The Essential Guide To Reinsurance

The essential guide to reinsurance
2010 Swiss Re. All rights reserved.

Title:
The essential guide to reinsurance
Principal contributors
Philippe Brahin, Jean-Michel Chatagny,
Urs Haberstich, Roman Lechner, Andreas Schraft
Writing and editing
Kai-Uwe Schanz, Katharina Fehr, Tom Armitage
Managing editor
Esther Baur
Graphic design and production:
Logistics/Media Production
Photograph:
pdil, Getty Images (Cover)
The material and conclusions contained in this
publication are for information purposes only and the
authors offer no guarantee for the completeness
of its contents. The statements in this report may
provide current expectations of future events based
on certain assumptions. These statements involve
known and unknown risks, uncertainties and other
factors which are not exhaustive. The authors of this
report undertake no obligation to publicly revise or
update any statements, whether as a result of new
information, future events or otherwise and in no
event shall Swiss Re Group or any of its entities be
liable for any damage and financial or consequential
loss arising in connection with the use of the infor-
mation relating to this publication.
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Swiss Re The essential guide to reinsurance 1
Reinsurance helps insurers to manage their risks
by absorbing some of their losses. Reinsurance
stabilises insurance company results and enables
growth and innovation to continue. Due to the large
sums of money that they invest in financial markets,
reinsurers also contribute significantly to the real
economy.
Though they were relatively little known in the past,
reinsurers are gaining recognition in the light
of major disasters for the role they play in helping
insurers, governments and society as a whole to
deal with todays risk landscape.
2 Swiss Re The essential guide to reinsurance

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Contents
Foreword 5
The essentials and origins of reinsurance 6
Benefits of reinsurance for customers and society 14
Basic forms of reinsurance 22
Managing risks in reinsurance 32
The regulatory framework 38
Reinsurance solutions for todays societal challenges 44
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Title: Dotstitle
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Foreword
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Anyone who ventures into unfamiliar terrain requires an experienced guide. To get your
bearings, there is no substitute for the knowledge of someone who has been there
before. It is in this spirit that we have produced The essential guide to reinsurance.
For many people, the reinsurance industry is not especially well known. Newcomers
to the sector, as well as those who deal with reinsurers as part of their daily work, might
be surprised to learn just how multifaceted the reinsurance business is. A truly global
industry, reinsurance has played a decisive role for more than a century in helping
companies, and ultimately society, to better prepare for and manage the risks that we
face.
In recent years, natural catastrophes such as Hurricane Katrina in 2005 or events such
as September 11, 2001, have brought home the important function that reinsurance
companies have in supporting the insurance industry in paying claims to their policy-
holders. As the world in which we live becomes more fraught with risk, then this role
will become all the more significant.
The essential guide to reinsurance is not the sum of all wisdom on the topic of reinsurance
nor do we claim that it is unique. But we do believe it lives up to its title in several ways.
In addition to an overview of the industrys defining characteristics, the publication also
describes the essence of reinsurance, its basic forms and the principal functions of
a reinsurance company. It also draws attention to the regulatory environment in which
reinsurance companies operate and stresses the importance of risk management
within the industry.
Most importantly, the guide describes the essential role that reinsurance plays in enabling
progress and contributing to the stability of our economy and society at large.
We hope that you enjoy reading this publication.
Michel M. Lis
Chief Marketing Officer

Living life and running businesses involves risks.
To mitigate these risks, individuals and companies
buy insurance. Insurers, too, need to protect
themselves and do so by buying reinsurance. This
industry touches almost every part of our lives and
draws on insights from virtually every scientific
discipline. Its also one of the few industries that
is, and always has been, truly global in nature.
The essentials and origins of reinsurance
What do reinsurers do?
In essence, reinsurance is insurance for
insurance companies. Only by sharing
some of their risk with reinsurers it
is possible for primary insurers to offer
cover against the key risks we face today
and to keep prices at affordable levels.
Reinsurers provide coverage against all
kinds of risks, all over the world: They
range from earthquake risks in Chile to
hurricane risks in the Gulf of Mexico;
from the effects of drought for Brazilian
farmers to mortality risks for a European
life insurer; and from an auto insurance
portfolio in the US to aviation liabilities
in Asia.
Risks are transferred from individuals and
companies, through primary insurers
to the reinsurer. Reinsurance allows those
parties to reduce their risk exposure
and own capital requirements. Freeing
up capital allows insurers to write
more business, thus enabling economic
growth and helping to create stability.
The diagram on the following page sets
out how.
Motor Home Life / Health Business Catastrophe
Primary
insurer
Primary insurance
Insurance companies
Reinsurance
Reinsurance companies diversify their portfolio
of risks by geography and type of risk
Retrocession/capital markets
As part of their risk management
processes, a reinsurer may pass on
some of these risks to:
Insured risks
Individuals and corporates are looking to
insure against specic risks relating to:
Each party transfers a portion of the risk
by paying a premium
In return the primary insurer safeguards
individuals and corporates
The primary insurer passes on portfolios
of similar risks or large single risks
Primary insurer benefits, as reinsurance:
reduces claims volatility
guards against extreme events, thereby
reducing the severity of claims
Another
reinsurer
Capital markets
through
securitisation
Primary
insurer
Primary
insurer
Reinsurer
How risks are transferred in insurance and reinsurance
While property reinsurance (covering
perils such as natural catastrophes or fire)
is one of the most immediately obvious
lines of business that most non-life
reinsurers cover, others such as marine
(cargo and shipping), casualty (including
product liability or employers liability
insurance) or engineering (construction
and new technologies) are also important
areas of focus. Life & Health reinsurers
cover portfolios of insurance policies that
pay out in the event of death, disability or
illness of the insured. This includes covers
for catastrophic events. They also reinsure
annuities, which provide the insured a
regular income payment for a specified
period of time.
Beyond the perils we face today,
reinsurers are also constantly scanning
the horizon for indications of emerging
and future risks. Because of their
experience in analysing, identifying
and modelling risks, reinsurers are also
key drivers in the adoption of better
risk management practices by many
organisations.
How does reinsurance work?
Under a reinsurance agreement, a
reinsurer takes on part of the risk that an
insurer has written. Reinsurers deal
therefore with professional corporate
counterparties, such as primary insurers,
reinsurance brokers or multinational
corporations and their own insurance
companies, so-called captive insurers.
The party transferring the risk, for
example a primary insurer, is known as
a cedant. The original policyholder,
for example the home owner or airline
operator, is not involved in the transaction.
There are many different forms and types
of reinsurance contracts: They either
cover entire insurance portfolios or just
relate to single risks; they may involve a
sharing of all premiums and losses or they
may just cover losses exceeding a certain
threshold. Whatever the differences
between the various contracts, they all
have the same ultimate goal: Reinsurance
contracts help provide capital relief, they
smooth the volatility in an insurance
companys earnings and protect their
balance sheet.
By spreading risks around the world,
reinsurance companies avoid over-
expo sure and act as a stabilising force in
local insurance markets, thus ensuring
that more insurance is available at lower
prices than would otherwise be possible.
Because of the broad range of risks that
they take on, reinsurers are also able to
cover particularly large one-off risks, such
as major construction or civil engineering
projects, aviation risks such as satellites
or large sporting events, thus enabling
innovation and growth. And because they
invest the premiums they generate on
a long-term basis in a range of different
financial assets, reinsurers provide capital
to the real economy and thereby support
the production and provision of goods
and services.
Since homeowners or motorists have no
dealings with the reinsurance company,
many people are generally not even aware
of the existence of reinsurers. Indeed,
they have maintained a low profile in the
past. However, this has changed in recent
years as a series of high-profile events,
whether man-made disasters or natural
catastrophes, have shone a spotlight on
the industry. As a result, the vital role that
reinsurers play in preserving the stability
of the insurance sector, and more
broadly the economy as a whole, is now
becoming more widely understood.
By transferring risks, insurers protect
their balance sheet, reduce
earnings volatility and make better
use of capital.
Reinsurers deal with professional
counterparties, such as insurers,
brokers and other reinsurers.
The origins of reinsurance:
Protecting the assets of traders
and merchants
The development of the insurance and
reinsurance industry reflects the major
industrial and trade developments of
the past 700 years. The first evidence of
insurance contracts dates back to the
great Italian commercial cities of the
14th century such as Genoa. At this time,
insurance was offered exclusively by
individual underwriters rather than
specialised companies. Insurers of the
time worked without statistics, rates, or
calculations of probability, relying solely
on their personal assessment of the risks.
To protect themselves against risks that
were too large, they started to transfer
part of the risk to another insurer. Reinsur-
ance at that time was only available for
individual risks. The other main risk-
sharing instrument used in this period
was co-insurance, a practice which
involves spreading risks among a pool
of insurers.
The foundations for the modern insurance
industry were laid in the 18th century.
The Industrial Revolution later saw the
creation of many insurance companies
and established the insurance industrys
importance. It also triggered increasing
demand for reinsurance as insurable
assets started to grow rapidly. Treaty
reinsurance, which provides cover for
portfolios of risks, was developed during
this period, too.
The growth in reinsurance markets was
fuelled by the insurance industrys
realisation that ceding their biggest risks
to another party could limit the volatility
of their earnings and optimise their
use of capital. This became particularly
important as the investor base of
the insurance industry became broader.
Co-insurance was seen as increasingly
problematic, since it involved disclosing
sensitive and often commercially valuable
information to competitors. Some direct
insurers founded professional reinsurers
as a way of bypassing the need to rely on
their competitors for cover.
The first independent professional
reinsurer, Cologne Re, was established in
1842 in the wake of a fire that devastated
the city of Hamburg. The reserves of local
insurers turned out to be grossly inade-
quate, highlighting the need to share
disaster risk among several carriers and
seek diversification on both a national
and international level. Professional
reinsurers were quick to fill this gap. The
following decades saw the establishment
of many more specialist providers such
as Swiss Re in 1863 also in response
to a city fire, namely the one in Glarus,
Switzerland and Munich Re in 1880.
An effective and efficient global
reinsurance market began to develop.
Reinsurers stabilise local insurance
markets and provide capital to the
real economy.
Swiss Re: The making of a global leader
Like the Hamburg fire of 1842, the 1861 fire in Glarus, Switzerland, made it clear that
insurance companies were ill-equipped to deal with the financial consequences
of large-scale catastrophic events. In light of this major disaster, 1863 saw the
Helvetia General Insurance Company in St. Gall, Credit Suisse of Zurich and the
Basle Commercial Bank set up the Swiss Reinsurance Company in Zurich.
Swiss Re started spreading its risks internationally as early as 1864, but the business
environment for reinsurance at the time was extremely difficult and it proved hard
to gain a firm foothold abroad. It was not until the San Francisco earthquake and fire
in 1906, however, that Swiss Re truly established a global reputation. Even though
this major disaster cost the company about 50% of its annual non-life premiums,
Swiss Re ultimately paid all claims. Soon after, in 1910, the company opened its first
foreign office in New York and laid the foundations for its international expansion.
By the 1930s, Swiss Re had become the worlds leading reinsurance company, with
strong footholds in the US, Great Britain and Continental Europe, as well as contracts
in Asia. Thanks to solid reserves, the global recession of the 1920s and 1930s was
overcome without serious difficulties. Due to Swiss neutrality, World War II did not
severely impact Swiss Res global business relations. The post-war period presented
the company with major challenges as its previously leading position in the countries
of the newly formed Soviet bloc was lost and decolonisation in Africa and Asia led to
fundamental changes in local marketplaces. However, this was more than offset by
the post-war consumer boom in Europe and North America. It was during this period
that Swiss Res reputation for technical, engineering and scientific expertise was
formed. At the same time, Swiss Re expanded its globe-spanning presence through
subsidiaries and branches in Australia, Canada, Hong Kong and South Africa.
The 1990s saw significant structural changes in the insurance industry, primarily
driven by deregulation and liberalisation of markets, leading to a wave of mergers and
acquisitions, the increasing globalisation of the industry and strong growth in the
life insurance business. Swiss Re took advantage of these changes and expanded
its Life & Health portfolio, primarily through acquisitions. In 1994 this line of business
accounted for only 15% of its business but by 2009 this had risen to 46%.
In parallel with the growth in Life & Health activities and in response to concerns that
traditional reinsurance was reaching its limits, Swiss Re developed complementary
financial services capabilities, such as comprehensive risk-financing solutions for
large losses and catastrophes. Swiss Re has been the major global force from the
outset in developing insurance-linked securities (ILS). These are instruments which
securitise hazards such as earthquakes, hurricanes or pandemics in order to pass
them on to capital markets.
Over the course of the last decade, while expanding its Life & Health business and
building capital markets capabilities, Swiss Re also accelerated the internationalisation
of its Property & Casualty business. In 2005, the firm consolidated its leading position
through the acquisition of GE Insurance Solutions, the 5th largest reinsurer worldwide
at the time, from General Electric Company (GE).
While Swiss Res traditional reinsurance business weathered the financial crisis of
2008/2009 well, the company reported a full-year net loss for 2008 due to losses
in its financial services business and investment operations. Swiss Re consequently
overhauled its financial services strategy. Building on its almost 150 years of
experience in reinsurance, the company strengthened its focus on the core business
of reinsurance and large commercial risks, ensuring that it remains a strong partner
for clients. In 2009, Swiss Re returned to a net profit and restored its capital strength.
The modern reinsurance
marketplace
Today, there are about 200 companies
offering reinsurance, most of which are
specialised reinsurers. The top ten non-
life reinsurers by premium volume account
for about half of the total global premium
volume while the ten biggest life reinsurers
account for about two thirds of the market.
Germany, the US and Switzerland are
the three most important domiciles for
reinsurance companies but key players
can also be found in Bermuda and among
the Lloyds of London syndicates. Beyond
this circle, a number of large primary
insurance companies also write reinsur-
ance business, either through their
in-house reinsurance departments or
through reinsurance subsidiaries.
Geographical origin of cessions to reinsurance companies
USD bn
With annual premium income of around
USD 200 billion in 2008 and shareholder
equity of about the same amount, the
reinsurance industry has a strong capital
base. This allows reinsurers to take on the
worlds largest and most complex risks.
Roughly half of all reinsurance business
originates from North America. This not
only reflects the huge size of the primary
insurance market there, but also the fact
that North America is heavily exposed
to natural catastrophes and liability risks.
In relative terms, however, insurers in
emerging markets tend to rely in particular
on reinsurance; many emerging countries
are also very vulnerable to natural
catastrophes, insurance penetration is
lower there, and local insurance
companies tend to be smaller and less
Source: Swiss Re, Economic Research & Consulting
Top 5 natural catastrophe loss events
USD bn
111bn Hurricanes Katrina, Rita and Wilma (2005)
48bn Hurricanes Charley, Frances, Ivan and Jeanne (2004)
43bn Hurricanes Ike, Gustav (2008)
37bn Hurricane Andrew (1992)
34bn Winter storms Lothar and Martin (1999)
North America
28.2
59.1
Africa
4.1
0.8
Latin America
6.7
0.6
2% Africa
8% Asia & Oceania
26% Europe
1% Latin America
63% North America
3% Africa
21% Asia & Oceania
33% Europe
4% Latin America
39% North America
Life reinsurance market, 2009
USD 45 bn
Non-life reinsurance market, 2009
USD 152 bn
0
10
20
30
40
50
Munich Re
1
Swiss Re
Hannover Re
Berkshire Hathaway
2
Lloyds
SCOR
RGA
PartnerRe
3
Transatlantic Re
Everest Re

Worlds biggest reinsurance companies, 2009
Net premiums, USD bn
Reinsurance segment only, after elimination of intra-group transactions
Reinsurance segment only, estimated
Including Paris Re, pro forma
Geographical origin of cessions to reinsurance companies
USD bn
diversified, meaning that big, well-
diversified reinsurance companies are
important partners.
The reinsurance industry has proven its
solidity as a partner by consistently
paying out following the major insured
disasters of modern history; examples
that spring to mind are the San Francisco
earthquake in 1906, Hurricane Andrew
in 1992, and the terrorist attack on the
World Trade Centre on September 11,
2001, as well as the hurricanes Katrina,
Rita and Wilma in 2005 and the Chile
earthquake of 2010. Also, throughout the
financial crisis of 2008/2009, reinsurers
continued to operate as usual, meeting
their obligations to clients and providing
sufficient capacity.
The key to this solid standing is the broad
geographical base of the risks that a
reinsurer takes on. From the very
beginning, reinsurance has been a global
industry, harnessing the benefits of a
diversified portfolio of risks spread
across the world to offer cover for major
catastrophes at reasonable prices.
Beneath the surface of complexity lies
a fascinating business, characterised
by a truly holistic perspective on the risk
landscape of today and tomorrow.
Europe
49.9
11.7
Asia & Oceania
32.3
3.8
Latin America
Life
Non Life
All figures for 2009
From the very beginning, reinsurance
has been a global industry.
The increasing severity and frequency
of major disasters, including natural
catastrophes and manmade events, has
shed light on the role that reinsurers
play as shock absorbers for the global
economy. By helping to mitigate the
potential losses that could result from
risks such as major new construction
projects or breakthrough new technol-
ogies, reinsurers also fulfil an important
function as enablers of innovation.
And as long-term investors in equities,
bonds and other asset classes, reinsurers
provide capital to the economy and thus
give companies the means necessary
to grow and prosper.
What motivates clients to buy
reinsurance?
Motivations for purchasing reinsurance
and the amount of reinsurance required
vary according to an insurers level
of capitalisation and their exposure to
different kinds of risk. Insurers with a
significant exposure to highly volatile lines
of business or with exposure to natural
catastrophe risks tend to rely particularly
heavily on reinsurance. The same applies
to small, local or regional insurers, or
specialised insurers which have only
limited scope to diversify their book of
business or who lack capital to grow it.
The value that reinsurers create for primary
insurers who transfer their risks is relatively well
understood. But it is only more recently that
the value of reinsurance for society as a whole
has become more widely appreciated.
In general, life insurance is a fairly stable
business with a significant savings
component. As a result, only a small
fraction of the worldwide life insurance
business is reinsured, representing
USD 46 billion or 2% of primary insurance
premium income in 2009. When life
insurers do seek reinsurance, they do so
for high sums assured mortality and
morbidity risks (disability, accidents &
health) or in other words, the risk that
more people die, become sick or are
disabled than projected. This is in stark
contrast to non-life insurance, where
significant shares of the property, liability
and motor businesses are ceded to
reinsurers. These lines of business tend to
be more volatile and catastrophe-prone
than life & health insurance. On average,
about 9% of the premium volume in
primary insurance is ceded to reinsurers,
accounting for USD 156 billion in 2009.
What are the benefits of
reinsurance for clients?
There is a strong economic argument
in favour of a primary insurer buying
reinsurance. Both the insurer and the
reinsurer hold capital so that they can
deal with larger-than-expected losses.
A reinsurer, however, needs to hold com-
paratively less to cover a risk than does an
insurance company. To explain, reinsurers
generally carry a broad array of risks on
their books: They are abiding by the rule
of not putting all their eggs in one basket.
A reinsurer might, for instance, reinsure
earthquakes in Japan as well as hurricanes
in Florida. These two events are uncorre-
lated and it is highly unlikely that they
would happen at the same time.
Reinsuring both these risks contributes
to the diversification of a reinsurers
portfolio.
Because a reinsurer is generally more
broadly diversified than an insurer, the
reinsurer does not need to hold as much
capital to cover the same risk as an
insurer: The difference between the
insurers and the reinsurers capital needs
for the same risk represents the economic
gain that reinsurance produces.
Benefits of reinsurance for customers and society
Reinsurance reduces volatility,
provides capital relief, and can be a
source of knowledge and information.
Reducing claims volatility
Were it not for reinsurance, huge
disasters such as Hurricane Katrina or an
unprecedented event such as the attacks
of September 11, 2001 might have led
to a wave of insolvencies amongst insurers.
Reinsurance is an effective means of
mitigating the effects of disasters which
might be too severe for an insurer to
absorb or simply uneconomic for the
insurer to cover with its own capital.
Having reinsurance contracts in place
means insurers can shield their capital
base against such peak exposures.
To illustrate the point, let us consider
2005 which was a year with a particularly
large number of catastrophes. Hurricanes
Katrina, Rita and Wilma had a significant
impact on US non-life insurers. According
to Swiss Res economic research publica-
tion sigma, around 12% of all direct
insurers in the US received payments
from reinsurers that were equal to or
exceeded 100% of their shareholders
equity in that year. And about 23% of
them received payments from reinsurers
that accounted for more than one third
of their equity capital. In other words,
reinsurance helps reduce the likelihood
that insurers would face potentially grave
consequences as a result of a significant
depletion in capital.
Life insurers also face similar challenges.
Just as a series of disasters could threaten
the financial stability of a non-life company,
a sharp increase in fatalities as a result of
a pandemic or a major catastrophe would
severely affect a life insurer. While an
inherently positive trend for society,
longevity is another major risk for this
sector: If people live longer than
expected, pension scheme and annuity
providers will suffer in consequence. Just
as reinsurance can help a non-life insurer
to protect against unexpectedly high
catastrophe claims, life insurers can
purchase reinsurance to mitigate volatility
and to protect their balance sheets from
potentially devastating impacts.
Reducing balance sheet volatility can
enhance the risk-return profile of an insur-
ance company: As volatility decreases,
the company becomes increasingly
attractive for equity and debt-market
investors, all other things being equal.
This is a very important benefit,
in particular for non-life insurers: Major
catastrophes or unexpected liability
claims can result in large fluctuations in
earnings for non-life insurers, making
them less attractive to investors.
Providing capital relief
When insurers write new business, they
take on additional risk. Their ability to
write business is limited by two factors:
The cost of acquiring that business and
the extent of their capital. When an
insurer reaches its limit in terms of capital,
it can raise more capital or seek capital
relief. Alternatively, it can stop writing
new business or scale back existing
business. Reinsurance offers insurers the
opportunity to transfer portions of their
risk thus freeing up capital, and allowing
them to write more business.
Capital relief is particularly useful to
life insurance companies where initial
statutory reserves, solvency capital
requirements and commissions can
amount to a multiple of the first years
premium for new business they write.
Reinsurance alleviates this strain on
capital, helping life insurers to fulfil their
role of providing protection and savings
The capital needed to cover a
particular exposure falls as
diversification increases, making
reinsurance inherently attractive.
schemes to society. With capital relief in
place, insurers can write more business
and begin to reap the economies of scale
from expanding their customer base:
They can spread overheads such as
administration, distribution and claims
management expenses over a broader
base of business.
Advisory expertise
Traditionally, reinsurers assist their clients
in assessing and underwriting risks,
designing contract wordings, managing
claims as well as developing and pricing
new products. Reinsurers typically carry
a diversified portfolio of business on
a global basis. This equips them with a
broad and deep understanding of a wide
variety of insurance markets and
products. Their global reach also provides
them with superior data from a wide
range of insured populations. Based on
this experience, reinsurers develop tools
which help insurers underwrite risks and
process new business.
Insurers who are looking to enter new
geographical markets or expand into new
products might seek reinsurance to
benefit from reinsurers underwriting and
product expertise. This motivation to
buy reinsurance is particularly common in
life insurance, but also non-life insurance,
given the lack of publicly available market
data and the complexity of certain products
which require specialised actuarial and
underwriting skills. Alternatively, those
who are exiting certain businesses or
markets might choose to transfer entire
books of business and the underlying
liabilities associated with these contracts
to reinsurance companies.
On that basis, reinsurers have established
a reputation as trusted advisors to the
insurance industry, lending their support
in pricing, product development and
geographic expansion, for example. From
the perspective of ceding companies, the
reinsurers intellectual capital is an
important complement to the financial
strength they provide. Ultimately, these
What are the benefits of reinsurance for clients?
What reinsurers do Benefits for clients
Risk transfer function Stabilise financial results by smoothing
the impact of unexpected major losses
and peak risks
Companies become a more attractive
investment proposition and benefit from
reduced cost of capital
Risk finance function Offer reinsurance as a cost effective
substitute for equity or debt, allowing
clients to take advantage of global
diversification
Capital freed up, thereby increasing
underwriting capacity and enabling
growth
Information function Support clients in pricing and
managing risk, developing new
products and expanding their
geographical footprint
Accelerate profitable growth
Reinsurance helps cover peak risks,
whether earthquakes or pandemics,
and frees up insurers capital, allowing
them to expand their business.
Insurers call on reinsurers expertise
when entering new markets.
complementary capabilities and services
indirectly benefit individual policyholders
through more efficient claims processes,
innovative products and stable, affordable
coverage.
What are the benefits of
reinsurance for society?
Reinsurers are able to assume some of
the worlds largest and most complex
risks because they spread risk on a global
basis. Because they enjoy this superior
diversification, reinsurers make a vital
contribution to stabilising domestic
insurance markets which, otherwise,
might face disruption following major
catastrophic events. Foreign (re)insurers,
for instance, made more than 60% of
payments related to the destruction of
the World Trade Center in 2001 and
hurricanes Katrina, Rita and Wilma in
2005, respectively (see graphic below).
In Chile, where a devastating earthquake
at the beginning of 2010 wrought
severe damage, reinsurers are expected
to pay about 80% of all insurance claims.
Without reinsurance, some domestic
direct insurers may have experienced
difficulties in meeting claims in the event
of a major catastrophe. In anticipation
of such losses, capital limitations may
have forced insurers to restrict the scope
of coverage or to write less business.
Reinsurance, therefore, helps to make
insurance more broadly available and
adds credibility to its promise to pay.
Transferring risk enables economic
growth
Reinsurance helps to unlock the full
potential of insurance as a catalyst for
economic growth. A strong and efficient
insurance sector encourages commerce
and trade significantly. It enables entre-
preneurs to take risks and thus fuels
innovation. Without insurance products
that cover liability risks, many goods and
services would simply not be available.
Investors will often require that assets
such as power stations, factories, shops
or laboratories be insured before they
commit money to a project. Without
reinsurance, primary insurance companies
would often not be able to insure many
of these risks.
Spreading risk globally means
reinsurers can take on large and
complex risks.
Source: J. David Cummins, The Bermuda Insurance
Market: An Economic Analysis,
6 May 2008.
100%
80%
60%
40%
20%
0%
US Reinsurance
Other
US Insurance
Lloyds
Europe
Bermuda
Wilma Rita Katrina
Foreign (re)insurers
made more than
60% of Wilma, Rita
and Katrina total
loss payments of
USD 59 bn
Global diversification allows reinsurers
to absorb major losses
Regional distribution of 2005 hurricane payments: Wilma, Rita and Katrina
The construction of the skyscrapers
Henry Ford wit nessed in Manhattan are
now commonplace throughout the world,
a testimony to the impact that insurance
can have on society (see box below).
In our age of megaprojects, insurance
continues to play a significant role not just
as an enabler but also as a promoter of
improved practices to manage the risks
associated with such major undertakings.
Part of the value that insurers and
reinsurers add is to put a price tag on
risks. This encourages companies to take
a long-term perspective on their
businesses and to consider all the risks
that they are likely to face in the projects
that they launch. Mitigating those risks
through insurance enables firms to take
other risks.
For instance, new technologies as
incorporated in state-of-the-art aircraft
need significant investments to become
reality. Many of these projects would
never happen if the manufacturers were
required to hold all the capital necessary
to absorb every conceivable loss. An
insurance company, however, can help
here in taking on some of the risk. In turn,
a reinsurance company can relieve the
insurer of parts of that risk burden, thus
freeing up capital to help another
manufacturer elsewhere. In this sense,
What are benefits of reinsurance for society?
What reinsurers do Benefits for society
Risk transfer function Diversify risks on a global basis Make insurance more broadly available
and affordable; enable economic growth
Risk finance /capital market
function
Invest premium income according to
expected payout
Provide long-term capital to the
economy on a continuous basis
Information function Put a price tag on risks Set incentives for risk-adequate
behaviour
Enabling innovation by absorbing risks
In the early 20th century, the United States
was experiencing a building boom. The
skyline of cities like Chicago and New York
were changed forever by the construction
of skyscrapers of 20 floors and more.
Once, Henry Ford I heard a visitor to New York
express wonder at the sight of the city with
its soaring towers. This has only been made
possible by the insurers, Ford said. They are
the ones who really built this city. With no
insurance, there would be no skyscrapers.
No investor would finance buildings that one
cigarette butt could burn to the ground.
Reinsurance unlocks the full potential
of insurance as a catalyst for economic
growth.
insurance and reinsurance are an
essential part of the risk-taking process,
something that oils the wheels of tech-
nological progress and the development
of our society.
Providing long-term capital to the
economy
With more than USD 16 trillion in assets
under management in 2009, insurers and
reinsurers are among the worlds largest
investors. The industry holds more than
a fifth of all institutional investors assets.
Together with pension funds, (re)insurers
account for more than 50% of the total,
global institutional asset base (see
graphic on page 21).
By collecting premiums from
policyholders or ceding companies,
insurers and reinsurers accumulate huge
funds. The funds, which are needed to
pay future claims arising from policies
written today, are invested, usually with
a long-term perspective, in ways that
reflect or correspond to the companys
liabilities. These investments might be
in government bonds, corporate bonds
or equity investments. Life insurance,
in particular, is an important vehicle for
channelling peoples savings into
investments. By enabling insurers to
assume risk and grow, reinsurers directly
and indirectly contribute to this capital
market role. Reinsurance therefore goes
far beyond simply compensating
insurance companies in the case of
losses. It is also a key pillar of any modern
economys financial system and promotes
growth by financing the real economy. It
is important therefore that investment
rules for (re)insurance companies are not
made overly conser vative as this would
mean lower returns for policyholders and
less capital for the real economy.
Promoting risk-adequate behaviour
Reinsurers assess the worlds largest and
most complex risks on a global basis.
By putting a price tag on risks, they help
to improve capital allocation, create
important incentives for appropriate risk
behaviour and promote risk prevention.
Reinsurers invest significant resources
in extensive research. They try to better
understand existing risks as well as to
anticipate emerging developments in the
risk landscape. Climate change is a case
in point. Decades before this phenomenon
hit the headlines and entered the global
political arena, the worlds leading
reinsurers were already incorporating
research findings on climate change into
their business decision-making.
Risk management in major projects
Heathrow Airports Terminal Five was 25 years
in the making and involved a four-year
public enquiry. After lengthy preparations,
construction began in November 2002 on
a site the size of Londons Hyde Park
(260 hectares).
With 20 000 suppliers and 8 000 workers,
coordinating construction and managing
the risks that exist on a major building site
was a mammoth task.
The construction was insured by many
companies, Swiss Re among them. These
insurers would not have offered the project
an insurance policy without the knowledge
that it was backed by a solid risk-management
strategy.
The real economy needs the financing
from (re)insurers and pension funds.
The findings of these research efforts
back up reinsurance underwriting
decisions and help to support the
evaluation of loss potentials. Reinsurers
set a price (or premium) for cover based
on the assessed riskiness. The higher the
exposure, the higher the price will be.
Some exposures are so high that
reinsurers refuse to cover them at any
price: For example, during times of war
there would be such a significant
accumulation of risks as to render the
situation uninsurable.
By putting a price tag on risks, reinsurers
and insurers exercise significant influence
on the risk-taking and risk mitigation
activities of their clients, setting incentives
for risk-adequate behaviour and fostering
risk awareness throughout society.
Assets under management
USD trillion, 2008
(Re)insurers are among the worlds biggest institutional investors
Insurance companies
Mutual funds
Pension funds Petrodollar foreign assets
Asian sovereign
Hedge funds
Private equity
Insurers world-wide
investments totalled
USD 16.2 trillion
(= 22.5% of institu-
tional investors assets
at end of 2008)
Insurers and pension
funds together
account for 57% of
institutional investors
assets under
management
0
10
20
30
Source: McKinsey Global Institute, The new power brokers, 2009
Asset allocations of non-life and
life insurers
2008
100%
80%
60%
40%
20%
0%
Other
Cash
Real estate
Loans
Equities
Bonds
Non-Life Life
5% Cash and other invested assets
4% Policy Loans
4% Equities
11% Mortgage Loans
12% US and Foreign Govt Securities,
Treasuries and Municipals
17% Mortgage-Backed Securities
47% Corporate and Other Fixed Income
Securities
1
US, Japan, UK, France, Germany
Based on five largest insurance markets
1
Example US life insurers
Basic forms of reinsurance
Facultative reinsurance:
Case-by-case risk transfer
Insurance underwriters use the term risk
to refer not only to specific hazards but
also to the actual object insured. A bridge
or a building, for example, would be a risk
that requires insurance. Such risks are
exposed to many different perils and
represent a complex situation that would
require individual treatment on the part
of the reinsurer.
For these risks, facultative reinsurance is
the appropriate solution since it adopts a
case-by-case approach. Unlike obligatory
reinsurance, which as its name suggests
involves obligatory risk sharing, the
reinsurer in a facultative contract retains
the option or the faculty to accept
or refuse all or any policy offered to it.
Likewise, the primary insurer is free to
choose which risks they want to reinsure.
Today, facultative reinsurance is mostly
used by the primary insurer as a
complement to obligatory reinsurance,
covering additional risks above and
beyond what has already been covered
by the obligatory reinsurance treaty.
Obligatory reinsurance: Covering
entire portfolios
When a primary insurer wishes to reinsure
all of its insurance policies within certain
risk categories, then an obligatory
reinsurance contract is most likely to fit the
bill. This form of cover is used in both life
and non-life reinsurance.
A primary insurer agrees to cede a portion
of the risk of all of its health insurance
policies or all of its motor insurance policies
There are two basic forms of reinsurance.
Facultative reinsurance, the oldest form, is a
case-by-case approach to transferring risks.
The other form is obligatory reinsurance, in which
an insurer and reinsurer are bound by an
obligation to cede and assume a contractually
agreed share of a portfolio of risks.
Facultative reinsurance is reinsurance
of individual risks. It grants the
reinsurer the option to accept or
refuse all or any policy offered.
to the reinsurer. Obligatory reinsurance
derives its name from the fact that both
parties are obliged to cede or to accept
any risk covered in the treaty that they
conclude. The reinsurer is bound by the
treaty to accept its share of the risks, and
it cannot refuse to provide insurance
protection for an individual risk or policy
that falls within the scope of the cover.
The insurer is likewise obliged to cede
the agreed-upon risks. Obligatory
reinsurance is also often called treaty
or automatic reinsurance
Because of its automatic nature, this
form of reinsurance is efficient in terms of
administration. Non-life reinsurance
treaties are usually renewed on an annual
basis. Reinsurance treaties for some
Life & Health contracts such as medical
insurance or personal accident insurance
are also renewed, like the original
contract, on either an annual or a five-
year basis. Many life reinsurance treaties
for mortality business, however, are not
renewed. Because the original policy has
guaranteed premium income throughout
the duration of the contract, these
particular reinsurance contracts will
generally run for the same amount of
time, which can be up to 30 years.
Both obligatory and facultative
reinsurance can be proportional or non-
proportional. Proportional reinsurance
involves one or more reinsurers taking a
pre-agreed percentage share of the
premiums and liabilities of each policy
an insurer writes. Non-proportional
reinsurance on the other hand reimburses
losses suffered above a fixed sum.
Single risks such as those involved in running
a complex factory or insuring an individual life
with a large sum assured are unique. They
require detailed contracts and individual,
facultative solutions.
Whole portfolios of risks that are similar, such
as motor insurance portfolios, can be covered
under treaty reinsurance: Insurers and
reinsurers are obliged to cede and accept the
risks on a predetermined basis.
Whats the difference between
facultative and obligatory reinsurance?
Obligatory reinsurance is reinsurance
of an entire portfolio of policies. It
obliges both parties to cede or accept
all risks covered in the treaty.
Proportional reinsurance
Under proportional reinsurance, the
primary insurer and the reinsurer share
premiums and losses by a ratio defined in
their contract. The reinsurers share of the
premiums is directly proportional to its
obligation to pay any losses. Additionally,
the reinsurer compensates the primary
insurer for a portion of its acquisition and
administration costs by paying a
reinsurance commission. This is usually
expressed as a percentage of the original
premium. The commission paid to the
primary insurer also serves as the price
for the reinsurance: it is reduced or
increased according to the quality of
the portfolio and it is calculated
independently of the primary insurers
original premium.
Quota share reinsurance: Sharing
premiums and losses
The simplest form of proportional
reinsurance is the quota share. The
reinsurer assumes an agreed-upon, fixed
quota or percentage of all the policies
written by the direct insurer within the
particular branch or branches defined in
the treaty. The primary insurer retains a
fixed percentage of each policys
premiums and cedes the remainder.
Losses are apportioned at the same ratio.
In other proportional reinsurance
contracts, this ratio may vary from risk to
risk, but for quota share the ratio is fixed.
This means the quota share is ideal for
homogenous portfolios like motor and
household insurance where all the risks
are fairly similar. The maximum size of the
policies that can be ceded is limited by
quota share agreements.
Quota share reinsurance treaties are
also particularly suitable for young, fast-
growing insurers or established
companies which are new to a certain
class of business. Quota share reinsurance
also makes sense for primary insurers
who are seeking capital relief in light of
solvency considerations or protection
against random fluctuations across an
entire portfolio. Another reason to enter
into a quota share might be changes
triggered by unexpected legal
developments or economic factors,
such as inflation.
However, quota share reinsurance has its
drawbacks. It is based on the relatively
crude notion of the proportional sharing
of premiums and losses. As such, it does
not effectively protect the insurer against
extreme loss scenarios, such as an
accumulation of losses as a result of a
natural disaster. The potential imbalances
in a primary insurers portfolio also remain
unaddressed. By the same token, because
it is not flexible, quota share reinsurance
may also result in a primary insurer
ceding too much and retaining too little
possibly at the expense of profitability.
A popular solution to these drawbacks is
for the insurer to take out coverage to
protect it from extreme losses. A medium-
sized life insurer, for instance, might
combine a quota share agreement with a
so-called surplus reinsurance agreement.
What is a balanced portfolio and why is it relevant?
To be considered homogenous or balanced, a portfolio should include many similar
and equivalent risks. In this way, losses can be balanced collectively and minimal
reinsurance will be needed. A big motor insurance portfolio with a large direct
insurer is a good example for this. If there are enough individual risks in the portfolio
(say 200 000 motor policies) then the law of large numbers applies, meaning that
the ratio of losses to premiums should fluctuate only minimally from year to year.
Reinsurance might still be needed to cover unexpected claims like losses from a
hailstorm or a spike in car theft.
Proportional reinsurance means the
insurer and reinsurer share premiums
and losses by a defined ratio.
The primary insurer retains: 70%
The reinsurer accepts: 30%
Sum insured: 10 m
Primary insurer retains: 7 m
Reinsurer accepts: 3 m
Premium is 2% of the sum: 20 000
Primary insurer retains: 14 000
Reinsurer accepts: 6 000
Losses: 6 m
Primary insurer retains: 4.2 m
Reinsurer accepts: 1.8 m
1200
600
900
300
Reinsurer's
quota share
30%
Direct insurer's
retention
70%
C
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u
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i
s
Policies
Quota share reinsurance: An example
In this example, the reinsurers quota share is
30%. This ratio is reflected throughout, with
losses and premiums shared at the same rate.
Quota share reinsurance:
An illustration
Surplus reinsurance: Beyond the
insurers retention
Surplus reinsurance is the most common
form of proportional reinsurance cover.
With surplus reinsurance, the reinsurer
does not participate in all risks; up to a
specific amount, the primary insurer
retains all risks for its own account. This
is in contrast to quota share reinsurance
where the retention is defined as a
percentage, starting from the very first
dollar of premium. Under surplus
reinsurance, the reinsurer is obliged to
accept the surplus or the amount which
exceeds the primary insurers retention.
The limit of a surplus agreement is based
on the maximum amount of liability a
reinsurer is prepared to take on. This limit
is usually expressed as a multiple of the
primary insurers retention, known as a
line. For example, a three-line surplus
means the reinsurer assumes coverage
up to three times the primary insurers
retention.
The reinsurer pays a commission to the
insurer. Originally, the commission was
intended to compensate the insurer for
the costs incurred in writing the business
in the first place. Given the compet-
itiveness of the marketplace for direct
insurance, however, this premium is often
insufficient: after the direct insurer deducts
his operating costs, the remaining original
premium is less than the total losses
incurred. More and more reinsurers are
thus adopting the procedure of returning
to the direct insurer only that part of
the original premium that was not paid
out for losses. Therefore the reinsurance
commission is increasingly defined by
commercial considerations rather than
the direct insurers actual operating costs.
Surplus reinsurance is a useful tool for
balancing a primary insurers portfolio by
limiting its exposure to the single largest
risks in its portfolio; this makes the
resulting retained portfolio more homo-
genous. Surplus agreements can be
used to calibrate a primary insurers
reinsurance needs much more accurately
than a quota share can. Retentions can
be set at various levels depending on
the type of risk, the size of a risk and the
companys overall risk appetite. This
flexibility, however, comes at the price
of more complicated and costly treaty
administration.
The following table shows an insurance
portfolio containing three different
policies. In each case, the total amount
insured is shown, followed by the amount
that the insurer wishes or is able to retain.
In this example, the insurer has a
retention (line) of 300 000. The reinsurer
takes the surplus between the retention
and the total insured sum, in this case
up to a maximum multiple of 9 times the
retention. The premium in all cases is
1.50 of the sum insured.
Surplus reinsurance: Treatment of a
portfolio of risks
Policy I is a straightforward surplus
reinsurance contract. Policy II shows that the
reinsurer does not participate in risks that fall
within the primary insurers chosen retention
(line). Policy III shows that the reinsurer takes
its maximum surplus, but that the primary
insurer must either bear the additional
respective losses itself (in this case 14.29% of
the sum insured or 500 000) or else purchase
an appropriate amount of facultative
insurance.
Surplus reinsurance: An illustration
Total Insurer retains Reinsurers surplus
(1 line) (9 lines max)
Policy I
Sum insured 3 000 000 300 000 = 10% 2 700 000 = 90%
Premium 4 500 450 = 10% 4 050 = 90%
Losses 1 500 000 150 000 = 10% 1 350 000 = 90 %
Policy II
Sum insured 130 000 130 000 = 100% 0 = 0%
Premium 195 195 = 100% 0 = 0%
Losses 80 000 80 000 = 100% 0 = 0%
Policy III
Sum insured 3 500 000 300 000 = 8.57% 2 700 000 = 77.14%
+500 000 = 4.29%
= 22.86%
Premium 5 250 1 200 = 22.86% 4 050 = 77.14%
Losses 2 000 000 457 200 = 22.86% 1 542 800 = 77.14%
14.3%
9.1%
3.2%
75%
1200
900
600
62.5%
46.4%
Policies
21.4% 22.7% 24.2% 25% 37.5% 53.6%
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t
s
Direct insurer
1 line = 300
Reinsurance
3 lines = 900
Fac. reinsurance,
or other cover
100%
25%
75%
300
1500
64.3% 68.2% 72.6%
Non-proportional reinsurance
In the 1970s, non-proportional reinsur-
ance emerged as an alternative and
a complement to traditional proportional
forms of cover. Insurance companies
were growing financially stronger, enabling
them to retain the more frequent small
risks for their own account. Reinsur ance
solutions were consequently sought that
would provide protection against
the biggest and accumulated losses,
those which could potentially jeopardise
primary insurers solvency. Non-propor-
tional forms of cover meaning cover
where there is no fixed or pre-determined
split of premiums and losses were
devised to address these needs.
Non-proportional reinsurance requires
that all losses up to a certain amount are
borne by the primary insurer. This amount
is known as a deductible, the net retention,
excess point or priority. Losses that
exceed this deductible are assumed by
the reinsurer up to a pre-agreed cover
limit. In contrast to proportional insurance,
where the sum insured is the important
figure, for non-proportional covers it
is the loss amount that is of paramount
importance.
Capping an insurers liability at a
suitable point
From a primary insurers point of view,
the advantages of non-proportional
reinsurance are clear: It can limit its
liability with a deductible which reflects
its willingness and capacity to bear
risk. As smaller losses within the primary
insurers net retention are no longer
covered by the reinsurer, the company
retains for its own account a higher
proportion of its gross premiums, thus
enhancing its earnings potential. Finally,
administration costs are far lower for
both parties as the primary insurer no
longer needs to calculate his proportion
of a loss for each risk (as under surplus
reinsurance).
These solutions offer the insurer the
benefit of retaining more of its premium,
potentially allowing it to make more profit.
However, in contrast to a proportional
insurance contract, an insurer is also
obliged to pay out the full amount up to
its deductible in the case of a loss. From
the perspective of the reinsurer, the
advantage lies in being able to determine
the pricing of the risk, regardless of how
the risk was originally priced by the
insurance company. This implies in both
scenarios that the reinsurer obtains data
from the underlying portfolio. As the price
for this cover, the reinsurer demands a
suitable portion of the original premium.
In defining (rating) this price, the reinsurer
considers the loss experience of recent
years (known as the experience rating)
as well as the losses expected from that
type and composition of risk (exposure
rating).
Excess of loss reinsurance: The most
popular form
Excess of loss reinsurance is the most
common form of non-proportional
reinsurance. It helps the insurance
industry to handle various loss situations.
These include the risk of a single building
burning to the ground as well as the
accumulation of losses incurred from a
single event, such as a severe windstorm.
These contrasting needs are met by two
different kinds of coverage: Excess of
loss per risk and catastrophe excess of
loss or excess of loss per event.
Excess of loss per risk is a traditional
reinsurance product where the reinsurer
indemnifies the primary insurer for the
loss amounts of all the individual policies
affected, which are defined in the treaty
terms and conditions and which exceed
the contractually fixed deductible.
The reinsurers participation in each
claim is limited by the reinsurance cover
and there is usually an additional annual
limitation of the total amount of all claims
that the reinsurer pays. The excess of
loss per risk is a very effective means of
risk mitigation against large single losses
(eg a large bodily injury claim in a motor
Non-proportional reinsurance covers
losses that exceed the insurers
deductible up to an agreed cover limit.
third-party liability insurance or a large
fire claim in property insurance).
However, such a contract does not offer
adequate protection against frequency
or against cumulative losses, where many
policies are affected by the same loss
event such as a major natural catastrophe.
Catastrophe excess of loss is a more
sensible solution for such situations. The
essential difference to excess of loss
per risk is that the unit of loss is not the
individual loss per policy but the
aggregate loss caused by one event
within the insurance portfolio covered
by the reinsurance treaty. Therefore, the
excess of loss per event represents
effective risk mitigation against large
catastrophe losses made up of the sum
of potentially hundreds or thousands of
relatively small losses created by the
same cause. These could be claims from
private property insurance after a
windstorm, or claims from motor policies
after a hailstorm event.
12
10
8
6
4
2
0
Covered by WXL/R
reinsurer
Not covered
Retained by primary
insurers
Loss amount in millions
Risk1 Risk2 Risk3 Risk4 Risk5
Not covered
WXL/R coverage
Retained
Excess of loss per risk: An illustration
After applying all proportional covers, a direct
insurer retains 8 million. To protect his retention
from major loss, he buys WXL/R protection
of 6 million in excess of 2 million (6 million xs
2 million).
Catastrophe excess of loss:
An illustration
To further protect his retention from
catastrophic events, such as earthquakes,
the direct insurer also buys a CatXL coverage
with the limits 4 million xs 5 million. This
means the direct insurers net loss from the
catastrophe is 5 million. The CatXL reinsurers
net loss in this case is 3 million.
12
10
8
6
4
2
0
Risk 2 2m
Risk 1 1m
Risk 3 2m
Risk 4 2m
Risk 5 1m
Catastrophic event
8
7
6
5
4
3
2
1
0
R
e
i
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s
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r
s

l
o
s
s
Loss amount in millions
I
n
s
u
r
e
r
s

l
o
s
s
Risk1 Risk2 Risk3 Risk4 Risk5
Stop-loss reinsurance: Protection
against annual claims volatility
A less frequent form of non-proportional
cover is stop-loss reinsurance. Under
such a treaty, the reinsurer covers any
part of the total annual loss burden which
exceeds the agreed deductible (usually
expressed as a percentage of annual
premiums) or a specified absolute amount.
This allows the primary insurer to smooth
its earnings by protecting itself against
large claims fluctuations from year-to-
year. As a rule, this form of reinsurance
only comes into play when the primary
insurer has suffered a technical loss, that
is to say when claims and administration
costs exceed premiums. This ensures
that the primary insurer continues to have
skin in the game and is not relieved
of all entrepreneurial risk which could
otherwise encourage excessively risky or
even reckless underwriting. This type of
treaty provides primary insurers with the
most comprehensive level of coverage.
New forms of reinsurance
In recent decades, new risk transfer
techniques have been developed. The
spectrum ranges from multi-year, multi-
line structured insurance contracts
to securitising insurable risks and tapping
capital market investors as an additional
source of underwriting capacity. The
following section introduces some of
these new forms of reinsurance.
Insurance-linked securities:
Transferring risks to capital markets
Insurance-linked securities (ILS) are a
means of ceding insurance-related risks
to the capital markets. Cash flows from
regular (re)insurance premium payments
are transformed into interest-bearing
sec urities. Since the first cat bond in 1997,
ILS have been used to transfer a wide
range of risks from natural catastrophes
to life insurance risks. ILS can be used to
transfer peak risks, for example the risk
of a severe natural catastrophe event or
the risk of extreme mortality. The
motivation for an insurance or reinsurance
company to use ILS might be to tap into
additional capacity offered by capital
markets, or to benefit from the unique
features of an ILS transaction compared
to traditional reinsurance.
In a typical ILS structure used for catas-
trophe bonds, a special purpose vehicle is
established which provides conventional
reinsurance to an insurer or reinsurer
(the sponsor). The SPV capitalises itself
through the issuance of interest bearing
notes to the capital markets and invests
the proceeds from the notes in high-
1
Stable value
investment
Premium
Hurricane
cover
Bond
proceeds
Bond
coupon
Scheduled
interest
Ceding company
(sponsor
or reinsured)
Special purpose
vehicle (issuer)
Investors
(sophisticated, large
institutional buyers)
Investment
earnings
3
1 2
4
Source: Swiss Re
A typical insurance-linked security (ILS)
structure
1. The reinsurer (sponsor) enters into a
financial contract with a Special Purpose
Vehicle (SPV)
2. The SPV hedges the financial contract by
issuing notes to investors in the capital
markets
3. Proceeds from the securities offering are
invested in high quality securities and held
in a collateral trust
4. Investment returns are swapped to a
LIBOR-based rate by the swap
counterparty
Insurance-linked securities are
a means of transferring insurance-
related risks to the capital markets.
quality securities such as government
bonds held in a collateral trust. The SPVs
funds are paid out to the sponsoring
insurer or reinsurer if the bonds specified
catas trophe event (eg the magnitude of
an earthquake on the Richter scale) is
triggered. Investors principal is reduced
by the amount of loss payment.
From the sponsors perspective, ILS offer
various advantages. These include the
ability to transfer peak risks which might
be otherwise difficult to place through
traditional reinsurance as well as addi-
tional underwriting capacity. Because ILS
typically have a multi-year duration,
the sponsor can also partially uncouple
from the pricing cycles common in
the insurance and reinsurance industries.
In addition, counterparty credit risk
(ie the risk of a reinsurer defaulting on its
payment obligations vis--vis the primary
insurer) is very limited as the proceeds
from the securities issued are held in
a collateral trust.
Payments in case of a loss event in ILS
transactions can be based on actual
losses but are in most cases tied to
pre-specified measurements such as
the intensity of a disaster in a particular
location. This simplifies the claims
settlement process. One of the principal
tasks in structuring such index-based
contracts or parametric triggers is to
minimise basis risk, ie the risk that the
actual losses of the sponsor differ from
the losses implied by the index or
parametric trigger.
For investors, ILS offer attractive potential
for diversification. Changes in inflation
or interest rates and the implications for
equity and bond markets have obviously
no bearing on the frequency and severity
of natural catastrophes, for example.
The volume of outstanding catastrophe
bonds has grown steadily since their
first emergence. In 2008, the ILS market
suffered a temporary set-back in the
wake of the global financial market
dislocation. New issuance of ILS dropped
sharply, but recovered quickly. Future
development of ILS is expected to be
favourable: These securities have proved
their worth as an effective tool for diver-
sification and were one of the very few
asset classes which generated positive
returns during the financial crisis of
2008/2009.
Admin Re: Solutions for Life
restructuring
Administrative reinsurance (Admin Re)
is a specific form of reinsurance, mainly
used by life insurance companies. Some
firms may stop writing new business
completely or stop writing new business
in certain lines, or they want to exit the
insurance business. However, they still
have policies in force. In an Admin Re
transaction, a reinsurer acquires these
closed blocks of in-force life, pension
and health insurance business or even
an entire portfolio from a life insurance
company which no longer writes any
new business. The reinsurer assumes
responsibility for administering the
underlying policies either directly or
through third parties. Longevity, mortality,
lapse, market, credit and expense risks
are transferred to the reinsurer. Such a
deal enables the primary insurer to exit
a product or market, release capital and
redeploy it to core operations or new
ventures. For clients mainly interested in
solvency capital relief, administrative
reinsurance is preferable to traditional
reinsurance as a sale or business transfer
does not incur any counterparty credit
risk for the insurer (unlike traditional
reinsurance).
Insurance-linked securities are
particularly attractive for investors
seeking diversification.
Risk management in reinsurance is about
anticipating, identifying, assessing,
modelling and controlling risks. Reinsurers
create value by extracting information
from a very large data pool of risks which
they collect globally. A parti cular challenge
is to establish where the interdependencies
between individual risks lie and to ensure
that the aggregate exposure is in line with
what a reinsu rance company is willing
and able to bear. While it might look like
reinsurers take a bet on whether an
adverse event will happen or not, decisions
about risk-taking are made in a controlled
way and enabled by a very sophisticated
risk management framework.
Enabling risk control: The risk
management framework
It is important to clarify roles and responsi-
bilities and distinguish between the risk
owner (Board), the risk taker (business
unit) and the risk controller (independent
risk manager) for the entire business
and specific transactions. Senior
manage ment is the ultimate risk owner
of the company and plays an important
risk manage ment role by defining
the company strategy. Business unit
managers are the actual risk takers and
have the responsibility for properly
assessing and pricing risks. The specific
risk management function, under the
stewardship of the chief risk officer,
is responsible for risk governance, risk
oversight and independent monitoring
of risk-taking activities. It supports
Managing risks lies at the heart of what
reinsurers do. In recent decades the scope of
risk management has widened significantly.
It is no longer confined to traditional
underwriting risk but also encompasses risks
to a companys investments, its capital
base and liquidity position.
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degree of diversification by operating
internationally, across a wide range of
different lines of business and by
assuming a large number of independent
risks. Diversification over time is also an
important factor. The more risks meeting
these criteria that are added to a reinsu-
rers portfolio, the lower the volatility
of that reinsurers results. Lower volatility
translates into reduced capital
requirements, or alternatively, allows
the reinsurer to take on more risk with
its existing capital base.
Based on these considerations, specific
limits are then set for every single risk-
taking activity. It is of utmost importance
for reinsurers to adopt a holistic approach
towards risks, not only looking after
traditional insurance and hazard risks
but also to incorporate counterparty
credit, financial market and operational
risks. The risk management framework
should encompass all three major value
drivers in reinsurance: Underwriting
management, asset management and
capital management.
Underwriting: Assessing, pricing
and assuming insurance risk
The core business of insurers is to take
insurable risks off households and firms
shoulders. Before assuming these risks on
their balance-sheet, insurers examine,
classify and price them. The underwriting
process in the reinsurance industry is
very similar; the major difference is that
the risks are assumed from insurance
companies and not from policyholders
themselves.
An insurer seeking coverage provides
the reinsurer with the relevant data. The
reinsurer then determines whether
additional information about the charac-
teristics of the insured objects or persons
is needed. In non-life reinsurance, this
usually includes information about
an objects specific location, value and
particular exposure to certain risks.
For individual buildings, for example, the
specific exposure can be established
through flood or wind zone maps. In life
reinsurance, underwriting decisions are
essentially based on information about
Managing risks in reinsurance
It is important to distinguish between
the risk owner, the risk taker and the
risk controller.
decision-making with state-of-the-art risk
models that provide insights into how
each risk that the company assumes
contributes to the overall risk profile and
affects capital requirements.
A particular challenge is to take account
of accumulation potential. In contrast to
a portfolio of different and independent
fire risks, exposures to earthquakes
or windstorms carry a potentially huge
accumulation potential for the reinsurer.
One single event can easily trigger losses
in thousands of policies and therefore
appropriate modelling and assessment
are required.
Risk management starts at the top of the
organisation, with the strategic steering
of the company, in particular by defining
the risk tolerance and the risk appetite.
Defining the organisations risk tolerance
means stating explicitly what magnitude
of a loss event the company can withstand
without going bankrupt. This maximum
aggregate loss amount depends on the
available capital and required liquidity.
The risk appetite is then defined to
determine where the companys capital
is best invested to generate the required
returns or in other words defining what
types of risks the company wants to
assume (eg natural catastrophes versus
liability or life insurance risks) and
allocating the capital to these businesses
accordingly. Decisions about particular
transactions are then taken by the risk
taker, which could be, for example,
a particular business unit. Steps and
decisions made by the company should
be monitored and signed off by the risk
controller which is risk management.
A key consideration is to what extent a
risk can be diversified. A reinsurers
capacity to safely assume complex and
large risks depends not only on its capital
strength, but also on its ability to spread
its risks. Reinsurers achieve a high
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the risk of death or illness of the policy-
holder, such as age, gender, and medical
as well as lifestyle factors.
When assessing risks, any insurer or
reinsurer must take into account the
fundamental principles and limitations
of insurability. Insurability is not a strict
formula but rather a set of basic criteria
which must be fulfilled for a risk to be (re)
insurable. Disregarding these constraints
would ultimately jeopardise the (re)
insurers solvency and ability to honour
its obligations. But that also means that
certain exposures remain uninsurable.
The following are criteria for insurability:
Randomness: The time and location of
an insured event must be unpredictable
and occurrence itself must be
independent of the will of the insured.
Insurers have to keep in mind, that
the existence of insurance may change
the behaviour and the occurrence of an
insurable event (moral hazard).
Assessability: The frequency and
severity of claimable events can be esti-
mated and quantified within reasonable
confidence limits.
Mutuality: For the insurer and reinsurer,
it must be possible to build a risk pool
in which risk is shared and diversified at
economically fair terms.
Economic viability: From the reinsurers
perspective, the price needs to cover
the expected cost of acquiring and
administering the business as well as
and this is the bulk of the total claims
costs. In addition, the price must allow
for an appropriate return on the capital
allocated to the risk, a return which
meets shareholders return requirements.
Risk management and steering the
companys strategy
Source: Swiss Re
Strategy
Capital
allocation
Target
setting
Decision-
making
Portfolio- and
performance
measurement
Limit monitoring
Accumulation control
Risk/return review
Definition of risk appetite to
determine where to allocate
capital
Risk-taking decisions
in underwriting and asset
management
Risk/return optimisation
Definition of risk limit
Definition of risk tolerance
Risk management should encompass
the three value drivers: Underwriting,
asset management and capital
management.
Experience- or exposure-based rating
can be applied to determine the price of
a risk. Experience-based pricing is used
when historical claims experience can
be applied to the current situation, as for
example with fire and mortality risks
where underwriters can draw on long
historical time series. For other risks, like
low-frequency, high-severity natural
catastrophes or pandemics, there are no
extensive data pools on insured losses.
Underwriters need to come up with a
price based on the individual merits of
the exposure which is being specifically
modelled, using both scientific information
and expert judgment as well as scenario
thinking. Pricing, therefore, is more than
a quantitative science.
For a reinsurer, thinking the unthinkable
is a core competency of utmost relevance
to its long-term survival. The graphic
below illustrates the enormous size
of natural catastrophe exposures which
need to be modelled.
When assessing risks, any reinsurer
must take into account the funda-
mental principles of insurability
a basic set of criteria to be fulfilled for
a risk to be insurable.
The worlds largest natural catastrophe loss potentials
Insurance loss potentials from natural catastrophes are on the rise globally. This
trend reflects an increasing concentration of insured values in catastrophe-prone
areas, such as Chinas Eastern coastal region, changing weather patterns related
to climate change as well as the growing complexity and interconnectedness of
globally integrated economies and corporate value chains. Especially for reinsurers,
the correct modelling of such exposures is of crucial importance given their major
role in assuming and managing these risks.
Quake California
Storm Europe
50 bn
35 bn
Quake New Madrid/
US Midwest*
20 bn
30 bn
Hurricane East Coast
85 bn
125 bn
Insurance loss potentials
in USD billions
Loss potentials from
events with a return period
of 200 years
of 500 years
of 1000 years
* A very small loss is assumed for the 200 year return period
Quake Japan
75 bn
Peak risks consist of:
Earthquakes or storms
in industrialised countries
with high insurance density
Asset management: The other
side of the reinsurance business
model
Asset management is an integral part
of the core reinsurance business model.
Reinsurers collect premiums and in
exchange they provide their clients with
protection. Reinsurers are thereby obliged
to indemnify their client after a claim
event. Generally, there is a time-lag
between the premium payment and the
claim payment during which the funds
are held on the reinsurers balance sheet
and can be invested in different asset
classes. How long the funds are held
differs significantly between lines
of business and contract structure. This
influences the investment decision.
To have sufficient funds for claims
payments, the reinsurer estimates the
expected future claims payments,
establishes adequate reserves and
invests these funds in corresponding
asset classes. Premium and investment
income together need to cover all the
expected losses, administrative expenses
and capital costs, in order to generate
economic value. In addition to these claims
reserves, the reinsurance company needs
to hold shareholder capital as a buffer to
cover eventual adverse surprises. The
shareholders accordingly expect to have
sufficient yield on the provided capital.
The objective for the reinsurance invest-
ment management process is therefore
to create value for both cedants buying
reinsurance and the shareholders of the
reinsurance company. Both estimated
future claims payments (= liabilities)
and the values of the invested reserves
(=assets) change with the movements
of the capital markets. If the value of
liabilities and investments diverge, then
this can have an impact on shareholder
capital in both directions. Matching
and then managing the relative changes
between liabilities and investments is a
core competency of any reinsurance
company. This process is known as asset-
liability management (ALM), which is
described in the box below.
The ALM process also takes into account
other investment constraints, apart from
the matching of the liabilities, such as the
companys overall risk tolerance and
regulatory restrictions. In every market in
which the reinsurance company conducts
business, there is a regulator. The regulator
makes requirements of the reinsurance
company to hold sufficient assets,
proscribing not only their value, but also
their liquidity risk and, in many cases,
the type of instrument. Furthermore, the
reinsurer needs to review the risk and
return expectations for the different
assets.
Terrorism: Testing the limits of insurability
The destruction of the World Trade Center on 11 September, 2001 claimed more
than 2 600 lives and wrought hitherto inconceivable damage on a section of
lower Manhattan. Previously, losses from terrorist acts were comparable in size
to other property losses, and terrorism was rarely excluded from property policies.
The attacks, together with subsequent terrorist acts in Europe and Asia, clearly
demonstrated the human toll and financial consequences of international terrorism.
The potential losses of a major terrorist attack could involve multiple lines of
insurance and could far exceed the financial capacity of the insurance industry.
These developments, combined with increased demand for terrorism insurance, call
for new solutions involving public-private partnerships, such as specialised terrorism
pools making best use of the capacity available from insurers, reinsurers and the
government.
While parameters have changed, the risk of terrorism can nonetheless be insured
privately if liabilities are limited and premiums are commensurate with the
new dimension of this risk. In addition, appropriate involvement of governments
is needed to set the necessary framework and to provide funding for some of the
potentially enormous terrorist attacks. Without state involvement, extremely
large losses may be substantially underinsured.
Capital and liquidity management:
The flip side of risk management
For any insurer or reinsurer, capital is the
prerequisite for assuming underwriting,
financial market, counterparty credit and
operational risks. Capital provides a
buffer against unexpected losses. These
could come from different sources such
as when claims payments exceed
premiums and investment income, when
loss reserves turn out to be insufficient
or when assets are impaired, for example
during severe stock market slumps,
as we witnessed in 20012003 and
20082009. Capital management must
ensure that the company is able to with-
stand unexpectedly high levels of loss.
Any discrepancy between a reinsurers
risk profile and its capital base needs to
be addressed by raising additional
capital, transferring risk to third parties
(for example, through retrocessions,
which are cessions to other reinsurers, or
insurance-linked securities) or reducing
the amount of risk assumed in under-
writing and investment activities.
Liquidity management ensures that
the company is able to pay claims and
meet all financial obligations when
they fall due. Insurance and reinsurance
companies generate liquidity in their core
business through the premiums they
receive up-front when providing a (re)
insurance cover. As such they effectively
pre-fund future claims payments.
Therefore, liquidity risk is limited.
Nevertheless, it is important to monitor
and manage liquidity actively to have
sufficient liquidity even in extreme
situations. A reinsurers capital and
liquidity management has to respond
to various and partially conflicting
stakeholder interests: Customers, ie
primary insurers, care about the prompt
payment of claims. Regulators focus on
policyholder protection and in light
of the financial crisis overall systemic
stability. Rating agencies are primarily
interested in capital being sufficiently
available to honour obligations to
policyholders and debt holders. And
investors seek attractive risk-adjusted
returns and put pressure on companies
to maximise capital efficiency. While all
stakeholders agree that a reinsurer
should have an adequate capital position,
there are different views as to how
capital adequacy should be measured.
These differences in perspective reflect
the dynamics of the regulatory, accounting
and competitive environ ments and add
significantly to the complexity of a
reinsurers capital and liquidity manage-
ment processes. The convergence of
these perspectives towards a consistent
economic view has gathered pace
recently (partly driven by Solvency II) and
is ultimately expected to prevail.
Asset-liability management
The ALM process is designed to maximise the risk-adjusted investment return. This
can be achieved at different levels of the investment management process and is
normally differentiated into risk-free return, market-return and active return. The risk-
free return originates from the liability matching portfolio set-up in order to avoid a
mismatch between the outstanding liabilities and invested reserves. These portfolios
are mainly invested in low-risk fixed income instruments with similar cash flow
characteristics as the expected future claims. For example: Expected mortality
claims payments in five years can be replicated by a five-year zero-coupon bond
with the same maturity and payout.
The market return is generated by investing in different asset classes. The risk
allocated to the respective asset class is determined by the reinsurers overall risk
capacity and risk appetite. The active return is generated by identifying temporary
market dislocations. A dedicated portfolio manager and committed teams are
necessary to follow the financial markets closely. A variety of instruments and
techniques can be used to generate active, above-market returns.
Future claims payments are effectively
pre-funded by premium income.
Regulators and supervisors in the financial industry
aim to protect customers and to ensure the general
functioning of the financial markets. But financial
institutions differ greatly from one another and it is
important their unique characteristics are taken
into account when new regulations are developed.
The regulatory framework for reinsurance
on retail customers in so far as it could
possibly bring a primary insurance
company to the brink of default. It is
therefore in the interests of the primary
insurer to cede their risks to a reinsurer
which enjoys strong financial health.
That only a few insolvencies have been
attributable to a primary insurers inability
to recover reinsurance proceeds
illustrates the effectiveness of the reinsu-
rance market as well as the fact that
most primary insurers manage their
counter party exposure relative to their
other sources of capital.
Against this backdrop, capital require-
ments for reinsurers have traditionally
been either the same as those for primary
insurers or more liberal. The aim of
reinsurance regulation is to safeguard
the financial health of ceding companies
against the failure of the reinsurance
company and thereby to ensure
the proper functioning of the insurance
market. Some countries (eg USA,
Canada, Australia, UK) have for a long
time had prudential regulation of pure
reinsures on a similar basis to insurers.
Many EU countries had no regulation and
others a light regime. The EU introduced
minimum prudential regulation for
reinsurers effective in all Member States
in 2005. These rules are similar to those
applied to primary insurers in the EU.
The regulation also introduced a concept
of mutual recognition between Member
States, facilitating cross border business
within the EU and a concept of allowing
market access to non EU countries
meeting equivalent requirements.
In Switzerland reinsurers were subject to
reserving and capital requirements similar
to those for direct companies and
now are required to comply with the
Swiss Solvency Test. The International
Association of Insurance Supervisors
(IAIS) has standards on the supervision
of reinsurance and reinsurers.
While regulation and supervision are
needed to protect insurers and ensure the
stability of the market, they also play an
important role in establishing the basis
for reinsurance to function efficiently.
In addition to fundamental requirements
such as freedom of contract and legal
security, these conditions include capital
requirements which take into account the
specific characteristics of the reinsurance
business model as well as the ability
to provide reinsurance internationally.
A different regulatory framework
for reinsurers
There are significant differences between
primary insurance and reinsurance. Most
insurance policies are sold to households
and individuals, and the main objective
of regulators is to protect these parties.
Therefore, in most countries, if an
insurance company has direct dealings
with retail customers, it needs a local
insurance license and virtually all aspects
of that insurers operations are subject to
regulatory oversight: Capital requirements,
claims practices, policy provisions and
in some countries even premium rates.
By imposing such robust regulatory
conditions, governments strive to protect
the solvency of primary insurers and,
ultimately, to ensure that they can
continue to pay legitimate claims made
by policyholders.
But one might ask the question whether
this also needs to be the case for
reinsurance companies. Most reinsurers
do not have direct contact with retail
clients. Reinsurance clients are
sophisticated counterparties such as
insurers, brokers or other reinsurers.
However, the default of a reinsurance
company could have an indirect impact
Insurer insolvencies typically result
for different reasons hardly
ever from an inability to recover
reinsurance proceeds.
Capital requirements:
Towards a risk-based and
economic approach
The European Unions new regulatory
framework for insurers and reinsurers is
due to be applied by 2013. The Solvency
II framework replaces Solvency I which
was not risk sensitive. Non-insurance
risks were not explicitly captured. For
non-life business, capital requirements
were set as a percentage of premium
income or a percentage of claims and for
life business, as a percentage of reserves
and of sum at risk both rather simplistic
and crude approaches which disregarded
the fact that, in terms of underlying risk,
one unit of premium or reserve can differ
significantly from another.
The new Solvency II framework is more
closely aligned with the (re)insurers
specific risk profile: In addition to
conventional hazard risks (eg a fire loss),
other major risks emanating from
financial markets (eg changing interest
rates), counterparties (eg insolvencies)
and operations (eg faulty IT systems)
need to be underpinned by capital.
In the United States, the Risk-Based
Capital (RBC) system was introduced as
early as 1994. However, Solvency II goes
one decisive step further: It will rely on
market-consistent valuation of assets and
liabilities, whereas RBC is based on US
statutory accounting rules, and thus does
not reflect the true economic reality of
a companys balance sheet.
Solvency regimes based on economic
principles and an all-risk approach are
pointing the way forward for how
insurance and reinsurance regulations
should look around the world.
Access to international markets:
A prerequisite for doing reinsurance
business
Diversification is a fundamental part of
how reinsurers create value and it
ultimately provides efficient and effective
cedant protection a key aim of law-
makers and regulators. It is achieved by
writing a mix of business that is exposed
to different, not totally connected,
risk factors. This can arise from different
geographical locations but also from
different lines of business. As a result,
a loss event within one product line or
a local market can be absorbed by the
return on other policies not affected by
that event.
For example a reinsurer who accepts
Japanese earthquake exposure could
balance this with uncorrelated exposure
from other parts of the world. Any barriers
to accessing international markets would
impair a reinsurers capacity to absorb
risk in an economically viable, socially
responsible and reliable way. Examples of
such restrictions include regulations that
prevent foreign reinsurers from setting up
in a country or prohibiting local insurers
from wholly or partially reinsuring abroad.
For international diversification to work,
reinsurers also need the ability to invest
their premium income internationally to
pay local claims and to move their
capital from one jurisdiction to another.
Restrictions on the free flow of capital for
Principle-based, all-risk
approaches point the way forward
for (re)insurance regulation.
Open markets for reinsurance are
a pre-requisite to absorb large risks
efficiently.
reinsurers curtail their ability to move
funds to cover major events. Deposit or
collateral requirements which compel
reinsurers to maintain specific funds
within the country to cover their liabilities
to ceding companies may serve as an
example of such restrictions. Such
policies lead to a fragmentation of the
reinsurers capital base, requiring
companies to maintain larger capital
funds than otherwise needed. The
servicing of that capital adds to the cost
of reinsurance which has to be reflected
in reinsurance pricing.
Core reinsurance business does
not pose a systemic risk
The financial crisis of 20082009 has
highlighted the importance of effective
regulation and supervision of the financial
industry and the need for better mon-
itoring of potential systemic risks. Studies
on the potential impact of an extreme loss
scenario have shown that the effects of
the collapse of a large reinsurer would not
threaten the stability of the insurance
market or financial system. The business
model of insurance and reinsurance is
fundamentally different from that of other
financial services providers. Banks for
example are exposed to the risk of a run
on deposits, triggered by nervous
customers who might wish to empty their
accounts in the event of an impending
collapse. For insurers, who effectively
pre-fund claims from the premiums they
earn at the start of a contracts life, such a
risk is not relevant. Pay-outs are triggered
by actual events and not at the behest
of the policyholder. The exception is with
certain life insurance policies. But even
here early-withdrawal penalties make this
unlikely.
Size Diversification not size is the key
Interconnectedness Modest impact of reinsurer failure due to low
cession rates and conservative reinsurance
recoverables held on primary insurers balance
sheets
Substitutability Reinsurance is highly substitutable as demonstrated
by net capital inflows into natural catastrophe
reinsurance during periods of rising prices
Timing Timing of transmission between insurers is
significantly slower than between banks, allowing
mitigation measures that dampen systemic risk
Why are (re)insurers core activities not a systemic risk?
Note: Criteria based on Financial Stability Board and IAIS
Source: Geneva Association, Systemic Risk Report, 2010
The business model of (re)insurers
is fundamentally different from that
of banks.
Solvency II A new global benchmark for insurance regulation
In early 2008, the European Council, together with the European Parliament,
approved a joint compromise on the Solvency II Framework Directive, paving the
way for a new pan-European approach to calculating capital requirements. When
fully implemented, insurers and reinsurers in the European Union will operate
under some of the worlds most progressive insurance and reinsurance regulatory
standards. But what exactly will change under Solvency II?
The new solvency rules are intended to establish a more risk-sensitive capital
regime. The Solvency II framework is built on three pillars. The first of these pillars
sets out the quantitative requirements that an insurance companys financial
resources must fulfil. A key component here is that the use of internal risk models will
be permitted to determine the required capital. The second pillar has a qualitative
aspect: It establishes the principles for the supervisory review process as well
as for the internal risk management of insurers. The third pillar concerns disclosure
and transparency, with the aim of promoting market discipline.
Solvency II is based on an economic view and takes into account the companys
total balance sheet. Broadly speaking, available capital is calculated as the
difference between assets and liabilities valued on a market consistent basis. The
Solvency Capital Requirement (SCR) is determined by taking into account all the
risks facing insurance or reinsurance companies balance sheets in an integrated
way, be it insurance, market, counterparty credit and operational risk.
A major difference between Solvency II and the old Solvency I system is that the
new approach will assess accumulation potential and explicitly recognise diversi-
fication benefits. Diversification is a fundamental principle of insurance, and in
particular reinsurance. Under Solvency II, (re)insurance companies will be required
to check whether their available capital is sufficient to pay even for rare (1 in 200
year), large-scale claims, taking into account correlations between risk factors, that
is to say, their accumulation potential.
A study published in early 2010 by the
Geneva Association, a global insurance
industry think-tank, confirmed earlier
findings. A reinsurers core activities
managing capital, providing reinsurance
protection and transferring risk through
retrocession or capital markets
fundamentally pose no systemic threat to
the financial system. These activities are
either too limited in size to pose a danger
to the stability of financial markets,
or their potential impact could be easily
absorbed by the industry, such as in
the case of unprecedentedly large claims
which in any case are only paid out
gradually. Contagion risk, or the risk of
knock-on effects from the failure of a
particular organisation, is also low due to
the moderate level of interconnectedness
in the industry.
Reflecting economic reality:
Towards cross-border group
supervision
Insurance and reinsurance regulation
still largely operates at the national level,
whereas an increasing number of
companies write business and maintain
an operating presence in many different
jurisdictions. The financial crisis
highlighted the ineffectiveness of such
a fragmented regulatory approach.
It is obvious that large cross-border
institutions, whether banks, insurers or
financial conglomerates, should be
supervised in their entirety, for example,
by a lead supervisor, based in the groups
home country, who works in close
coordination with local counterparts.
Such an approach would also effectively
support the harmonisation and mutual
recognition of standards across
jurisdictions.
The global risk landscape is becoming
ever more complex, creating significant
issues for insurance companies and for
governments around the world. Changes
in demographics are putting pressure on
available funding for retirement in many
industrialised economies. At the same
time, exposure to natural catastrophes is
also increasing, as people and assets
become ever more concentrated in those
parts of the world that are prone to
disasters such as hurricanes. In the long
term, there looms the threat that climate
change will only exacerbate the frequency
and severity of weather-related events
such as floods, drought and wildfires. The
impact of these develop ments will have
profound consequences for sectors such
as construction, as well as agriculture.
Longevity risk: Managing the
shortfall between pension assets
and liabilities
Increased life expectancy and ageing
populations pose enormous challenges
to society. According to the European
Commission, there are currently four
people of working age in the EU for
each individual over 65. By 2060, it is
estimated that this ratio will halve.
Amongst other factors, this development
reflects major medical advances,
increased levels of wealth and improved
nutrition. By the middle of this century, life
expectancy at birth is projected to reach
the mark of 90 years in certain countries.
Reinsurance was invented to help societies deal
with the bigger risks associated with economic
growth in the 19th century. In a similar way,
reinsurance continues to help companies and
society tackle some of the biggest challenges
of the 21st century.
To be clear, the challenge of managing
this longevity risk is not that people are
living longer, but rather that life
expectancy is increasing much faster
than predicted, at a rate that is constantly
outpacing actuarial projections. This can
lead to considerable shortfalls between
pension fund assets and future liabilities,
particularly in a low interest rate
environment and in the case of defined
benefit pension plans. There are simply
fewer wage and salary earners to finance
a growing number of retirees.
If current trends continue, pension
schemes will become increasingly
unsustainable, presenting the danger
that individuals will outlive the means that
are available to them to support their
retirement. In order to manage longevity
risk associated with annuities or defined
benefit pensions, many pension providers
are switching to a defined contribution
scheme and/or transfering their liabilities
to insurance companies using bulk
annuities. This allows a pension scheme
provider to transfer all investment,
inflation and longevity risks associated
with paying income to retirees in exchange
for a premium and a share of the assets.
However capacity for this kind of longe-
vity risk in insurance is limited and will be
insufficient to address the long-term
challenges associated with demographic
change.
In order to bridge the gap, traditional
insurance solutions need to be
complemented by innovative ways of
hedging or redistributing longevity risk.
One potentially more efficient way to
de-risk pension schemes is to remove
longevity risk and manage it separately.
Longevity swaps, in which a (re)insurer
covers annual payments for longer-living
pensioners in return for a specified
stream of payments, are becoming a
preferred way to do that. By exchanging
potential future claims for fixed premiums,
this type of risk transfer gives pension
providers the certainty of making known
payments to a counterparty over a
specified period instead of paying
Reinsurance solutions for todays societal challenges
benefits to its pensioners for an unknown
period. In practice, rather than the
pension plan paying a premium to the
insurer and the insurer paying the claims
to the pension plan, only the net
difference is exchanged or swapped.
Another option would be to hedge
longevity risk with a contract where
payments are made based on the value of
a longevity index linked to improvements
in life expectancy within a given popu-
lation. While such transactions have been
rare, they have the benefit of allowing the
pension scheme to hedge risks in
connection with general longevity gains.
Reinsurers play an essential role in devel-
oping and offering innovative products
such as these. However, with capacity
in the industry limited and the future
development of pension costs unclear, it
is apparent that capital markets solutions
need to be developed and that longevity
risk needs to become a viable asset class
for a broad base of investors. Until now,
insurance and reinsurance companies
have been the principal buyers of
longevity risk, reflecting their natural
interest in diversifying portfolios and
offsetting mortality risks written through
life insurance policies. With their unrivalled
expertise in pricing risk, reinsurers
have an important role to play in helping
to transform longevity into a viable
investment product. By transferring
longevity risk from pension schemes to
(re)insurers and then passing some
of these risks onto capital markets, the
mechanisms of the new longevity market
would be similar to the natural cata-
strophe insurance risks that have been
transferred to investors in the form
of insurance-linked securities. A capital
market structure would take time to
establish, but this is necessary to develop
future capacity for longevity risk in the
insurance industry and beyond.
Innovation in disaster risk
financing: Making societies more
resilient
The economic losses that result from
natural catastrophes are clearly increasing,
driven by the concentration of people
and assets in catastrophe-prone areas
and by climate change. Despite increasing
insurance penetration, a large part of
these losses remains uninsured, placing
a considerable financial burden on
individuals and governments. More often
than not, governments and ultimately
taxpayers are left holding the bill for
major disasters, exacerbating the strain
on public finances that may already be
stretched.
The gap between insured and economic
losses tends to be widest in developing
and emerging economies. Generally, these
are the economies where the financial
resources necessary to deal with the
impact of disasters are most limited and
where the economic consequences of
Innovative approaches to managing sovereign risks
Mexico decided to take an innovative approach to managing the countrys
catastrophe exposure and turned to international organisations with experience in
capital markets to tap investors for funds which are ultimately deployed to those
in need in the event of a disaster.
The resulting collaboration with the World Bank produced a product that pays out
based on the pre-defined magnitude of a trigger event (eg the magnitude of an
earthquake).
Such insurance coverage can be a particularly effective tool for regions that are
afflicted by droughts, storms, floods or earthquakes but where loss assessment is
prohibitively expensive or difficult.
Reinsurers play a leading role in
designing and developing risk transfer
solutions for governments.
natural catastrophes can have long-term
implications by hampering future growth
prospects and even reversing the gains
already made. Especially for these
countries, solutions involving risk transfer,
can bring major benefits in terms of being
better able to manage and fund the
impact of disasters.
Reinsurers also play a significant role in
terms of creating the conditions necessary
for local insurance companies to provide
individuals and corporations with
insurance coverage against major natural
catastrophes. In order to properly fulfil
their economic and societal function in
this regard, however, reinsurers and
insurers must be able to charge the true
price for the risks that they take on. For
example, if insurance or reinsurance were
to be offered at artificially low levels, then
that would risk producing the wrong
signals about where and what to build
when it comes to constructing in hazard-
prone areas.
Supporting the development of new
solutions designed to address insurance
gaps is another of the important functions
that reinsurers play in terms of helping to
making society as a whole more resilient
to natural catastrophes and other
disasters. Microinsurance is one way
of providing low-income households with
access to insurance, thus making them
less vulnerable to the risk of falling into
poverty as the consequence of a major
disaster. Reinsurers have contributed
to the recent growth of microinsurance by
assisting microfinance institutions and
primary insurers in designing and devel-
oping appropriate products and in
helping to set-up appropriate risk sharing
frameworks. In fact, reinsurance coverage
is generally seen to be a necessary
condition for the scaling up of microinsu-
rance solutions.
Governments themselves are also highly
exposed to the financial consequences of
natural catastrophes. They not only
shoulder the immediate burden of paying
for emergency and relief efforts, but
they are also responsible in the longer
term for the subsequent costs of major
infrastructure projects aimed at rebuilding
damaged roads and other public facilities.
Traditionally, the public sector has
adopted a post-event approach to disaster
funding. This includes raising taxes,
reallocating funds from other budget items,
accessing domestic and international
credit, and borrowing from multilateral
finance institutions. Increasingly,
however, governments are taking a more
proactive approach to disaster risk
financing and are securing potentially
required funding before natural
catastrophes even occur. Such pre-event
financing mechanisms include insurance
cover and also certain capital market
Reinsurers were crucial in
the development of weather-index
insurance.
Agricultural crop insurance
In July 2009, Swiss Re entered into an agricultural reinsurance agreement with the
Beijing Municipal Government. Under the agreement, the Beijing Municipal
Government will pool all agricultural insurance business, and provide funding for
purchasing reinsurance cover directly from reinsurers. Thereby, the government
is able to transfer substantial agricultural risks to the private sector. In the event of
a catastrophe loss, Swiss Re, as lead reinsurer, will absorb a large portion of the
claims. This public-private partnership facilitates the sustainable development
of agricultural insurance, stimulating agricultural productivity in China amid global
concern over food security.

The transaction is a further example of how partnerships between the public and
private sectors can increase local and regional food security. Swiss Re concluded
a number of agriculture-related, public-private business transactions including the
provision of weather insurance in Mexico, India and Africa.
solutions, such as bonds that pay out in
the event of a pre-defined trigger such as
an earthquake of a particular intensity.
Reinsurers again play a leading role in
designing and developing such new risk
transfer solutions for governments.
Food security: Weather-index
insurance to stimulate agricultural
investments
Farmers are highly exposed to the
consequences of a failure in their harvest,
whether as the result of drought or
other natural catastrophes. This makes
investment to increase food production
a massive challenge. Reinsurers can help
to develop or to support innovative
solutions that provide them with financial
protection against those weather
conditions that would threaten agricul-
tural production and impact their ability
to make a living from the land. In
developing and emerging countries
in particular, such products can make
an important contribution to promoting
economic and social development.
Innovative solutions for agricultural
protection include index-based insurance
products. Instead of being tied to an
actual loss amount, these are tied to an
index such as rainfall, temperature,
humidity, crop yields or satellite-based
vegetation indices. As a result,
administrative costs for these products
are much lower, as there is no need for
a case-by-case damage assessment and
payout is often faster.
Reinsurers have been crucial in the
development of weather derivatives, a
market which has been growing strongly
for over 10 years. The insurance industry
has successfully translated this tool
to various weather-exposed industries.
Addressing climate change:
Adapting to the unavoidable
consequences and enabling green
technologies
The prospects of more extreme weather
events due to climate change and the
potentially devastating economic, social
and political ramifications are of great
concern to reinsurers. Reinsurance is key
to helping governments to develop
effective climate adaptation and helping
societies become more climate-resilient.
Reinsurers started looking at the
phenomenon of climate change as early
as the 1970s, making their findings
available to the public. Building on their
core competence of risk underwriting,
reinsurers are actively developing and
launching new products which not only
help policyholders adapt to climate
change but also have a great potential
to facilitate the successful conversion
to a low-carbon economy. Reinsurance
companies have a long tradition of
enabling new technologies, including
green technologies, such as wind farms
and solar technologies, by providing
reinsurance coverage.
As major risk carriers, reinsurers are at the
forefront of efforts to identify emerging
risks posed by new technologies. This is
a vital element in safeguarding primary
insurers and ultimately each individual
and corporate policyholder over the
long-term against the financial conse-
quences of adverse events, and to enable
the economy and society at large to take
the risks that allow them to move forward.
Reinsurers have a long tradition of
enabling new technologies.
Swiss Reinsurance Company Ltd
Mythenquai 50/60
P.O. Box
8022 Zurich
Switzerland
Telephone +41 43 285 2121
Fax +41 43 285 2999
www.swissre.com
2010 Swiss Re. All rights reserved.

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