CU-BBA-SEM-IV-Risk management-Second draft

interest rates rise over the life of the loan, the loan rate will never exceed the predetermined rate limit. Interest rate caps can also be structured to limit incremental increases in the rate of a loan. An adjustable-rate mortgage or ARM has a period in which the rate can readjust and increase if mortgage rates rise. The ARM rate might be set to an index rate plus a few percentage points added by the lender. The interest rate cap structure limits how much a borrower's rate can readjust or move higher during the adjustment period. In other words, the product limits the number of interest rate percentage points the ARM can move higher. Interest rate caps can give borrowers protection against dramatic rate increases and provide a ceiling for maximum interest rate costs. Example of an Interest Rate Cap Structure Adjustable-rate mortgages have many variations of interest rate cap structures. For example, let's say a borrower is considering a 5-1 ARM, which requires a fixed interest rate for five years followed by a variable interest rate afterward, which resets every 12 months. With this mortgage product, the borrower is offered a 2-2-5 interest rate cap structure. The interest rate cap structure is broken down as follows: The first number refers to the initial incremental increase cap after the fixed-rate period expires. In other words, 2% is the maximum the rate can increase after the fixed-rate period ends in five years. If the fixed rate was set at 3.5%, the cap on the rate would be 5.5% after the end of the five-year period. The second number is a periodic 12-month incremental increase cap meaning that after the five- year period has expired, the rate will adjust to current market rates once per year. In this example, the ARM would have a 2% limit for that adjustment. It's quite common that the periodic cap can be identical to the initial cap. The third number is the lifetime cap, setting the maximum interest rate ceiling. In this example, the five represents the maximum interest rate increases on the mortgage. So, let's say the fixed rate was 3.5% and the rate was adjusted higher by 2% during the initial incremental increase to a rate of 5.5%. After 12 months, mortgage rates rose to 8%; the loan rate would be adjusted to 7.5% because of the 2% cap for the annual adjustment. If rates increased by another 2%, the loan would only increase by 1% to 8.5%, because the lifetime cap is five percentage points above the original fixed rate. 201 CU IDOL SELF LEARNING MATERIAL (SLM)

13.3 COLLARS An interest rate collar is a relatively low-cost interest rate risk management strategy that uses derivatives to hedge an investor's exposure to interest rate fluctuations. Key Takeaways  An interest rate collar uses options contracts to hedge interest rate risk to protect variable rate borrowers against rising rates or lenders against falling rates in the case of a reverse collar.  A collar involves selling a covered call and simultaneously buying a protective put with the same expiration, establishing a floor and a cap on interest rates.  While the collar effectively hedges interest rate risk, it also limits any potential upside that would have been conferred by a favorable movement in rates. Understanding Interest Rate Collar A collar is a broad group of options strategies that involve holding the underlying security and buying a protective put while simultaneously selling a covered call against the holding. The premium received from writing the call pays for the purchase of the put option. In addition, the call caps the upside potential for appreciation of the underlying security's price but protects the hedger from any adverse movement in the value of the security. A type of collar is the interest rate collar. Essentially, an interest rate collar involves the simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount. An interest rate collar uses interest rate options contracts to protect a borrower against rising interest rates while also setting a floor on declining interest rates. An interest rate collar can be an effective way of hedging interest rate risk associated with holding bonds. With an interest rate collar, the investor purchases an interest rate ceiling, which is funded by the premium received from selling an interest rate floor. Remember that there is an inverse relationship between bond prices and interest rates—interest rates fall as bond prices rise, and vice versa. The objective of the buyer of an interest rate collar is to protect against rising interest rates. Purchasing an interest rate cap (i.e., a bond put option or rates call option) can guarantee a maximum decline in the bond's value. Although an interest rate floor (bond call option or rates put option) limits the potential appreciation of a bond given a decrease in rates, it provides upfront cash and generates premium income that pays for the cost of the ceiling. 202 CU IDOL SELF LEARNING MATERIAL (SLM)

Let's say an investor enters a collar by purchasing a ceiling with a strike rate of 10% and sells a floor at 8%. Whenever the interest rate is above 10%, the investor will receive a payment from the seller of the ceiling. If the interest rate drops below 8%, which is below the floor, the investor who is short the call must now make a payment to the party that purchased the floor. Clearly, the interest rate collar strategy protects the investor by capping the maximum interest rate paid at the collar's ceiling but sacrifices the profitability of interest rate drops. Interest Rate Caps and Floors An interest rate cap establishes a ceiling on interest payments. It is simply a series of call options on a floating interest rate index, usually 3- or 6-month London Inter-bank Offered Rate (LIBOR), which coincides with the rollover dates on the borrower's floating liabilities. The strike price, or strike rate, of these options represent the maximum interest rate payable by the purchaser of the cap. An interest rate floor is the minimum interest rate that is created using put options. It reduces the risk to the party receiving the interest payments since the coupon payment each period will be no less than a certain floor rate or strike rate. Reverse Interest Rate Collar A reverse interest rate collar protects a lender (e.g., a bank) against declining interest rates, which would cause a variable rate lender to receive less interest income if rates decline. It involves the simultaneous purchase (or long) of an interest rate floor and sale (or short) of an interest rate cap. The premium received from the short cap partly offsets the premium paid for the long floor. The long floor receives a payment when the interest rate falls below the floor exercise rate. The short cap makes payments when the interest rate exceeds the cap exercise rate. 13.4 PRICING TECHNIQUES Pricing strategies to attract customers to your business. There are dozens of ways you can price your products, and you may find that some work better than others — depending on the market you occupy. Consider these five common strategies that many new businesses use to attract customers. 13.4.1. Price skimming Skimming involves setting high prices when a product is introduced and then gradually lowering the price as more competitors enter the market. This type of pricing is ideal for businesses that are entering emerging markets. It gives companies the opportunity to capitalize on early adopters and then undercut future competitors as they join an already-developed market. A successful skimming strategy hinges largely on the market you’re looking to enter. 203 CU IDOL SELF LEARNING MATERIAL (SLM)

Example-Good examples of price skimming include innovative electronic products, such as the Apple iPhone and Sony PlayStation 3. For example, the PlayStation 3 was originally sold at $599 in the US market, but it has been gradually reduced to below $200. 13.4.2. Market penetration pricing Pricing for market penetration is essentially the opposite of price skimming. Instead of starting high and slowly lowering prices, you take over a market by undercutting your competitors. Once you develop a reliable customer base, you raise prices. Many factors go into deciding on this strategy, like your business’s ability to potentially take losses up front to establish a strong footing in a market. It’s also crucial to develop a loyal customer base, which can require other marketing and branding strategies. Market penetration pricing relies on the strategy of using low prices initially to make a wide number of customers aware of a new product. ... Penetration pricing examples include an online news website offering one month free for a subscription-based service or a bank offering a free checking account for six months. 13.4.3. Premium pricing Premium pricing is for business that create high quality products and market them to high- income individuals. The key with this pricing strategy is developing a product that is high quality and that customers will consider to be high value. You’ll likely need to develop a “luxury” or “lifestyle” branding strategy to appeal to the right type of consumer. Premium is defined as a reward, or the amount of money that a person pays for insurance. An example of a premium is an end of the year bonus. An example of a premium is a monthly car insurance payment. An amount paid or required, often as an installment payment, for an insurance policy. 13.4.4. Economy pricing An economy pricing strategy involves targeting customers looking to save as much money as possible on whatever good or service they’re purchasing. Big box stores, like Walmart and Costco, are prime examples of economy pricing models. Like premium pricing, adopting an economy pricing model depends on your overhead costs and the overall value of your product. An example of economy pricing is generic food sold at grocery stores. The generic items are priced lower due to the fact that they require very little marketing and promotion expenses. 13.4.5. Bundle pricing When companies pair several products together and sell them for less money than each would be individually, it’s known as bundle pricing. Bundle pricing is a good way to move a lot of 204 CU IDOL SELF LEARNING MATERIAL (SLM)

inventory quickly. A successful bundle pricing strategy involves profits on low value items outweighing losses on high value items included in a bundle. Examples of bundle pricing range in magnitude from everyday items to large purchases: The purchase of a “combo meal” at a fast-food restaurant, usually providing an entree, a side and a drink for one single set price. Cable television packages that offer a collection of channels in a single bundle or tier. 13.5 OPERATIONAL ASPECTS Operational aspects in pricing are emerging as one of the important risks financial institutions worldwide are concerned with. Unlike other categories of risks, such as credit and market risks, the definition and scope of operational risk is not fully clear. Several diverse professions such as internal control and audit, statistical quality control and quality assurance, facilities management, and contingency planning, etc., have approached the subject of operational risk thereby bringing in different perspectives to the concept. While studies carried out on bank failures in the U.S. show that operational risk has accounted for an insignificant proportion of large bank failures so far, it is widely acknowledged that most of the new, unknown risks are under the category of operational risk. This necessitates the need for an understanding of the operational risks in financial services in general and banking. Definition of Operational Risk According to the Basel Committee, Operational risk is defined as “the risk of loss resulting from inadequate or failed processes, people and systems or external events. This definition includes legal risk but excludes strategic and reputational risk” (The New Basel Capital Accord, Consultative Document released in April 2003. Bankers Trust (now a part of Deutsche Bank) asked a very simple question way back in 1992 to understand the nature of operational risk: what risks were not being addressed by market and credit risk models and functions? Answering the question led the bank to identify risks associated with the bank’s exposures as under: Primary operational risk/exposure classes are Relationship Risks. Non-proprietary losses caused to a firm and generated through the relationship or contact that a firm has with its clients, shareholders, third parties or regulators (e.g., accommodations/reimbursements to clients, settlements or penalties paid, etc.). People/Human Capital Risks The risk of loss caused intentionally or unintentionally by an employee (i.e., an employee error, employee misdeed, etc.) or involving employees, such as in employment disputes, intellectual capital, etc. 205 CU IDOL SELF LEARNING MATERIAL (SLM)

Technology and Processing Risks the risk of loss caused by a piracy, theft, failure, breakdown or other disruption in technology, data, or information; also includes technology that fails to meet the intended business needs. Physical Risks: The risk of loss through damage of bank-owned properties or loss to physical property or assets for which the firm is responsible. Other External Risks The risk of loss caused by the actions of external parties, such as in the perpetration of fraud on the bank, or in the case of regulators, the promulgation of change that would alter the firm’s ability to continue operating in certain markets. All five exposure classes include several dimensions of risk, including direct economic loss, the economic impact of indirect loss or business disruption, and/or legal liability. Intuitively operational risk is the potential for any disruption in the firm’s operational processes. The disruption may come from one-off events, ranging from rogue trading and accounting mistakes to terrorist activities and landmark legal settlement, and from improper sales practices and systems failures to sabotage, regulatory violations, and acts of God. The very diversity of events that lead to operational risk makes precise definitions exclusive. 13.6 SUMMARY  It is essential to understand the difference between forex exposure and forex risk. Foreign exchange exposure is the sensitivity to changes in the real domestic currency value of assets, liabilities or operating incomes to unanticipated change in exchange rates.  Foreign exchange risk exposure is quite often used interchangeably with the term ‘foreign exchange risk’, although they are conceptually quite different. Foreign exchange risk is defined in terms of variance of unanticipated changes in exchange rates. It is measured by the variance of the domestic currency value of an asset, liability or operating income that is attributable to unanticipated changes in exchange rates.  Technology and Processing Risks The risk of loss caused by a piracy, theft, failure, breakdown or other disruption in technology, data or information; also includes technology that fails to meet the intended business needs.  All five exposure classes include several dimensions of risk, including direct economic loss, the economic impact of indirect loss or business disruption, and/or legal liability. Intuitively operational risk is the potential for any disruption in the firm’s operational processes. The disruption may come from one-off events, ranging from rogue trading and accounting mistakes to terrorist activities and landmark legal settlement, and from 206 CU IDOL SELF LEARNING MATERIAL (SLM)

improper sales practices and systems failures to sabotage, regulatory violations, and acts of God  Physical Risks: The risk of loss through damage of bank-owned properties or loss to physical property or assets for which the firm is responsible.  A collar is a broad group of options strategies that involve holding the underlying security and buying a protective put while simultaneously selling a covered call against the holding. The premium received from writing the call pays for the purchase of the put option.  As a part of aggressive financing policy, c0mpanies may prefer to increase their exposure under cash flows, debts and receivables in strong currencies and increase borrowings and trade creditors in weak currencies. Simultaneously, they reduce exposed borrowing and trade creditors in strong currencies.  External techniques which are also known as active hedging techniques, essentially involve contractual relationship with outside agency. Hedging is a method whereby one can reduce the financial exposure faced in an underlying asset due to volatility in prices by taking an opposite position in the derivatives market in order to offset the losses in the cash market by a corresponding gain in the derivatives market 13.7 KEYWORDS 1. Legal settlement: A settlement is an agreement between the parties. It generally involves one party agreeing to pay compensation to the other party or meet the other party's demands, and the other party agreeing to take no further legal action on their claim. 2. Audit: Audit is the examination or inspection of various books of accounts by an auditor followed by physical checking of inventory to make sure that all departments are following documented system of recording transactions. It is done to ascertain the accuracy of financial statements provided by the organization. 3. Statistical quality control: Use of statistical methods to measure and improve the quality of manufacturing processes and products. The term \"statistical process control\" is often used interchangeably. 4. Quality assurance: the maintenance of a desired level of quality in a service or product, especially by means of attention to every stage of the process of delivery or production. 5. Facilities management: Facilities management can be defined as the tools and services that support the functionality, safety, and sustainability of buildings, grounds, 207 CU IDOL SELF LEARNING MATERIAL (SLM)

infrastructure, and real estate. Facilities management includes Lease management, including lease administration and accounting. 6. Contingency planning: contingency planning refers to the plans, policies, procedures, and technical measures that enable the recovery of IT operations after an unexpected incident. A disruptive event could include a major natural disaster such as a flood, or something smaller, such as malfunctioning software caused by a computer virus. 13.8 LEARNING ACTIVITY 1. Conduct a survey on how to remember that there is an inverse relationship between bond prices and interest rates—interest rates fall as bond prices rise, and vice versa. ______________________________________________________________________________ ______________________________________________________________________________ 2. Prepare a report on operational aspects in pricing is emerging as one of the important risk’s financial institutions worldwide. ______________________________________________________________________________ ______________________________________________________________________________ 13.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is Price Skimming? 2. What is the meaning of Market Penetration Pricing? 3. Explain the term Premium Pricing? 4. What is Economy Pricing? 5. What is the meaning of Bundle Pricing? Long Questions 1. What are the learning Objectives instruments of external techniques of risk management? 2. Define the term: i. Caps ii. Collars 208 CU IDOL SELF LEARNING MATERIAL (SLM)

3. What is the meaning of Pricing Techniques? Define Price Skimming, Market Penetration Pricing, and Premium Pricing? 4. How is Economy Pricing and Bundle Pricing a part of pricing techniques? 5. What do you mean by Operational Aspects in instruments of external techniques of risk management? B. Multiple Choice Questions 1. The risk of loss caused intentionally or unintentionally by an employee (i.e., an employee error, employee misdeed, etc.) or involving employees, such as in employment disputes, intellectual capital, etc. is called. a. People/Human Capital Risks b. Liabilities risk c. Credit risk d. Operational risk 2. A collar is a broad group of options strategies that involve holding the underlying security and buying a protective put while simultaneously selling a covered call against the a. Customers b. Organisation c. Institutions d. Holding. 3. Premium pricing is for business that create ---------------and market them to high-income individuals. a. High quality products b. Low quality products c. Business risks d. All of these 4. --------------------caused to a firm and generated through the relationship or contact that a firm has with its clients, shareholders, third parties or regulators (e.g., accommodations/reimbursements to clients, settlements or penalties paid, etc.). a. Business b. Risk 209 CU IDOL SELF LEARNING MATERIAL (SLM)

c. Competition d. Non-proprietary losses 5. -------------------------is the sensitivity to changes in the real domestic currency value of assets, liabilities, or operating incomes to unanticipated change in exchange rates. a. Foreign exchange exposure b. Share market c. Trading d. Economic crisis Answers 1-a, 2-d, 3-a, 4-d, 5-a 13.10 REFERENCES References  Pellegrino JM. Risk management in agriculture: Argentine evidence of perceived sources of risk, risk management strategies and risk efficiency in rice farming [masterthesis]. Lincoln, New Zealand: Lincoln University; 1999.  Katikarn K. Risk and uncertainty of farmers in the central plain of Thailand [doctoral thesis]. Lexington, Kentucky: University of Kentucky; 1981  Booch G., Jacobson I., Rumbaugh J., The Unified Modeling Language, Addison Wesley,1998. Textbooks  Harwood J, Heifner R, Coble K, Perry J, Somwaru A. Managing risk in farming:concepts, research, and analysis. [report]. In press 1999.  Shadbolt NM, Martin SK. Farm management in New Zealand. Auckland: Oxford University Press; 2005.  Patamakitsakul S. Thailand agriculture in the 10th National Economic and SocialDevelopment Plan (2007-2011) (in Thai)2006. Websites  https://www.investopedia.com/articles/optioninvestor/08/protective-collar-bullish- collar.asp 210 CU IDOL SELF LEARNING MATERIAL (SLM)

 https://www.shahucollegelatur.org.in/  https://www.lucidchart.com/blog/risk-management-process  https://www.iedunote.com/risk-management  https://www.lucidchart.com/blog/risk-management-process 211 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 14: REINSURANCE STRUCTURE 14.0 Learning Objectives 14.1 Introduction 14.2 Benefits of Reinsurance 14.3 Types of Reinsurance 14.4 Reinsurance in the Insurance Sector 14.5 Areas of the Application of Reinsurance 14.5.1 The buyer’s Reinsurance Needs. 14.5.2 Reinsurance Underwriting Information 14.5.3 The Reinsurance Programme’s 14.5.4 Reinsurance Portfolio Management 14.5.5 Alternative Risk Transfer 14.5.6 Financial Aspects 14.6 Summary 14.7 Keywords 14.8 Learning Activity 14.9 Unit End Questions 14.10 References 14.0 LEARNING OBJECTIVES After completion of this unit, you will be able to:  Examine and evaluate the various Learning Objectives, Introduction of reinsurance.  Evaluate the benefits of Reinsurance.  Explain and understand Types of Reinsurance.  Illustrate how Reinsurance in the Insurance Sector effects the economy as whole. 212 CU IDOL SELF LEARNING MATERIAL (SLM)

 Evaluate various Areas of the Application of Reinsurance with respect to the buyer’s Reinsurance Needs, Reinsurance Underwriting Information, The Reinsurance Programmes, Reinsurance Portfolio Management, and Alternative Risk Transfer.  Evaluate and Understand to implement Financial Aspects of reinsurance. 14.1 INTRODUCTION Reinsurance is insurance for insurance companies. It’s a way of transferring or “ceding” some of the financial risk insurance companies assume in insuring cars, homes and businesses to another insurance company, the reinsurer. Reinsurance is a highly complex global business. U.S. professional reinsurers (companies that are formed specifically to provide reinsurance) accounted for about 7 percent of total U.S. property/casualty insurance industry premiums written in 2010, according to the Reinsurance Association of America. The reinsurance business is evolving. Traditionally, reinsurance transactions were between two insurance entities: the primary insurer that sold the original insurance policies and the reinsurer. Most still are. Primary insurers and reinsurers can share both the premiums and losses, or reinsurers may assume the primary company’s losses above a certain dollar limit in return for a fee. However, risks of various kinds, particularly of natural disasters, are now being sold by insurers and reinsurers to institutional investors in the form of catastrophe bonds and other alternative risk-spreading mechanisms. Increasingly, new products reflect a gradual blending of reinsurance and investment banking, see also Background section. Reinsurance is also known as insurance for insurers or stop-loss insurance. Reinsurance is the practice whereby insurers transfer portions of their risk portfolios to other parties by some form of agreement to reduce the likelihood of paying a large obligation resulting from an insurance claim. The party that diversifies its insurance portfolio is known as the ceding party. The party that accepts a portion of the potential obligation in exchange for a share of the insurance premium is known as the reinsurer. Reinsurance, or insurance for insurers, transfers risk to another company to reduce the likelihood of large payouts for a claim. Reinsurance allows insurers to remain solvent by recovering all or part of a payout. Companies that seek reinsurance are called ceding companies. 14.2 BENEFITS OF REINSURANCE 213 CU IDOL SELF LEARNING MATERIAL (SLM)

 By covering the insurer against accumulated individual commitments, reinsurance gives the insurer more security for its equity and solvency by increasing its ability to withstand the financial burden when unusual and major events occur.  Through reinsurance, insurers may underwrite policies covering a larger quantity or volume of risk without excessively raising administrative costs to cover their solvency margins. In addition, reinsurance makes substantial liquid assets available to insurers in case of exceptional losses.  Insurers are legally required to maintain sufficient reserves to pay all potential claims from issued policies.  Reinsurance is insurance for insurance companies. It’s a way of transferring or “ceding” some of the financial risk insurance companies assume in insuring cars, homes and businesses to another insurance company, the reinsurer. Reinsurance is a highly complex global business. U.S. professional reinsurers (companies that are formed specifically to provide reinsurance) accounted for about 7 percent of total U.S. property/casualty insurance industry premiums written in 2010, according to the Reinsurance Association of America.  The reinsurance business is evolving. Traditionally, reinsurance transactions were between two insurance entities: the primary insurer that sold the original insurance policies and the reinsurer. Most still are. Primary insurers and reinsurers can share both the premiums and losses or reinsurers may assume the primary company’s losses above a certain dollar limit in return for a fee. However, risks of various kinds, particularly of natural disasters, are now being sold by insurers and reinsurers to institutional investors in the form of catastrophe bonds and other alternative risk- spreading mechanisms. Increasingly, new products reflect a gradual blending of reinsurance and investment banking.  Recent Developments Financial and Market Conditions: According to the Reinsurance Association of America (RAA), a group of 18 reinsurers property/casualty reinsurers wrote $28.4 billion of premiums in the first six months of 2014, compared with $13.5 billion during the same six-month period in 2013, an increase driven largely by some specific transactions reported by one of the 18 reinsurers surveyed by the RAA. The combined ratio, a measure of profitability that shows what percentage of the premium dollar that was spent on claims and expenses, was 92.3 percent, a deterioration from the 85.9 reported in the first six months of 2013. Policyholders’ surplus, capital that represents a cushion against unexpectedly high losses, now stands at $142.9 billion, up from $138.7 billion at the end of first quarter 2014. Net income for the period rose to $5.9 billion. 214 CU IDOL SELF LEARNING MATERIAL (SLM)

RAA members account for about two-thirds of reinsurance coverage provided by U.S. reinsurers and their affiliates. Catastrophe Bonds: Industry observers predict that the catastrophe (cat) bond market will have an extraordinarily successful year, possibly topping the previous record issuance of $7 billion set in 2007. Cat bonds issued in the second quarter alone rose to $4.5 billion, with 17 deals consummated, putting the total for the first six months of the year at about $5.7 billion, according to the Willis Group. Some speculate that the figure could rise to more than $8 billion before the end of the year. The largest cat bond ever, a $1.5 billion deal, was issued by Citizens Property Insurance Corp., Florida’s insurer of last resort, to cover the state’s hurricane risk. Demand was so strong and pricing and conditions for cat bonds and traditional reinsurance so favorable that Citizens was able to increase the offering twice from the original $400 million and nearly double last year’s reinsurance program for almost the same cost, a spokesperson said. Study: The Federal Insurance Office (FIO) released a long-awaited report on the reinsurance and insurance industries in December 2013. Among its many recommendations is one that deals with credit for reinsurance. It suggests ending a long-standing debate on the issue of posting 100 percent collateral on reinsurance transactions with non-U.S. reinsurers by following the National Association of Insurance Commissioners (NAIC) amended version of its model law adopted at the organization’s November 2011 meeting. The NAIC’s Credit for Reinsurance Model Law allows financially sound non-U.S. reinsurers to post less than 100 percent collateral and lets the NAIC decide which foreign jurisdictions have sufficiently rigorous regulations for their reinsurers to be considered “qualified” and therefore permitted to post a lower collateral amount. The law also requires insurers to notify state commissioners when the amount that they expect to recover under their reinsurance contracts exceeds 50 percent of their policyholders’ surplus, the financial cushion that allows insurers to pay unexpectedly high claims. It also requires insurers to diversify their reinsurance programs to lower the risk of not being able to collect on their reinsurance contracts.  Background Reinsurance is insurance for insurance companies. Just as a homeowners or auto insurance policy reduces the amount of cash a person must have on hand to pay for a new car after an accident or to rebuild a home after a hurricane, a reinsurance contract can protect an insurance company against large catastrophic losses. Reinsurance also enables an insurer to underwrite more or larger insurance policies. When an insurance company issues an insurance policy, an auto insurance policy, for example, it assumes responsibility for paying for the cost of any accidents that occur, within the parameters set out in the policy. By law, an insurer must have sufficient capital to ensure it will be able to pay all potential future claims related to the policies it issues. This requirement protects consumers but limits the amount of business an insurer can 215 CU IDOL SELF LEARNING MATERIAL (SLM)

take on. However, if the insurer can reduce its responsibility, or liability, for these claims by transferring a part of the liability to another insurer, it can lower the amount of capital it must maintain to satisfy regulators that it is in good financial health and will be able to pay the claims of its policyholders. Capital freed up in this way can support more or larger insurance policies. The company that issues the policy initially is known as the primary insurer. The company that assumes liability from the primary insurer is known as the reinsurer. Primary companies are said to “cede” business to a reinsurer. Reinsurance can be divided into two basic categories: treaty and facultative. Treaties are agreements that cover broad groups of policies such as all a primary insurer’s auto business. Facultative covers specific individual, generally high-value or hazardous risks, such as a hospital, that would not be accepted under a treaty. In most treaty agreements, once the terms of the contract, including the categories of risks covered, have been established, all policies that fall within those terms – in many cases both new and existing business—are covered, usually automatically, until the agreement is cancelled. With facultative reinsurance, the reinsurer must underwrite the individual “risk,” say a hospital, just as a primary company would, looking at all aspects of the operation and the hospital’s attitude to and record on safety. In addition, the reinsurer would also consider the attitude and management of the primary insurer seeking reinsurance coverage. This type of reinsurance is called facultative because the reinsurer has the power or “faculty” to accept or reject all or a part of any policy offered to it in contrast to treaty reinsurance, under which it must accept all applicable policies once the agreement is signed. Treaty and facultative reinsurance agreements can be structured on a “pro rata” (proportional) or “excess-of-loss” (non-proportional) basis, depending on the arrangement by which losses are apportioned between the two insurers. A primary company’s reinsurance program can be very complex. Simply put, if it were diagrammed, it might look like a pyramid with ascending dollar levels of coverage for increasingly remote events, split among several reinsurance companies each assuming a portion. It would include layers of proportional and excess of loss treaties and possibly a facultative excess of loss layer at the top. Regulation: As an industry, reinsurance is less highly regulated than insurance for individual consumers because the purchasers of reinsurance, mostly primary companies that sell car, home, and commercial insurance, are considered sophisticated buyers. However, in the early 1980s, state insurance officials became increasingly concerned about the reliability of reinsurance contracts – the ability of the reinsurer to meet its contractual obligations — and a primary company's use of them. Following the June 1982 annual meeting of the National Association of Insurance Commissioners (NAIC) in Philadelphia, an advisory committee was formed to review the regulation of reinsurance transactions and parties to those transactions. A model Credit for Reinsurance Act was adopted in 1984. 216 CU IDOL SELF LEARNING MATERIAL (SLM)

All insurers submit financial statements to regulators who monitor their financial health. Financial health includes not assuming more risk or liability for future claims than is prudent, given the amount of capital available to support it, i.e., to pay claims. The principal value of reinsurance to a ceding company (the purchaser of reinsurance) for regulatory purposes is the recognition on the ceding company's financial statement of a reduction in its liabilities in terms of two accounts: its unearned premium reserve and its loss reserve. The unearned premium reserve is the amount of premiums equal to the unexpired portion of insurance policies, i.e., insurance protection that is still \"owed\" to the policyholder and for which funds would have to be returned to the policyholder should the policyholder cancel the policy before it expired. The loss reserve is made up of funds set aside to pay future claims. The transfer of part of the insurance company’s business to the reinsurer reduces its liability for future claims and for return of the unexpired portion of the policy. The reduction in these two accounts is commensurate with the payments that can be recovered from reinsurers, known as recoverable. The insurer’s financial statement recognizes as assets on the balance sheet any payments that are due from the reinsurer for coverage paid for by the ceding company. By statute or administrative practice, all states (but with considerable variation) recognize and grant credit on the financial statement for the reduced financial responsibility that reinsurance transactions provide. When reinsurers are not licensed in the United States, (these are known as “alien” or offshore companies) they must post collateral (such as trust funds, letters of credit, funds withheld) to secure the transaction. An alien company can also participate in the U.S. marketplace by becoming licensed in the states in which it wishes to do business. For many years, few people outside the insurance industry were aware that such a mechanism as reinsurance existed. The public was first introduced to reinsurance in the mid-1980s, during what has now become known as the liability crisis. A shortage of reinsurance was widely reported to be one of the factors contributing to the availability problems and high price of various kinds of liability insurance. A few years later, in 1989, the reinsurance business once again became a topic of interest outside the insurance industry as Congress investigated the insolvencies of several large property/casualty insurers. The publicity surrounding the investigations and the poor financial condition of several major life insurance companies prompted proposals for some federal oversight of the insurance industry, particularly insurers and reinsurers based outside the United States. However, no federal law was enacted. While a large portion of the insurance industry opposes federal regulatory oversight, many U.S. reinsurers and large commercial insurer’s view compliance with a single federal law as preferable to compliance with the laws of 51 state jurisdictions. A critical tool for evaluating solvency is the annual \"convention\" statement, the detailed financial statement submitted by all insurance companies to the NAIC. In 1984, for the first time, the 217 CU IDOL SELF LEARNING MATERIAL (SLM)

annual statement required insurers ceding liability to unauthorized reinsurers (those not licensed or approved in a designated jurisdiction) to include the amount of incurred but not reported (IBNR) losses in addition to known and reported losses. (IBNR losses are losses associated with events that have already occurred where the full cost will not be known and reported to the insurer until some later date.) This requirement reflects regulators' concern that all liabilities are identified and determined actuarially, including IBNR losses, and that IBNR losses are secured by the reinsurer with additional funds, or a larger letter of credit than otherwise would have been required. Related to solvency is the issue of reinsurance \"recoverable,” payments due from the reinsurer. In the mid-1980s, some reinsurance companies that had entered the reinsurance business during the period of high interest rates in the early 1980s left the market, due to insolvency or other problems. (When interest rates are high, some insurance/reinsurance companies seek to increase market share to have more premiums to invest. Those that fail to pay attention to the riskiness of the business they are underwriting may end up undercharging for coverage and going bankrupt as a result.) Consequently, some of the insurers that reinsured their business with these now- defunct companies were unable to recover monies due to them on their reinsurance contracts. To enable regulators, policyholders, and investors to assess a company's financial condition more accurately, the NAIC now requires insurance companies to deduct 20 percent of anticipated reinsurance recoverable from their policyholders’ surplus on their financial statements—surplus is roughly equivalent to capital—when amounts are overdue by more than 90 days. The rule helps regulators identify problem reinsurers for regulatory actions and encourages insurers to purchase reinsurance from companies that are willing and able to pay reinsured losses promptly. Concern about reinsurance recoverable led to other changes in the annual financial statement filed with state regulators, including changes that improve the quality and quantity of reinsurance data available to enhance regulatory oversight of the reinsurance business. After Hurricane Andrew hit Southern Florida in 1992, causing $15.5 billion in insured losses at the time, it became clear that U.S. insurers had seriously underestimated the extent of their liability for property losses in a mega disaster. Until Hurricane Andrew, the industry had thought $8 billion was the largest possible catastrophe loss. Reinsurers subsequently reassessed their position, which in turn caused primary companies to reconsider their catastrophe reinsurance needs. When reinsurance prices were high and capacity scarce because of the high risk of natural disasters, some primary companies turned to the capital markets for innovative financing arrangements. 218 CU IDOL SELF LEARNING MATERIAL (SLM)

Catastrophe Bonds and Other Alternative Risk Financing Tools: The shortage and high cost of traditional catastrophe reinsurance precipitated by Hurricane Andrew and declining interest rates, which sent investors looking for higher yields, prompted interest in securitization of insurance risk. Among the precursors to so-called true securitization were contingency financing bonds such as those issued for the Florida Windstorm Association in 1996, which provided cash in the event of a catastrophe but had to be repaid after a loss, and contingent surplus notes — an agreement with a bank or other lender that in the event of a mega disaster that would significantly reduce policyholders’ surplus, funds would be made available at a predetermined price. Funds to pay for the transaction should money be needed, are held in U.S. Treasuries. Surplus notes are not considered debt, therefore do not hamper an insurer's ability to write additional insurance. In addition, there were equity puts, through which an insurer would receive a sum of money in the event of a catastrophic loss in exchange for stock or other options. A catastrophe bond is a specialized security that increases insurers’ ability to provide insurance protection by transferring the risk to bond investors. Commercial banks and other lenders have been securitizing mortgages for years, freeing up capital to expand their mortgage business. Insurers and reinsurers issue catastrophe bonds to the securities market through an issuer known as a special purpose reinsurance vehicle (SPRV) set up specifically for this purpose. These bonds have complicated structures and are typically created offshore, where tax and regulatory treatment may be more favorable. SPRVs collect the premium from the insurance or Reinsurance Company and the principal from investors and hold them in a trust in the form of U.S. Treasuries or other highly rated assets, using the investment income to pay interest on the principal. Catastrophe bonds pay high interest rates but if the trigger event occurs, investors lose the interest and sometimes the principal, depending on the structure of the bond, both of which may be used to cover the insurer’s disaster losses. Bonds may be issued for a one-year term or multiple years, often three. Increasingly, catastrophe bonds are being developed for residual market government entities and state-backed wind pools. Taking advantage of the growing popularity of catastrophe bonds as investments, Florida’s Citizens Property Insurance Corp. issued bonds through the special purpose vehicle, Everglades Re. Bonds were issued by the Massachusetts Property Insurance Underwriting Association, two North Carolina pools (the Fair Plan and Beach Plan) and the Alabama wind pool. In addition, the California State Compensation Insurance Fund issued a bond to cover workers compensation losses in the event of a catastrophic earthquake. Other bonds have been created to cover extreme mortality and medical benefit claim levels. The catastrophe bond market, which was largely pioneered by reinsurers, has begun to change. In 2009, for the first time, primary insurance companies were sponsors of most bond issues– about 60 percent. Industry observers say primary companies are increasingly integrating cat 219 CU IDOL SELF LEARNING MATERIAL (SLM)

bonds into their core reinsurance programs to diversify and increase flexibility. Whereas traditional reinsurance is mostly purchased on an annual basis, cat bonds generally provide multiyear coverage and may be structured in tranches that mature in successive years. Of the many new ways of financing catastrophe risk that have been developed over the past decade or two, catastrophe bonds are best known outside the insurance industry. One lesser- known alternative is the industry loss warranty contract (ILW). Unlike traditional reinsurance, where the reinsurer pays a portion of the primary company’s losses according to an agreed upon formula, the ILW is triggered by an agreed-upon industry loss. The contract “warrants” that the reinsurer will pay up to $100 million toward the buyer’s losses if the industry suffers a predetermined loss amount, say $5 billion or more. Another recent innovation is the sidecar. These are relatively simple agreements that allow a reinsurer to transfer to another reinsurer or group of investors, such as hedge funds, a limited and specific risk, such as the risk of an earthquake or hurricane in each geographic area over a specific period. Side-car deals are much smaller and less complex than catastrophe bonds and are usually privately placed rather than tradable securities. In sidecars, investors share in the profit or loss the business produces along with the reinsurer. While a catastrophe bond could be considered excess of loss reinsurance, assuming the higher layers of loss for an infrequent but potentially highly destructive event, sidecars are like reinsurance treaties where the reinsurer and primary insurer share in the results. An insurance company’s willingness to offer disaster coverage is often determined by the availability of reinsurance. When catastrophe bonds were first issued after Hurricane Andrew, they were expected to gain industry wide acceptance as an alternative to traditional catastrophe reinsurance, which was then in short supply, but they still represent a small, albeit growing, portion of the worldwide catastrophe reinsurance market. Several of the first attempts at true securitization were withdrawn because of time constraints — the hurricane season had begun before work on the transaction could be completed, for example — and lack of sufficient interest on the part of investors. The first deals were consummated in December 1996, one by a U.S. reinsurer, St Paul Re, and the second by Winterthur, a Swiss insurer which issued convertible bonds to pay auto damage claims stemming from hailstorms. This was the first large transaction in which insurance risk was sold to the public markets. The company said that it did not need to finance hailstorm damage in this way but sold the bonds to test the market for securitizing insurance risks. Six months later there was strong investor interest in a bond offering that provided USAA with catastrophe reinsurance to pay homeowners losses arising from a single hurricane in eastern coastal states, proving for the first time that insurance risk could be sold to institutional investors on a large scale. 220 CU IDOL SELF LEARNING MATERIAL (SLM)

The field has gradually evolved to the point where some investors and insurance company issuers are beginning to feel comfortable with the concept, with some coming back to the capital markets each year. In addition to the high interest rates catastrophe bonds pay, their attraction to investors is that they diversify investment portfolio risk, thus reducing the volatility of returns. The returns on most other securities are tied to economic activity rather than natural disasters. The National Association of Insurance Commissioners (NAIC), which oversees insurance company investments and sets the rules that influence insurers’ investment strategies, classifies these new types of catastrophe risk securities as bonds rather than equities. Equities are considered riskier under formulas that dictate how much capital must be set aside to support various liabilities. In addition, at its June 1999 meeting, the NAIC approved a so-called “protected cell” model act that makes it easier to transact deals in the United States. Up to then, most securitization deals had been conducted offshore through special entities created for this purpose. The protected cells, separate units within an insurance company, protect investors from losses incurred by the insurer. In addition to catastrophe bonds, catastrophe options were developed but the market for these options never took off. Another alternative is the exchange of risk where individual companies in different parts of the world swap a certain number of losses. Payment is triggered by the occurrence of an agreed upon event at a certain level of magnitude. Disaster Recovery Bonds and Regional Pools: Disaster recovery bonds serve much the same purpose as a business income insurance policy, helping the government entity/policyholder get back on track after a catastrophic event. In developing countries insurance penetration is low, meaning that few individuals and businesses have insurance, so the burden of recovering from a disaster falls almost entirely on the government. Traditionally, developing countries have relied on post-disaster funding to finance recovery efforts, including donations from developed countries, international emergency aid and humanitarian relief organizations. A faster and more reliable way to fund the recovery is refinancing in the form of reinsurance, catastrophe bonds or other alternative risk transfer mechanisms. One example of prefunding is the Caribbean Catastrophe Risk Insurance Facility, the first regional insurance fund. CCRIF provides hurricane and earthquake catastrophe coverage to its member nations, so that in the aftermath of a disaster they can quickly fund immediate recovery needs and continue providing essential services. In 2004 hurricanes severely damaged the economy of several small Caribbean islands, causing losses more than $4 billion. This prompted Caribbean governments to request the help of the 221 CU IDOL SELF LEARNING MATERIAL (SLM)

World Bank in facilitating access to catastrophe insurance. The CCRIF started operations in June 2007, after two years of planning. The CCRIF acts as a mutual insurance company, allowing member nations to combine their risks into a diversified portfolio and purchase reinsurance or other risk transfer products on the international financial markets at a saving of up to 50 percent over what it would cost each country if they purchased catastrophe protection individually. In addition, since a hurricane or earthquake only affects one to three countries in the Caribbean on average in any given year, each country contributes less to the reserve pool than would be required if each had its own reserves. The CCRIF was initially capitalized by its members with help from donor partners — developed countries, the World Bank, and the Caribbean Development Bank. Its members pay premiums based on their probable use of the pool’s funds. As countries raise building standards to provide better protection against disasters, premiums will decrease. Because the CCRIF uses what has become known as parametric insurance to calculate claim payments, claims are paid quickly. Under a parametric system, claim payments are triggered by the occurrence of a specific event that can be objectively verified, such as a hurricane reaching a certain wind speed or an earthquake reaching a certain ground shaking threshold, rather than by actual losses measured by an adjuster, a process that can take months to complete. Payout amounts are derived from models that estimate the financial impact of the disaster. As a form of deductible that encourages risk mitigation, participating governments are only allowed to purchase coverage for up to 20 percent of their estimated losses, an amount believed to be sufficient to cover initial needs. 14.3 TYPES OF REINSURANCE There are various methods for reduction and mitigations of risks. Transfer of Risks is the one of them. The concept of Re-Insurance emerges, when an insurance company transfers some of its risks to another insurance company. It is the insurance that is purchased by an insurance company (the “Ceding Company”) from one or more other insurance companies (the “Reinsurer) as a means of Risk Management. The Ceding Company and the Re-insurer will enter into a Re-insurance Agreement which details the conditions upon which the reinsurer would pay as share of the claims incurred by the Ceding Company. The Re-insurer may be either a Specialist Re-Insurance Company (General Insurance Corporation of India) or can be another insurance company. Types of Reinsurance: 222 CU IDOL SELF LEARNING MATERIAL (SLM)

There are two types of reinsurance contracts:  Facultative Reinsurance; and  Treaty Reinsurance. Let’s discuss. Facultative Reinsurance: This type of Policy protects an insurance provider only for an individual, or a specific risk, or contract. If there are many contracts for reinsurance, then all shall be negotiated separately by Ceding Company with Re-insurer. The Re-insurer has all right to accept or deny a facultative reinsurance proposal. In this type of agreement, the Ceding Company (Primary Insurer) identifies which risks it wants to cover and which risks will be ceded to the reinsurer. This type of reinsurance is less common because each policy is offered and considered on an individual risk basis. Facultative reinsurance normally is purchased by insurance companies for individual risks not covered by their reinsurance treaties, for amount more than the monetary limits of their reinsurance treaties, and for unusual risks. Each facultative policy issued delineates the terms of each risk that is reinsured. From above we can draw a conclusion that “Facultative Reinsurance is a case-by case reinsurance where each individual risk before acceptance, and exceeding the retention of the direct insurer, is presented to the reinsurer. Both the Direct (Ceding) Insurer and the reinsurer are free to present or accept the risk. The Underwriting Expenses, and in particular personal costs, is higher for such business because each risk is individually underwritten and administered. Because the reinsurance underwriters must evaluate each risk separately and access accurately the risk involved in the policy. Treaty Reinsurance: it means Ceding Company and the reinsurer negotiate and execute a Reinsurance Contract. The reinsurer then covers the specified share of more than one insurance policy issued by the Ceding Company which comes within scope of that contract. The Reinsurance Contract may oblige the reinsurer to accept reinsurance of all contracts within the Scope (known as “Obligatory” Reinsurance), or it may allow the insurer (Ceding Company) to choose which risks it wants to cede, with the reinsurer obliged to accept such risks (known as “Facultative Obligatory”). After negotiations, a Treaty (Reinsurance Contract) is issued by the reinsurance company to the Ceding Company reinsuring more than one policy. 223 CU IDOL SELF LEARNING MATERIAL (SLM)

A Treaty Reinsurance is a Partnership in which the insurer and reinsurer share risks at an agreed -upon level. Reinsurance Treaties can either be written on a “continuous” or” Term” basis. A continuous contract has not predetermined end date, but generally either party can give 90 days’ notice to cancel or amend treaty. Let’s Understand Types of Treaty Reinsurance Contracts Treaty Reinsurance ↓ Proportional Reinsurance Non-Proportional Reinsurance ↓ ↓ Quota Share Surplus Share Excess of Loss Stop Loss Table 14.1: Reinsurance contracts Proportional Reinsurance: under this type of reinsurance, the reinsurer will receive a prorated share of the premiums of all policies sold by the Insurance Company (Ceding Company) being covered and hence when claims are lodged the reinsurance company will bear portion of losses. In proportional coverage, the reinsurance company will also reimburse the insurance company for all processing, business acquisition and writing costs. This is known as Ceding Commission. Proportional Reinsurance spreads the risk of loss and creates a broad identity of interests between the Cedent and the reinsurer, which effectively co-venture in relationship to their relative shares of the risk, even though only the cedent has contractual privity with the Direct Insured. a) Quota Share Reinsurance Under Quota Share Reinsurance, a fixed percentage of business premiums is shared with the reinsurer for the fixed percentage of claim. Example: let’s consider if there is a Rs. 100 losses under 75% Quota Share Reinsurance Contract, the Cedent would bear only Rs. 25/- of the loss and the reinsurer concurrently would bear Rs. 75/- of that loss. In this contract percentage always shown the percentage of risk borne by the reinsurer. The portion of the risk that the reinsurer assumes is called the “Ceded Risk” and the portion that the Cedent keeps is referred to as the reinsurance “Retention”. b) Surplus Share Reinsurance 224 CU IDOL SELF LEARNING MATERIAL (SLM)

This is like Quota Share Reinsurance but differs in that the portion of the reinsured policy the direct insurer retains is expressed as a fixed monetary amount, and the reinsurance may or may not apply from first rupee (i.e., the reinsurance may apply only more than the fixed Rupees amount or the cedent and reinsurer may together share losses as they are incurred until the cedent incurs and amount equal to its overall retention). Under a Surplus Share Agreement, the ceding company decides on a “Retention Limit”, – Let’s consider there is Retention Limit of Rs. 100000 in a Policy reinsured. In this case the Ceding Company will retain the full amount of each risk, with a maximum Rs. 100000 per policy or per risk and balance will be transferred to the reinsurer. Non-Proportional Reinsurance in this type of coverage the reinsurer will only get involved if the insurance company’s loss exceeds a specified amount, which is referred to as priority or retention limit. In this case the reinsurer does not have a proportional share in the premiums and losses of the insurance provider. The priority or retention limit may be based on a single type of risk or an entire business category. 14.4 REINSURANCE IN THE INSURANCE SECTOR Reinsurance companies, also known as reinsurers, are companies that provide insurance to insurance companies. In other words, reinsurance companies are companies that receive insurance liabilities from insurance companies. Reinsurance companies, or reinsurers, are companies that provide insurance to insurance companies. Reinsurers play a major role for insurance companies as they allow the latter to help transfer risk, reduce capital requirements, and lower claimant payouts. Reinsurers generate revenue by identifying and accepting policies that they believe are less risky and reinvesting the insurance premiums they receive. 225 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 14.2: Reinsurance working Understanding Reinsurance Companies Recall that reinsurance companies provide insurance to insurance companies. How exactly does it work? A primary insurer (the insurance company) transfers policies (insurance liabilities) to a reinsurer (the reinsurance company) through a process called cession. Cession simply refers to the portion of the insurance liabilities transferred to a reinsurer. Similar to the way individuals pay insurance premiums to insurance companies, insurance companies pay insurance premiums to reinsurers for the transfer of insurance liabilities. The diagram below depicts such a relationship. 14.5 AREAS OF THE APPLICATION OF REINSURANCE  Reinsurance in Fire Insurance Business:The surplus treaty is most widely used. Quota share treaties are used by the newly established companies or with regard to the new business of established companies. The service of facultative reinsurance is also 226 CU IDOL SELF LEARNING MATERIAL (SLM)

occasionally utilized, particularly with regard to bigger risks, where the standing treaty arrangement does not provide full automatic protection. Excess of loss treaties is utilized for catastrophe risks or where there is a possibility of accumulation of risks leading to conflagration fire, or where fire policies provide additional covers such as cyclone, hurricane flood etc.  Reinsurance in Marine and Aviation Insurance Business:Quota share and surplus are quite common even though the facultative method is still very widely used.Excess of loss and stop loss arrangements are also made in catastrophe hazards, such as general average, the total loss to hull etc.  Reinsurance in Accident Insurance Business:All types of treaties are commonly used. In cases of hazardous elements or where accumulation and catastrophe are apprehended or in cases of liability insurances, an excess of loss or stop loss is most favored. Pools are considered in special types of risks, such as crop insurance.The facultative method is not much used unless the business is beyond the absorption capacity of the treaty.The facultative method is also used when the ceding company does not wish to interest the treaties for some obvious reasons.  Reinsurance in Life Insurance Business:The most commonly used type is the surplus treaty. The facultative cover is also still in use although in a very limited degree.Pools are used for various types of impaired lives, such as lives suffering from heart disease, blood pressure, diabetes etc. 14.5.1 The buyer’s Reinsurance Needs  Sometimes insurance companies want the same kind of financial protection that they offer to their own customers, and they can find such protections in the so- called reinsurance market. Reinsurance companies provide insurance against loss for other insurance companies, especially losses related to catastrophic risks, such as hurricanes or the global financial crisis of 2008-2009.  Without reinsurance, today's insurance industry would be more vulnerable to risk and would likely have to charge higher prices on all of their policies to compensate for potential loss.  Reinsurance, or insurance for insurers, is the practice of risk-transfer and risk-sharing between and amongst insurance companies.  Treaty reinsurance involves one insurer buying broad coverage from a dedicated reinsurance issuer that covers all of the insured company's policies. 227 CU IDOL SELF LEARNING MATERIAL (SLM)

 Facultative reinsurance covers a single risk or a block of risks held in the primary insurer's book of business.  Reinsurers handle complex risks and must meet certain regulatory and financial conditions in order to operate. Basics of the Business Model Reinsurance companies typically offer two kinds of products. The first is known as treaty reinsurance, which is a type of contract where the reinsurer is bound to accept all of the policies, or an entire class of policies from the reinsured, including those that have yet to be written. The second type is facultative reinsurance, which is much more specific. These can cover single individual policies, such as reinsuring the excess insurance on a company or large building, or they may cover different parts with several policies pooled together. In addition to these categories, reinsurance may be considered proportional or not. Under proportional reinsurance, the reinsurer receives a prorated share of all policy premiums sold by the insurer. For a claim, the reinsurer bears a portion of the losses based on a pre-negotiated percentage. The reinsurer also reimburses the insurer for processing, business acquisition, and writing costs. With non-proportional reinsurance, the reinsurer is liable if the insurer's losses exceed a specified amount, known as the priority or retention limit. As a result, the reinsurer does not have a proportional share in the insurer's premiums and losses. The priority or retention limit is based on one type of risk or an entire risk category. Excess-of-loss reinsurance is a type of non- proportional coverage in which the reinsurer covers the losses exceeding the insurer's retained limit. This contract is typically applied to catastrophic events and covers the insurer either on a per-occurrence basis or for the cumulative losses within a set period. Reinsurers primarily deal in the largest and most complex risks in the insurance system. These are the kinds of risks that normal insurance companies do not want or are not able to internalize. These sorts of risks tend to be international in nature: war, severe recession, or problems in the commodity markets. For this reason, reinsurance companies tend to have a global presence. A global presence also allows the reinsurer to spread risk across larger areas. Reinsurance companies don't always deal solely with other insurers. Many also write policies for financial intermediaries, multinational corporations, or banks. However, most reinsurance clients are primary insurance companies. 14.5.2 Reinsurance Underwriting Information 228 CU IDOL SELF LEARNING MATERIAL (SLM)

Reinsurance underwriters are professionals who evaluate and analyze the risks involved in insuring people and assets. Insurance underwriters establish pricing for accepted insurable risks. The term underwriting means receiving remuneration for the willingness to pay a potential risk. Underwriters use specialized software and actuarial data to determine the likelihood and magnitude of a risk. Insurance underwriters assume the risk involved in a contract with an individual or entity. For example, an underwriter may assume the risk of the cost of a fire in a home in return for a premium or a monthly payment. Evaluating an insurer's risk before the policy period and at the time of renewal is a vital function of an underwriter. For example, homeowner’s insurance underwriters must consider numerous variables when rating a homeowner's policy. Property and casualty insurance agents act as field underwriters, initially inspecting homes or rental properties for conditions such as deteriorated roofs or foundations that pose a risk to the carrier. The agents report hazards to the home underwriter. The home underwriter additionally considers hazards that may trigger a liability claim. Hazards include unfenced swimming pools, cracked sidewalks, and the presence of dead or dying trees on the property. These and other hazards represent risks to an insurance company, which may eventually be required to pay liability claims in the event of accidental drowning’s or slip and fall injuries. Inputting several factors, which often includes an applicant's credit rating, homeowner insurance underwriters employ an algorithmic rating method to pricing. The system generates an appropriate premium based on the platform’s interpretation and the combination of all data reported from the observations of the field underwriter. The lead underwriter also subjectively considers answers submitted by the applicant on the policy application when arriving at a premium. Insurance companies must balance their approach to underwriting: if too aggressive, greater- than-expected claims could compromise earnings; if too conservative, they will be outpriced by competitors and lose market share. 14.5.3 The Reinsurance Programmes Reinsurance is insurance that an insurance company purchases from another insurance company to insulate itself (at least in part) from the risk of a major claims event. With reinsurance, the company passes on (\"cedes\") some part of its own insurance liabilities to the other insurance company. The company that purchases the reinsurance policy is called a \"ceding company\" or \"cedent\" or \"cadent\" under most arrangements. The company issuing the reinsurance policy is referred to as the \"reinsurer\". In the classic case, reinsurance allows insurance companies to remain solvent after major claims events, such as major disasters like hurricanes and wildfires. In 229 CU IDOL SELF LEARNING MATERIAL (SLM)

addition to its basic role in risk management, reinsurance is sometimes used to reduce the ceding company's capital requirements, or for tax mitigation or other purposes. The reinsurer may be either a specialist reinsurance company, which only undertakes reinsurance business, or another insurance company. Insurance companies that accept reinsurance refer to the business as 'assumed reinsurance'. 14.5.4 Reinsurance Portfolio Management Insurance companies must closely monitor the profitability of their insurance contracts. If the claims they pay consistently exceed the premiums they collect, then the insurer may struggle to fund its ongoing operations. One of the ways that companies in that situation can reduce their risk of insolvency is by shifting some of their policies over to other insurance companies, called reinsurers. In doing so, the company purchasing reinsurance would pay the reinsurer a percentage of the premiums received. In exchange, the reinsurer would accept responsibility for a percentage of any future claims arising from the contract. Portfolio reinsurance is simply a more extensive version of this basic transaction. Instead of reinsuring specific contracts, portfolio reinsurance involves reinsuring a large block of contracts—typically with the intention of no longer writing such contracts in the future. For instance, if an insurance companies decides to no longer offer home insurance policies, they might obtain portfolio reinsurance for all of their home insurance policies and then cease offering home insurance in the future. Real World Example of Portfolio Reinsurance Dorothy is an entrepreneur who recently acquired an insurance company specializing in home and auto insurance. After carefully reviewing the firm’s outstanding insurance policies, she determines that some of the regions in which the firm operates are consistently generating sub- standard margins. To improve her firm’s financial strength, Dorothy decides to divest herself of the unprofitable contracts and cease operating in those regions. To accomplish this, she negotiates with several reinsurers and reaches an agreement with one of them to transfer 100% of the outstanding liabilities associated with those claims. In exchange, the reinsurer receives all the premiums associated with those contracts in the future. After completing this portfolio reinsurance transaction, Dorothy transfers all outstanding premiums and loss reserves to the reinsurer. Going forward, no new policies will be transferred to the reinsurer, because none will be created. Similarly, no renewal policies will be transferred since Dorothy’s firm will exit that geographic market and let their past policies lapse. 14.5.5 Alternative Risk Transfer 230 CU IDOL SELF LEARNING MATERIAL (SLM)

A risk transfer occurs when one party deliberately shifts risk to a different entity, usually by purchasing an insurance policy. This risk may be shifted further, from an insurer to a reinsurer, so that the original insurer does not accumulate too much of a particular type of risk. An example of a risk transfer is when a doctor purchases malpractice insurance to transfer the risk from any losses incurred from patient lawsuits. Risk may also be transferred through contractual agreements with a firm's business partners. For example:  The partners in a joint venture can agree to share any losses arising from the venture.  A customer demands a one-year warranty on a product purchased from a supplier, which shifts the risk of product failure to the supplier for that one-year period.  Demand that the business to be named as an additional insured on another party's insurance policy, thereby extending insurance coverage to the business.  Insist that a hold-harmless clause be inserted into all contracts signed with other parties, which protects the organization from the acts or omissions of the other parties.  Require contractors to submit a certificate of insurance, which provides proof of their coverage. Otherwise, the company may be assuming risk if the contractor is responsible for injuries or damage. 14.5.6 Financial Aspects Finance is a business function that uses numbers and analytical tools to help managers make better decisions. Every business owner must learn at least basic finance principles to effectively run his company. Finance helps management gain a clear understanding of the company’s current financial position, particularly whether the business is profitable or not. Companies of all sizes benefit from thorough financial planning to guide the business steadily down the path to future growth.  Forecasting and Planning During the planning process, management determines numerical goals for the upcoming 12 months, or in the case of a long-range plan, for three years or more. Company management then maps out the actions that need to be taken, and the time frame, for the goals to be reached. Finance comes into play when the action steps are converted to forecast numbers for revenues and expenses. Managers with financial planning expertise can create forecasts that are attainable yet aggressive. They must also have sufficient understanding about company operations to build spreadsheet financial models based on assumptions that are realistic. 231 CU IDOL SELF LEARNING MATERIAL (SLM)

 Accounting and Measuring Results Accounting is the branch of finance responsible for recording financial data and generating financial statements that show the company’s operating results, as well as other critical functions such as tax compliance. Accounting has its own set of rules and standards for the recording of financial information and the presentation of results, called Generally Accepted Accounting Principles, or GAAP. Strict compliance with the standards allows company management to be assured the statements they receive are complete and accurate. Finance goes one step further and interprets the results. Variance analysis is done to compare actual results to forecast and uncover the reasons for negative or positive deviations. Finance staff members compare the company’s financial results to those of other companies in the industry to see whether the company is performing above or below average, compared with its peers.  Monitoring Cash Position All businesses, particularly smaller ones that do not have large cash reserves or borrowing capacity, must always keep an eye on their cash position – the inflows and outflows of cash. The finance department is charged with forecasting cash flow to prevent potentially disruptive shortages of cash. In a small company this can mean serious problems, such as not being able to pay employees at the end of the week. Investing surplus cash to achieve a maximum return is also part of the finance function. In larger companies these investment activities take place daily and involve constant monitoring of the financial markets to select the best investments for such things as the company’s employee retirement plan.  Analysis for Decision Making Finance can be likened to a toolbox for company management to use. The tools help answer questions that management must address when making small and large decisions. A small decision might be whether to lease or buy a new copy machine. A large decision for which finance provides guidance could be whether to acquire a competitor to grow the company more quickly. The goal of the data gathering, and sometimes complex financial modeling utilized in finance is to ensure the company makes the most efficient use of its finite resources, including the capital, human resources, and productive capacity. 14.6 SUMMARY 232 CU IDOL SELF LEARNING MATERIAL (SLM)

 Reinsurance is also known as insurance for insurers or stop-loss insurance. Reinsurance is the practice whereby insurers transfer portions of their risk portfolios to other parties by some form of agreement to reduce the likelihood of paying a large obligation resulting from an insurance claim.  The party that diversifies its insurance portfolio is known as the ceding party. The party that accepts a portion of the potential obligation in exchange for a share of the insurance premium is known as the reinsurer.  Reinsurance, or insurance for insurers, transfers risk to another company to reduce the likelihood of large payouts for a claim.  Reinsurance allows insurers to remain solvent by recovering all or part of a payout.  Companies that seek reinsurance are called ceding companies.  Reinsurance in Fire Insurance Business:The surplus treaty is most widely used. Quota share treaties are used by the newly established companies or with regard to the new business of established companies. The service of facultative reinsurance is also occasionally utilized, particularly with regard to bigger risks, where the standing treaty arrangement does not provide full automatic protection  Reinsurance companies, also known as reinsurers, are companies that provide insurance to insurance companies. In other words, reinsurance companies are companies that receive insurance liabilities from insurance companies.  Reinsurance companies, or reinsurers, are companies that provide insurance to insurance companies.  Reinsurers play a major role for insurance companies as they allow the latter to help transfer risk, reduce capital requirements, and lower claimant payouts.  Reinsurance is also known as insurance for insurers or stop-loss insurance. Reinsurance is the practice whereby insurers transfer portions of their risk portfolios to other parties by some form of agreement to reduce the likelihood of paying a large obligation resulting from an insurance claim.  The party that diversifies its insurance portfolio is known as the ceding party. The party that accepts a portion of the potential obligation in exchange for a share of the insurance premium is known as the reinsurer.  Reinsurance allows insurers to remain solvent by recovering some or all amounts paid to claimants. Reinsurance reduces the net liability on individual risks and catastrophe protection from large or multiple losses. The practice also provides ceding companies, 233 CU IDOL SELF LEARNING MATERIAL (SLM)

those that seek reinsurance, the capacity to increase their underwriting capabilities in terms of the number and size of risks. 14.7 KEYWORDS  Interprets: to explain or tell the meaning of: present in understandable terms interpret dreams needed help interpreting the results. To conceive in the light of individual belief, judgment, or circumstance: construe interpret a contract.  Entrepreneur: a person who sets up a business or businesses, taking on financial risks in the hope of profit.  Proportional share: means the annual revenue of a health care institution received in the form of medical assistance reimbursement or public employee insurance from the state, divided by the total annual revenue of the health care institution.  Catastrophe: an event causing great and usually sudden damage or suffering; a disaster.  Apprehend: to anticipate especially with anxiety, dread, or fear: to grasp with the understanding : recognize the meaning 14.8 LEARNING ACTIVITY 1. Conduct a survey on reinsurance companies which provide insurance to insurance companies. How exactly does it work? ______________________________________________________________________________ ______________________________________________________________________________ 2. Analyze and examine how reinsurance companies give insurance liabilities from insurance companies. ______________________________________________________________________________ ______________________________________________________________________________ 14.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Write down the Benefits of Reinsurance? 2. What are the various Types of Reinsurance? 3. Write a note on Reinsurance in the Insurance Sector? 234 CU IDOL SELF LEARNING MATERIAL (SLM)

4. What are the Areas of the Application of Reinsurance? 5. Write a short note on the buyer’s Reinsurance Needs? Long Questions 1. What are the basic Learning Objectives of reinsurance? 2. Write about the Benefits of Reinsurance? 3. What are the various Types of Reinsurance? Describe Reinsurance in the Insurance Sector. 4. Write a note on the following:  The buyer’s Reinsurance Needs  Reinsurance Underwriting Information  The Reinsurance Programmes  Reinsurance Portfolio Management  Alternative Risk Transfer 5. What do you mean by Financial Aspects of a company? B. Multiple Choice Questions 1. The finance department is charged with forecasting ---------------to prevent potentially disruptive shortages of cash. a. Cash flow b. Multiple transactions c. Ratio and proportion d. System analysis 2. One of the ways that companies in that situation can reduce their risk of insolvency is by shifting some of their policies over to other insurance companies, called. a. Investors b. Partners c. creditors d. reinsurers 3. The term underwriting means receiving remuneration for the willingness to pay a 235 CU IDOL SELF LEARNING MATERIAL (SLM)

a. Money b. Business share c. potential risk d. Funding 4. Treaty Reinsurance: it means Ceding Company and the reinsurer --------------and execute a Reinsurance Contract. a. Negotiate b. Argue c. Meetings d. Deals 5. Managers with ---------------------------expertise can create forecasts that are attainable yet aggressive. a. Business planning b. Economic planning c. financial planning d. None of these Answers 1-a, 2-d, 3-c, 4-a, 5-c 14.10 REFERENCES References  Bhardwaj, H.P. Foreign Exchange Handbook. Bhardwai Publishing Company,Mumbai .  Joel Bessis. (1998). Risk Management in Banking, Mls John Willy Sons, New York,U.S.A.  Rajwade A.V. (2000). Foreign Exchange lnfemalional Finance:Risk Management,Academy of Business Studies, Ansari Road. New Delhi. (1999). Textbooks  Trivedi and Hassan. Treasury Operations and Risk Munagetneni, Genesis Publishers,Mumbai. 236 CU IDOL SELF LEARNING MATERIAL (SLM)

 Banking in New Millenium: Report on Conference of Chairman of Bank, NIBM, Pune (2 000).  Risk Management Systems in Banks, Guidelines by Reserve Bank of India Websites  https://taxguru.in/corporate-law/concept-reinsurance-risk-management.html  https://corporatefinanceinstitute.com/resources/knowledge/finance/reinsurance- companies/  https://www.investopedia.com/articles/insurance/082916/business-model-reinsurance- companies.asp 237 CU IDOL SELF LEARNING MATERIAL (SLM)