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This is an extract from 'Hedging Hurricanes - A concise introduction to reinsurance, catastrophe bonds, and insurance linked funds'

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1. Reinsurance

screen-shot-2017-01-23-at-08-14-141.1 Introduction to reinsurance

A reinsurance company insures insurance companies. Insurance companies buy reinsurance for two related reasons: as an alternative to capital and to reduce the volatility of their results.

A single building, oil rig, or board of directors can be insured by multiple insurers each of which may in turn buy reinsurance from multiple reinsurers. Reinsurers themselves buy cover called retrocession. This web of contracts, enables very large claims to be absorbed by a global network of companies.

The simplified schematic on the below shows the traditional reinsurance hierarchy. The policies that link each entity represent a promise to pay certain losses. Rating agencies such as AM Best and S&P provide a guide to each entity’s ability to pay. In recent years, insurance-linked funds have been participating at every stage of the reinsurance chain.

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Reinsurance can be broadly categorised as either excess of loss or proportional. When a reinsurer sells excess of loss reinsurance, the policy will protect the insurer against large losses helping to reduce the volatility of earnings. Whereas, when a reinsurer sells proportional reinsurance it participates in the profits and losses of the insurer (minus some fees) in a similar way to owning equity.

The reinsurance market

Swiss Re estimates that the global insurance industry collected around $4.6 trillion in premiums in 2015. Around 56% of this was life insurance and the remainder was classed as property and casualty insurance.
Life insurers spent ­­­­approximately 2% their premium income on reinsurance whilst property and casualty insurers spent approximately 9%.According to S&P, the top 40 reinsurers wrote $194 billion of net premium in 2015. Here are the largest five reinsurance groups by premium.

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The insurance industry spends around $25 billion on reinsurance premiums to help absorb the cost of natural disasters. It is this part of the market that has seen the majority of interest from insurance-linked funds.

Rated reinsurance

A rated reinsurer creates a diversified portfolio to minimise the probability that it will be unable to meet all of its obligations. Rating agencies review a reinsurer’s business model to determine how confident they can be that the reinsurer will be able to honour all its claims. Key parameters will include the amount of capital that the reinsurer holds and the likely volatility of losses.

An A- (or better) from the rating agency AM Best is a de facto requirement for a reinsurance company. AM Best uses a quantitative model known as Best’s Capital Adequacy Ratio in addition to qualitative factors to determine its rating.

The range of AM Best ratings is: A++(superior), A+, A, A-, B++, B+, B, B-, C++, C+, C, C-, D, E, F (liquidation). In practice, it is very difficult for a reinsurer to sell reinsurance if it is downgraded to below A-.

Other stakeholders in a reinsurer such as regulators and boards of directors will use different calculations to come to their own view of how much capital a rated reinsurer must hold. These may impose more or less severe constraints than the rating agencies.

Any calculation will be based on ensuring that the reinsurance company can survive an extreme stress test. But a reinsurer’s theoretical liabilities are usually much greater than its capital base so an extreme, if improbable, set of events could cause the reinsurer to be unable to pay claims in full.

Fully collateralised reinsurance

Collateralised (or unrated) reinsurance is sold by reinsurers that lack credit ratings. All of the collateral that could be needed to pay claims is held in a trust account. This approach is implemented by catastrophe bonds and insurance-linked funds as it can be used to transform investments into reinsurance.

For example, a fund could sell a reinsurance contract with a maximum downside of $10m for a premium of $1m. The fund will place $9m of collateral into a trust account and the insurance company will pay $1m of premium into the same trust account. The most likely scenario is that there is no claim and at the end of the policy period the fund will take back its $9m along with the $1m of premium (an 11.1% return). If there is a full loss, the insurance company will be able to draw down $10m to help pay claims.

The creation of collateralised reinsurance has been a financial innovation that has dramatically reduced barriers to entry to the reinsurance market. A bank in Brazil or a pension fund in Canada is able to sell reinsurance policies to an insurance company in Florida or Japan using a low cost ‘transformer’, which converts an investment into a reinsurance transaction.

History of reinsurance

1370 First recorded reinsurance contract covering a ship sailing from Genoa to Bruges.
c1688 Opening of Lloyd’s Coffee House in London, which became a leading reinsurance market.
c1820 First fire reinsurance treaty in Germany.
1852 Cologne Re – the first independent reinsurance company – began writing business following the Great Fire of Hamburg in 1842.
1863 The predecessors of UBS and Credit Suisse formed Swiss Re in Zurich following a large fire in Glarus, which destroyed two-thirds of the town.
1880 Munich Re was established in Germany.
c1885 The first excess of loss reinsurance was sold by Cuthbert Heath at Lloyd’s.
1906 The San Francisco earthquake demonstrated the ability of the reinsurance market to fund catastrophic losses.
1967 Berkshire Hathaway bought National Indemnity, its first reinsurance business.
1985/86 ACE and XL were established in Bermuda.
1993 Bermuda’s Class of ’93 was capitalised with over $3.5 billion following Hurricane Andrew in August 1992. New reinsurance companies included Renaissance, Partner, and Tempest (now part of Chubb).
1998 Piper Alpha North Sea offshore platform disaster was one of the triggers of the ‘LMX spiral’ that almost caused the Lloyd’s market to collapse.
2001 The Class of ’01 (AWAC, Arch, Aspen, AXIS, Endurance, Montpelier and Platinum) raised more than $8 billion following the 9/11 terrorist attacks.
2005 Following Hurricanes Katrina, Rita, and Wilma (and Charley, Francis Ivan, and Jeanne the year before) the reinsurance industry was recapitalised with the Class of ’05. New companies including Ariel, Lancashire and Validus raised over $5 billion. In addition to this, several London Market companies followed Catlin in capitalising Bermuda-based entities and investors used sidecars on a large scale to access the reinsurance market.
2011 Record losses for the reinsurance industry following a series of loss events including floods in Thailand, tornadoes in the US and earthquakes in Japan and New Zealand. No new reinsurers were established but the inflows to insurance-linked funds accelerated.
2012 Hurricane Sandy caused significant destruction in the US North East.
2015 A record 19% of property catastrophe limit was ‘alternative’ capital including catastrophe bonds and collateralised reinsurance.

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