that, if the reinsurer is rating an entire excess of loss programme with several layers of cover, some of which may be per risk covers and others catastrophe, he will have a common income upon which to base his rates rather than having to reduce the GNPI by the amount of premium he is charging for any underlying layers. (Minimum and) Deposit Premium Most excess of loss contracts have a variable premium that can only be accurately calculated after the contract has expired. It is, therefore, usual for reinsurers to charge a deposit premium at the beginning of the period and to adjust it when the variable factors are known. Sometimes, one or more of these variables can be unexpectedly low, resulting in an unacceptably low contract premium after application of the rate. Reinsurers are effectively selling their capacity to different reinsureds throughout the year and their own capacity is limited by the size of their capital and their own reinsurance protections (retrocessions). Reinsurers, therefore, require a minimum premium for any contract that they accept, so that, even if the final GNPI is negligible, they will still receive sufficient premium to cover their own costs and exposure. Usually, the minimum premium and the deposit premium are the same figure, but there are some instances where two different figures are specified. When the two figures are the same, we refer to a ‘minimum and deposit premium’ or ‘M&D’. Therefore, we may see a contract premium described in the following way: “Minimum and deposit premium US$4,500,000, payable in four equal quarterly instalments on 1st January, 1st April, 1st July and 1st October 2012, adjustable upon expiry at 10% of the reinsured’s gross net premium income accounted during the period of this agreement”. Deposit premiums are frequently paid annually, half yearly or quarterly, and usually in advance. Reinsurers will often discount the deposit premium according to the speed with which they collect it. For example, if the deposit premium is to be paid in full at inception there may be a 20% discount from the estimated final contract