CPCU CORE REVIEW ARE 144,

REINSURANCE PRINCIPLES AND

PRACTICES

Dylan H. Kim, CPCU, CFA

1st Edition
COPYRIGHT
CPCU Core Review ARe 144, Reinsurance Principles and Practices, 1st edition
Copyright Dylan H. Kim, CPCU, CFA, 2014. All rights reserved.
chartermaker@illisharing.com

Published in 2014 by illi sharing corporation.

Printed in the United States by CreateSpace, An Amazon.com Company.

e-ISBN: 979-11-85406-08-4
ISBN: 978-1502490001

2
DISCLAIMER
"CPCU and Chartered Property Casualty Underwriter are trademarks owned
by The Institute. The Institute (formerly the American Institute of Chartered
Property Casualty Underwriter) does not endorse, promote, review, or warrant
the accuracy of the products or services offered by Illi Sharing."
The CPCU Core Review ARe 144 should be used in conjunction with the
original readings such as Text, Review Notes, and Course Guide, as set forth by
The Institute. The information contained in this Book covers topics contained in
the readings referenced by The Institute and is believed to be accurate. However,
their accuracy cannot be guaranteed nor is any warranty conveyed as to your
ultimate exam success. The authors of the referenced readings have not endorsed
or sponsored this book.
The CPCU Core Review ARe 144 may not be copied without written
permission from the author. The unauthorized duplication of this book is a
violation of global copyright laws and the CPCU Institute Code of Ethics. Your
assistance in pursuing potential violators of this law is greatly appreciated.

3
NOTES FROM THE AUTHOR

Dear CPCU candidates,

Welcome! I am very pleased that you've completed a cost-to-benefit analysis
and correctly concluded that this core review is well worth the purchase price.
When all is said and done, you will have invested a couple of months with this
subject and paid your hard-earned money to the CPCU Institute to take a one-
time examination with either pass or non-pass. Now, that's pressure!
Fear not, this book was written for you. It will help you attain your passing test
score and reduce your stress level, as well. This book is unique in that it will not
only prepare you to pass the CPCU test, but it will also help you save your time.
In my about 10 years of teaching all the CPCU programs, I've taught hundreds
of students who passed CPCU 520 exam with only 50~70 study hours. Today,
former candidates continue to contact me to let me know that without my review
work, they would not have scored as well as they did on their exams. Now, I've
applied all that good experience to the writing of this book.
In contrast to other test materials such as Text book, Review Notes, Course
Guide, Quiz Me application, you'll find that all you need to know in order to
have passing grade of 70% is summarized and focused in this single review. All
the nut-and-bolts concepts and questions you need are inside to fully diagnose
your knowledge and polish it up for test day.
Listen, do you want to know the real key to passing the CPCU exam with the
minimum study hours? The real key lies in developing your ability to grasp the
whole, focus on the main concepts, analysis details in question and answer, and
repeat. This review will help you have it all.
However, it should be noted that this book is created as a teaching material for
professionals, so it includes all the very intensive contents relating to the actual
exam. That means it will be difficult to study alone if you are a beginner who
have no experience in Property and Casualty insurance underwriting. If you are
a beginner, you need to study Text Book first and can take advantage of this book
as a final cleanup. For your information, CPCU Complete Review series by the
same author will be coming soon for the very beginner to explain all the
intensive contents of this book, CPCU Core Review, with easy examples and
cartoons.
Thank you and best of luck on the CPCU test!

Dylan H. Kim, CPCU, CFA

4
CONTENTS

ARe 144 Exam Guide

CPCU Program Description!7

CPCU Exam Information and Registration! 9
Taking an Exam! 11

SECTION 1. Introduction to Reinsurance

Topic 1: Reinsurance and Its Functions!16

Topic 2: Reinsurance Transactions and Sources!21

SECTION 2. Types of Reinsurance and Program Design

Topic 3: Types of Reinsurance! 30

Topic 4: Alternatives to Traditional Reinsurance! 40
Topic 5: Reinsurance Program Design!44

SECTION 3. The Reinsurance Placement Process

Topic 6: General Reinsurance Placement Process!52

Topic 7: FAC & TTY Reinsurance Placement Process!58

SECTION 4. Common Reinsurance Treaty Clauses, Part I

Topic 8: Common Reinsurance Treaty Clauses, Part I! 66

SECTION 5. Common Reinsurance Treaty Clauses, Part II

Topic 9: Common Reinsurance Treaty Clauses, Part II! 76

SECTION 6. Quota Share Treaties

Topic 10: Quota Share Treaties!84

SECTION 7. Surplus Share Treaties

Topic 11: Surplus Share Treaties!98

SECTION 8. Property Per Risk Excess of Loss Treaties

Topic 12: Property Per Risk Excess of Loss Treaties!108

SECTION 9. Casualty Excess of Loss Treaties

Topic 13: Casualty Excess of Loss Treaties!118

SECTION 10. Catastrophe Reinsurance

Topic 14: Catastrophe Reinsurance!130

5
 SECTION 11. Aggregate Excess of Loss Treaties

Topic 15: Aggregate Excess of Loss Treaties!140

SECTION 12. Reinsurance Audits

Topic 16: Reinsurance Audits!146

SECTION 13. Reinsurance Regulation

Topic 17: Reinsurance Regulation! 154

SECTION 14. Reinsurance Aspects of the NAIC Annual Statement

Topic 18: Reinsurance Aspects of the NAIC Annual Statement!166

SECTION 15. Loss Reserving Methods

Topic 19: Loss Reserving Methods!178

6
 CPCU Exam Guide

ARE 144 EXAM GUIDE

CPCU Program Description

Note: The following information refers to the CPCU Experience Booklet from
The Institute.

CPCU Course Descriptions

The current program stands at eight examinationsfour foundation courses,
one elective course and three concentration courses. The core courses continue to
reflect the broad-based curriculum of the early programrisk management and
insurance principles, operations, regulation, statutory accounting, law, and
finance. The elective course increases the relevancy to the individual allowing
study in a functional area of their choosing and provides opportunity to earn
cross-credit from other Institutes programs. The concentration courses allow
students to deepen their understanding of either commercial lines or personal
lines insurance. The core principles of education, ethics, and experience remain
strongly intact.

Foundation Courses
CPCU 500Foundations of Risk Management and Insurance
CPCU 520Insurance Operations
CPCU 530Business Law for Insurance Professionals
CPCU 540 Finance and Accounting for Insurance Professionals

Commercial Concentration Courses

CPCU 551Commercial Property Risk Management and Insurance
CPCU 552Commercial Liability Risk Management and Insurance
CPCU 553 Survey of Personal Insurance and Financial Planning

Personal Concentration Courses

CPCU 555 Personal Risk Management and Property-Casualty Insurance
CPCU 556Financial Planning
CPCU 557Survey of Commercial Insurance

7
CPCU Core Review ARe 144, Reinsurance Principles and Practices

Elective Courses
AAI 83Agency Operations and Sales Management
AIC 34Workers Compensation and Managing Bodily Injury Claims
AIC 31Property Claim Practices*
AIC 32Liability Claim Practices*
ARe 144Reinsurance Principles and Practices
ARM 56Risk Financing
AU 67Strategic Underwriting Techniques*
CPCU 560Financial Services Institutions
ERM 57Enterprise-Wide Risk Management: Developing and Implementing

CPCU Ethics Requirement

The Institutes believe that the study of ethics is essential to the professional
practice of risk management and insurance. By separating the ethics component,
students will be able to more effectively study ethics and achieve a greater
understanding of the science and art behind ethical decision-making in the
context of the insurance business.
The CPCU ethics requirement is satisfied by completing the online module,
Ethics and the CPCU Code of Professional Conduct (Ethics 312), or by having
credit for CPCU 510, prior to March 15, 2011.

CPCU Experience Requirement

The CPCU experience requirement is two years. The two-year experience
requirement applies to all CPCU students and candidates who qualify for the
class of 2010 and beyond, regardless of when the individual started in the
program.

8
 CPCU Exam Guide

CPCU Exam Information and Registration

Note: The following information refers to the CPCU Registration Booklet from The
Institute.

Exam Dates
Testing Windows for Computer Administered Institutes Exams
January 15-March 15
April 15-June 15
July 15-September 15
October 15-December 15

Exam Format
Exams are administered on computer. Computer administered exams are
preceded by an optional 30-minute tutorial and are followed by a brief survey.

Category Number and Type of Questions Time Limit

ARe, ARM 60-85 multiple-choice questions 2 hours

CPCU 500 60 multiple-choice questions 1.5 hours

CPCU 520, 530, 540, 551, 552,

85 multiple-choice questions 2 hours
553, 555, 556, and 557
CPCU 560 25-35 short essay questions 3 hours

All the above exams have passing grade of 70 percent.

Testing Centers
Computer exams are administered at Prometric Testing Centers and at
Institutes-approved on-site testing centers, usually an employer facility.
Prometric centers are located in more than 420 cities worldwide. Log on to
www.prometric.com/TheInstitutes to find a center. Examinees must arrive at
Prometric Testing Centers at least 30 minutes before a scheduled appointment for
check-in.

Registering for an Exam

Online www.TheInstitutes.org
Phone (800) 644-2101 (MondayFriday, 8 am to 6 pm EST)
Fax (610) 640-9576
Mail 720 Providence Rd., Suite 100,
Malvern, PA 19355-3433

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CPCU Core Review ARe 144, Reinsurance Principles and Practices

Exam Fee
CPCU 520, Oct 15 - Ded 15, 2015 for example
Institutes Prometric Test Prometric Test
Approved On-Site Center Early Center Standard
Testing Centers Registration Registration

Register through Register on or Register after Oct

Dec 15, 2015 before Oct 15, 2015 15, 2015
Exam Fee: $240 $260 $330
Registrations Dec 15, 2015 Oct 15, 2015 Dec 12, 2015
accepted through:
Cancellation Dec 15, 2015 You must cancel 3 You must cancel 3
deadline or more business or more business
days prior to your days prior to your
scheduled scheduled
Prometric Prometric
appointment appointment
Cancellation $135 $175 $175
Forfeiture
Cost to Transfer: $85 $110 $110

Payment
The Institutes accept American Express, Diners Club, Discover, MasterCard,
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Scheduling a Computer-Administered Exam Appointment

Schedule your appointment when you know you will be ready to sit for the
exam. Prometric will charge a $50 fee to students who reschedule their
appointments within 3 to 12 business days of a test date. Also, scheduling an
appointment far in advance and then canceling could deprive another examinee
of a desired testing date and time. Be considerate of others. Still, we also
recommend scheduling the exam appointment early in the testing window in
case the exam must be rescheduled or retaken.
To locate a Prometric Testing Center and schedule an appointment, log on to
www.prometric.com/TheInstitutes or call (877) 311-2525. Prometrics
international phone numbers are listed below.

10
 CPCU Exam Guide

Region Contact Center Region Contact Center

North AmericaU.S.
1-877-311-2525 Korea 82-2-1566-0990
& Canada

Latin America
1-443-751-4995 China 86-10-6279-9911
& Caribbean
Europe
31-320-239-540 Hong Kong 60-3-7628-3333
Middle East
31-320-239-530 Southeast Asia 60-3-7628-3333
& North Africa
Africa 31-320-239-593 India 91-124-414-7700
Australia &
Japan 81-3-5541-4800 61-2-9640-5899
New Zealand

Taking an Exam
Note: The following information refers to the CPCU Registration Booklet from
The Institute.

Exam Policies: Identification

You must present valid, unexpired identification that contains BOTH a
photograph and a signature. The name on your ID must exactly match your
name as it appears on the examination confirmation notice. If, for example, your
identification and confirmation notice do not match because you recently
married, bring the original copy of your marriage license. Contact The Institutes
at least one week before your appointment if you have any questions about
proper ID. If you are denied admission to a testing center because of a question
about your ID, immediately call The Institutes at (800) 644-2101 or (610) 644-2100.
Do not leave the testing center without calling The Institutes.

Examinee Conduct
CPCUs and CPCU candidates are subject to the CPCU Code of Professional
Conduct. The CPCU code is available at www.TheInstitutes.org/doc/
Canons.pdf.
CPCUs, along with all other persons taking Institutes exams, are subject to The
Institutes Code of Academic and Professional Integrity. The Institutes Code is
available at www.TheInstitutes.org/CAPI.
Furthermore, you will not be permitted to sit for an exam if you do not agree to
abide by the Rules of Conduct statement at the beginning of exam administration
and will forfeit the registration fee.

11
CPCU Core Review ARe 144, Reinsurance Principles and Practices

Prohibited Items
Food and drink, jackets and hats, study materials, notes, dictionaries, and any
form of electronic device, with the exception of an acceptable calculator (see
below), are expressly prohibited. Medical or dietary needs that are taken to a
Prometric Testing Center must be submitted to the Institutes for prior approval
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Centers reserve the right to ask examinees to turn out their pockets.

Provided Items for Electronic Exams

Scratch paper and a pencil will be provided and will be collected at the end of
the exam. Answers written on scratch paper, but not entered into the computer,
are not graded. Ear plugs and a basic calculator are available upon request at
Prometric Testing Centers.

Use of a Calculator
Based on the content of their study materials, examinees should determine for
themselves whether they need a calculator during an examination. Although a
financial calculator is not required for an exam, use of any solar- or battery-
powered calculator that does not have alphabetic keys for typing words and that
does not contain paper tape is permitted during an exam. Business/financial
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A PDA or cell phone is not an acceptable calculator. Prometric will provide a
basic calculator if requested. Call the Institutes (800) 644-2101 if you encounter a
problem concerning use of an acceptable calculator.

Problems During the Exam

Raise your hand if you encounter a problem during the exam. You may not
communicate with anyone other than the test administrator.

Breaks
No scheduled breaks are provided. However, examinees may visit the
restroom. When doing so, you will be required to sign out and then sign in again.
You must return to your exam within five minutes, and the examination clock
will continue to run. Communication with anyone other than a test administrator
is prohibited.

12
 CPCU Exam Guide

Prometrics Test Security Procedures

Security at Prometric Testing Centers is very stringent. You could be asked to
turn your pockets out to ensure they are empty. Cameras and video recording are
in constant use. Test Center administrators circulate within the testing room at
least every 30 minutes. Scratch paper is collected at the end of the exam and
shredded.

Information About Computer-Administered Exams

Demo Exam For a hands-on demonstration of computer delivered essay or
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Click on Exam Preparation/Grade Information under the Examinations tab and
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Taking an Institutes exam on a computer does not require special computer
skills. For objective exams, you can use a mouse or the keyboard to indicate an
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answers using the computer keyboard. Shortcuts commonly associated with
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You can Mark for Review any questions that you want to come back to later.
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were answered and marked or just those that remain unanswered. You can
practice Mark for Review with the Demo Exam.
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reference material.

Exam Grading
Multiple-Choice Exams: As soon as you complete the exam, you will receive an
unofficial pass/nonpass notification, unless grading is delayed.
Essay Exams: Essay exams are returned to The Institutes for grading. As many
as three graders may independently review an exam to determine the final score.
Grades are available within one month of the test date, unless grading is delayed.
When registering, please provide The Institutes with a current e-mail address
to ensure prompt grade notification. A notice sent to your preferred e-mail
address will inform you that an official grade report is available on The
Institutes website. Be advised that spam filters and firewalls could result in the
inability to deliver the grade notification.

13
CPCU Core Review ARe 144, Reinsurance Principles and Practices

14
SECTION 1. INTRODUCTION TO REINSURANCE

Topic 1: Reinsurance and Its Functions

Topic 2: Reinsurance Transactions and Sources

15
SECTION 1. Insurance Operations

Topic 1: Reinsurance and Its Functions

ARe 144 Review Notes / Assignment 1. Introduction to Reinsurance / EO 1

1.a. Reinsurance Concepts

Reinsurance is the transfer from one insurer (the primary insurer) to another
(the reinsurer) of some or all of the financial consequences of certain loss
exposures insured by the primary insurer's policies.
The primary insurer pays a reinsurance premium for the protection provided
in the same way any insured pays a premium for insurance coverage, but, since
the primary insurer incurs the expenses of issuing the underlying policy, the
reinsurer might pay a ceding commission towards the primary insurer.
Using a retrocession, one reinsurer, the retrocedent, transfers all or portion of
the reinsurance risk that it has assumed or will assume to another reinsurer, the
retrocessionaire.

1.b. Structure: Reinsurance Functions

Reinsurance Functions
Increase Large-Line Capacity
Provide Catastrophe Protection
Stabilize Loss Experience
Provide Surplus Relief
Facilitate Withdrawal From a Market Segment
Provide Underwriting Guidance

1.c. Increase large-line capacity

Increasing large-line capacity allows a primary insurer to assume more
substantial risks than its financial condition and regulations would otherwise
permit. The maximum amount of insurance or limit of liability allowed by
insurance regulations, which prohibit an insurer from retaining more than l0
percent of its policyholders' net worth on anyone loss exposure

1.d. Stabilize loss experience

Volatile loss experience can impact the stock value of a publicly traded insurer;
alter an insurer's financial rating by independent rating agencies; cause abrupt
alterations in the approaches used in operating the underwriting, claim, and
marketing departments; or undermine the confidence of the sales force.
Reinsurance can be arranged to stabilize the loss experience of a line of
insurance, a class of business, or a primary insurer's entire book of business.

16
 Topic 1: Classification of Insurers

1.e. Provide surplus relief

State insurance regulators monitor several financial ratios as part of their
solvency surveillance efforts, however the relationship of written premiums to
policyholders' surplus is usually a key financial ratio and one regarded as out of
bounds if it exceeds 3 to 1 or 300 percent.
Many insurers use reinsurance to supply surplus relief, which satisfies
insurance regulatory constraints on excess growth. Because the ceding
commission replenishes the primary insurer's policyholders' surplus, the surplus
relief facilitates the primary insurer's premium growth and the increased
policyholders' surplus lowers its capacity ratio.

1.f. Facilitate withdrawal from a market segment

One approach to withdrawal is for the primary insurer to transfer the liability
for all outstanding policies to a reinsurer by acquiring portfolio reinsurance. The
reinsurer accepts all the liability for specific loss exposures covered under the
primary insurer's policies, but the primary insurer must continue to fulfill its
obligations to its insureds.
A novation perfectly eliminates the liabilities a primary insurer has assumed. It
is not considered portfolio reinsurance for the reason that substitute insurer takes
on the direct obligations to insureds covered by the underlying insurance.

1.g. Provide underwriting guidance

Reinsurers work with a wide variety of insurers in the domestic and global
markets under many different circumstances and accumulate a great deal of
underwriting expertise.

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SECTION 1. Insurance Operations

1.h. Key Terms

Retention: The amount retained by the primary insurer under the reinsurance
transaction.
Reinsurance premium: The consideration paid by the primary insurer to the
reinsurer for accepting some or all of the primary insurer's insurance risk.
Ceding commission: An amount paid by the reinsurer to the primary insurer to
pay for part or all of the primary insurer's policy acquisition expenses.
Retrocession: A reinsurance agreement whereby one reinsurer (the retrocedent)
transfers all or portion of the reinsurance risk it has assumed or will assume to
another reinsurer (the retrocessionaire).
Line: The maximum amount of insurance or limit of liability that an insurer
will take on a single loss exposure.
Surplus relief: A replenishment of policyholders' surplus supplied by the
ceding commission paid to the primary insurer by the reinsurer.
Portfolio reinsurance: Reinsurance that passes to the reinsurer liability for a
whole type of insurance, territory, or book of business after the primary insurer
has issued the policies.
Novation: An agreement under which one insurer or reinsurer is replaced for
another.

18
 Topic 1: Classification of Insurers

1.1. Reinsurance Concepts

Which of the following statements is true with regard to reinsurance concepts?
I. Reinsurance is best identified as an agreement by a reinsurer to indemnify a
primary insurer for losses.
II. From a regulator's perspective, if an insurer's ratio of written premium to
policyholders' surplus exceeds 3 to 1, the insurer is selling more insurance
than is prudent compared to the size of its net worth.
III. A primary insurer could obtain surplus relief through reinsurance by
minimizing fluctuations in retained losses from year to year.
IV. The retention under a reinsurance agreement is always expressed in the form
of percentage of the original amount of insurance.
V. State insurance regulation mandates that, for accounting purposes,
premiums be recognized as reserve right at that moment a new policy is sold
and expenses be recognized as they are earned throughout the policy's life.
(A) I and II only

(B) I and III only

(C) II and IV only

(D) II and V only

Answer
III. A primary insurer could obtain surplus relief through reinsurance by
receiving ceding commissions to offset policy acquisition expenses.
IV. The retention under a surplus share or excess of loss reinsurance is
expressed in the form of stipulated dollar amount.
V. For accounting purposes, expenses are recognized as reserve at the time a
new policy is sold and premiums be recognized as they are earned throughout
the policy's life.
The correct answer is (A) I and II only.

19
SECTION 1. Insurance Operations

1.2. Reinsurance Functions

Which of the following statements is incorrect with regard to reinsurance
functions?
I. Increasing large-line capacity allows a primary insurer to reduce the financial
consequences of a single catastrophic event which causes multiple losses
II. Increasing large-line capacity allows a primary insurer to take a loss
exposure with potential financial consequences that are higher than its
financial condition would otherwise permit
III. Reinsurance is usually arranged to stabilize the loss experience of a line of
insurance, a class of business, or a primary insurer's entire book of business.
IV. One method to withdrawal is for the primary insurer to transfer the liability
for all outstanding policies to a reinsurer by purchasing portfolio
reinsurance.
V. A novation completely eliminates the liabilities a primary insurer has
assumed. It is not considered portfolio reinsurance for the reason that
substitute insurer assumes the direct obligations to insureds covered by the
underlying insurance.
(A) I only

(B) II only

(C) III only

(D) IV and V only

Answer
I. Large-line capacity is an insurer's ability to reinsure a larger proportion of its
single risk, not multiple risks.
The correct answer is (A) I only.

20
 Topic 2: Reinsurance Transactions and Sources

Topic 2: Reinsurance Transactions and Sources

ARe 144 Review Notes / Assignment 1. Introduction to Reinsurance / EO 2, 3

2.a. Treaty Reinsurance

Treaty reinsurance uses one agreement for a whole class or portfolio of loss
exposures, and is also called obligatory reinsurance. The reinsurance agreement
is usually called the treaty.
Although a few treaties allow the reinsurer limited discretion in reinsuring
individual loss exposures, most treaties require that all loss exposures within the
treaty's terms must be reinsured. Most, but not all, treaty reinsurance agreements
require the primary insurer to cede all eligible loss exposures to the reinsurer,
therefore the reinsurer is not exposed to adverse selection.

2.b. Facultative Reinsurance

Facultative reinsurance makes use of a separate reinsurance agreement for
each loss exposure it wants to reinsure, and is also called non-obligatory
reinsurance. The reinsurer issues a facultative certificate of reinsurance that is
attached to the primary insurer's copy of the policy being reinsured.
Facultative reinsurance serves four functions: Facultative reinsurance can
provide large line capacity for loss exposures that exceed the limits of treaty
reinsurance agreements. Facultative reinsurance can reduce the primary
insurer's exposure in a given geographic area. Facultative reinsurance can
insure a loss exposure with atypical hazard characteristics and thereby maintain
the favorable loss experience of the primary insurer's treaty reinsurance and any
associated profit-sharing arrangements. Facultative reinsurance can insure
particular classes of loss exposures that are excluded under treaty reinsurance.

2.c. Structure: Reinsurance Sources

Professional Reinsurers
Reinsurance Departments of Primary Insurers
Reinsurance Pools, Syndicates, Reinsurance pool
and Associations
Syndicate
Association

21
SECTION 1. Insurance Operations

2.d. Professional Reinsurers

Professional reinsurers get connected to other insurers either directly or
through intermediaries as primary insurers do. A reinsurer whose employees
deal directly with primary insurers is named a direct writing reinsurer.
Reinsurance intermediaries generally represent a primary insurer and work
together with that insurer to develop a reinsurance program that is then placed
with a reinsurer or reinsurers. The reinsurance intermediary gets a brokerage
commission.
Professional reinsurers assess the primary insurer before accepting a
reinsurance agreement because the treaty reinsurer underwrites the primary
insurer as well as the loss exposures being ceded. The primary insurer should
study the reinsurer's claim paying ability, reputation, and management
competence before entering into the reinsurance agreement.

2.e. Reinsurance Departments of Primary Insurers

Some primary insurers also provide treaty and facultative reinsurance. To
make sure that information from other insurers remains confidential, a primary
insurer's reinsurance operations are usually separate from its primary insurance
operations.

2.f. Reinsurance pool

Reinsurance pool is a reinsurance association that comprises of several
unrelated insurers or reinsurers which have joined to insure risks the individual
members are unwilling to individually insure.
A policy for the full amount of insurance is issued by a member company and
reinsured by the remainder of the pool members based on predetermined
percentages. A reinsurance pool may accept loss exposures from nonmember
companies or offer reinsurance only to its member companies.

2.g. Syndicate
Syndicate is a group of insurers or reinsurers involved in joint underwriting to
insure major risks that are beyond the capacity of a single insurer or reinsurer;
each syndicate member accepts predetermined shares of premiums, losses,
expenses, and profits.
Each member shares the risk with other members by accepting a percentage of
the risk. These members collectively constitute a single, separate entity under the
syndicate name. Syndicates are a key component of Lloyd's, an association that
provides the physical and procedural facilities for its members to write
insurance.

22
 Topic 2: Reinsurance Transactions and Sources

2.h. Association
Association is an organization of member companies that reinsure by fixed
percentage the total amount of insurance appearing on policies issued by the
organization. On most occasions, the member companies issue their own policies;
however, a reinsurance certificate is attached to each policy, under which each
member company assumes a fixed portion of the total amount of insurance.
Organizations of this type allow members to share risks that demand special
coverages or special underwriting techniques, and can enhance the primary
insurer's capacity to insure extra-hazardous risks.

2.i. Reinsurance Professional and Trade Association

Unlike many primary insurers, reinsurers do not use service organizations
such as Insurance Services Office (ISO) and the American Association of
Insurance Services (AAIS) to develop loss costs and draft contract wording.
However, the reinsurance field has several associations that serve member
companies and provide information to interested parties.
Intermediaries and Reinsurance Underwriters Association (IRU): Founded
in 196 7 and composed of intermediaries and reinsurers that broker or assume
nonlife treaty reinsurance, IRU publishes the Journal of Reinsurance.
Brokers & Reinsurance Markets Association (BRMA): BRMA represents
intermediaries and reinsurers that are predominately engaged in United States
treaty reinsurance business obtained through reinsurance brokers.
Reinsurance Association of America (RAA): RAA is a not-for-profit trade
association of professional reinsurers and intermediaries.

23
SECTION 1. Insurance Operations

2.1. Treaty Reinsurance

Which of the following statements is not true with regard to treaty
reinsurance?
I. Treaty reinsurance is best identified as a reinsurance agreement that covers a
whole class or portfolio of loss exposures, and all loss exposures that fall
within the treaty are automatically reinsured.
II. If treaty reinsurance agreements permitted primary insurers to select which
loss exposures they ceded, the reinsurer would be exposed to adverse
selection.
III. The treaty reinsurer is generally willing to allow the primary insurer to
eliminate high-hazard loss exposures from the treaty by using facultative
reinsurance.
IV. Treaty reinsurance agreements are usually intended to allow underwriters to
exercise discretion in determining which loss exposures to cede to the treaty
reinsurers.
V. A primary insurer's underwriting policy and underwriting guidelines are
usually designed by its treaty reinsurer.
(A) I and II

(B) III and IV

(C) IV and V

(D) II and V

Answer
IV. Although some treaties allow the reinsurer limited discretion in reinsuring
individual loss exposures, most treaties require that all loss exposures within the
treaty's terms must be reinsured.
V. A primary insurer's underwriting policy and underwriting guidelines are
usually developed by its staff underwriters.
The correct answer is (C) IV and V.

24
 Topic 2: Reinsurance Transactions and Sources

2.2. Facultative Reinsurance

Which of the following statements is true with regard to facultative
reinsurance?
I. The administrative costs related to placing facultative reinsurance are
relatively low.
II. Facultative reinsurance is generally not an option for insuring classes of loss
exposures that are excluded under treaty reinsurance.
III. Primary insurers generally use facultative reinsurance as the basis of their
reinsurance program.
IV. A facultative reinsurance agreement is written for a specified time period and
should not be cancelled by either party unless contractual obligations, such
as payment of premiums, are not met.
V. Facultative reinsurance can supply large line capacity for loss exposures that
exceed the limits of treaty reinsurance agreements.
(A) I and II only

(B) III and IV only

(C) IV and V only

(D) II and V only

Answer
I. The administrative costs associated with placing facultative reinsurance are
relatively high.
II. Facultative reinsurance is generally an important option for insuring classes
of loss exposures that are excluded under treaty reinsurance.
III. Primary insurers generally use treaty reinsurance as the foundation of their
reinsurance program.
The correct answer is (C) IV and V only.

25
SECTION 1. Insurance Operations

2.3. Reinsurance Transactions

Which of the following statements is not true with regard to Reinsurance
Transactions?
I. A long-term partnership with a reinsurer generally allows primary insurers
to consistently fulfill producers' requests to place insurance with them.
II. One role of treaty reinsurance is to protect a primary insurer's facultative
reinsurance from adverse loss experience.
III. Administrative expenses per-risk are higher under a treaty reinsurance
arrangement than under a facultative reinsurance arrangement.
IV. Treaty reinsurance obligates the reinsurer to assume those loss exposures that
fall within the treaty.
V. Treaty reinsurance provides primary insurers with the certainty needed to
formulate underwriting policy and develop underwriting guidelines.
(A) I and II only

(B) II and III only

(C) III and IV only

(D) II and V only

Answer
II. One function of facultative reinsurance is to protect a primary insurer's
treaties from adverse loss experience.
III. Administrative costs per-risk are higher under a facultative reinsurance
arrangement than under a treaty reinsurance arrangement.
The correct answer is (B) II and III only.

26
 Topic 2: Reinsurance Transactions and Sources

2.4. Reinsurance Sources

Which of the following statements is incorrect with regard to reinsurance
sources?
I. Reinsurance pools, syndicates, and associations are groups of insurers that
share the loss exposures of the group, usually through reinsurance.
II. Reinsurance intermediaries can often help secure high coverage limits and
catastrophe coverage.
III. Reinsurance intermediaries generally represent professional reinsurers and
receive a brokerage commission from the primary insurers.
IV. A reinsurance pool may accept loss exposures from nonmember companies
or offer reinsurance only to its member companies.
V. The Brokers & Reinsurance Markets Association (BRMA) is one of important
sources of reinsurance.
(A) I and III only

(B) III and V only

(C) II and IV only

(D) II and V only

Answer
III. Reinsurance intermediaries generally represent primary insurers and
receive a brokerage commission from the reinsurers.
V. BRMA is one of reinsurance professional and trade association and
represents intermediaries and reinsurers that are predominately engaged in
United States treaty reinsurance business obtained through reinsurance brokers.
The correct answer is (B) III and V only.

27
SECTION 1. Insurance Operations

2.5. Reinsurance Sources

Which of the following statements is not true with regard to reinsurance
sources?
I. Professional reinsurers have interaction with other insurers either directly or
through intermediaries.
II. Reinsurance pools, syndicates, and associations can be created by
reinsurance intermediaries to meet their clients' needs.
III. When a primary insurer offers reinsurance it typically incorporates the
reinsurance function into the existing underwriting function to leverage
underwriting skills.
IV. A reinsurance intermediary negotiates the reinsurance agreement between
the ceding company and the reinsurer.
V. During a record hard insurance market, four reinsurance intermediaries
(brokers) teamed up to offer reinsurance to clients that were having difficulty
obtaining reinsurance for several troublesome liability lines. The source of
the reinsurance made available to the clients is attributable to a reinsurance
pool.
(A) I and II only

(B) III only

(C) IV only

(D) IV and V only

Answer
III. When a primary insurer offers reinsurance it usually separates the
reinsurance operations to maintain the confidentiality of insurer information.
The correct answer is (B) III only.

28
 Topic 3: Types of Reinsurance

SECTION 2. TYPES OF REINSURANCE AND

PROGRAM DESIGN

Topic 3: Types of Reinsurance

Topic 4: Alternatives to Traditional Reinsurance
Topic 5: Reinsurance Program Design

29
SECTION 2. Types of Reinsurance and Program Design

Topic 3: Types of Reinsurance

Are 144 Review Notes / Assignment 2. Types of Reinsurance and Reinsurance Program
Design / EO 1

3.a. Structure: Types of Reinsurance

Pro Rata Quota Share

Surplus Share
Excess of Loss Per Risk XOL
Catastrophe XOL
Per Policy XOL
Per Occurrence XOL
Aggregate XOL

3.b. Pro Rata Reinsurance

Under pro rata reinsurance, or proportional reinsurance, the primary insurer
cedes a percentage of the original insurance premiums to the reinsurer as a
reinsurance premium. Pro rata reinsurance can be labeled as either quota share or
surplus share.
The reinsurer usually pays the primary insurer a ceding commission for that
loss exposures ceded. The ceding commission reimburses the primary insurer for
policy acquisition expenses incurred when the underlying policies were sold.
Types of commission are: Flat commission Profit-sharing commission
Sliding scale commission (see key terms).

30
 Topic 3: Types of Reinsurance

3.c. Quota share reinsurance

A type of pro rata reinsurance in which the primary insurer and the reinsurer
share the sums of insurance, policy premiums, and losses (including loss
adjustment expenses) by using a fixed percentage. Quota share reinsurance can
be used with both property insurance and liability insurance but is more
frequently used in property insurance.
Because the primary insurer cedes a fixed percentage under a quota share
treaty, even policies with low amounts of insurance that the primary insurer
could safely retain are reinsured. Because the primary insurer and the reinsurer
share liability for every loss exposure depending upon the quota share treaty, the
reinsurer is usually not susceptible to adverse selection.
A variable quota share treaty has the advantage of enabling a primary insurer
to retain a larger proportion of the small loss exposures that are within its
financial capability to absorb, while maintaining a safer and smaller retention on
larger loss exposures.

3.d. Surplus share reinsurance

A type of pro rata reinsurance in which the policies covered are those whose
amount of insurance exceeds a stipulated dollar amount, or line.
The surplus share treaty does not cover policies with amounts of insurance
that are lower than the primary insurer's line. Many primary insurers use surplus
share reinsurance as an alternative to quota share reinsurance therefore they do
not have to cede any part of the liability for loss exposures that can be safely
retained.
Because the percentage of policy premiums and losses varies for each loss
exposure ceded, surplus share treaties cost more to administer than quota share
treaties. Primary insurers must keep records and, in many cases, periodically
provide the reinsurer with a report termed as a bordereau.
Many surplus share treaties allow the primary insurer to increase its line from
a minimum amount to a maximum amount. The flexibility provided by the
reinsurer in the surplus share treaty is usually communicated to the primary
insurer's underwriters through a line guide, or line authorization guide.

31
SECTION 2. Types of Reinsurance and Program Design

3.e. Excess of Loss Reinsurance

The reinsurer responds to a loss only if the loss exceeds the primary insurer's
retention, known as the attachment point. The primary insurer fully retains losses
that are lower than the attachment point, and will sometimes, with co-
participation provision, be required by the reinsurer to also retain responsibility
for a proportion of the losses that exceed the attachment point.
Excess of loss reinsurance premiums are negotiated based on the likelihood
that losses will exceed the attachment point. The reinsurance premium for excess
of loss reinsurance is generally stated as a percentage (often called a rate) of the
policy premium charged by the primary insurer (often called the subject
premium or underlying premium).
Generally, reinsurers never pay ceding commissions, but the reinsurer may
reward the primary insurer for favorable loss experience by paying a profit
commission or reducing the rate applied in calculating the reinsurance premium.
A working cover enables the primary insurer to spread its losses over several
years. Reinsurers typically require a working cover to contain an occurrence
limitation of two or three times the reinsurance limit.
The purpose of a co-participation provision is to provide the primary insurer
with a financial incentive to efficiently manage losses that exceed the attachment
point.
In addition to indemnifying losses in a layer of coverage, the reinsurer's
obligation may also extend to payment of loss adjustment expenses. These are
the two most common approaches to handling loss adjustment expenses: Pro
rata in addition: Prorate the loss adjustment expenses between the primary
insurer and the reinsurer based on the same percentage share that each is
responsible for the loss. Loss adjustment expense included in the limit: Add
the loss adjustment expenses to the amount of the loss when applying the
attachment point of the excess of loss reinsurance agreement.

3.f. Per Risk and Per Policy Excess of Loss

Per risk excess of loss is often called property per risk excess of loss and is
generally used with property insurance. It applies separately to each loss
occurring to each risk, with the primary insurer usually determining what
constitutes one risk (loss exposure).
Per policy excess of loss is used predominantly with liability insurance and
applies the attachment point and the reinsurance limit separately to each
insurance policy issued by the primary insurer, despite the number of losses
occurring under each policy.

32
 Topic 3: Types of Reinsurance

3.g. Per Occurrence and Catastrophe Excess of Loss

Per occurrence excess of loss is generally used in liability insurance. It applies
the attachment point and the reinsurance limit to the total losses as a result of a
single event affecting one or more of the primary insurer's policies.
Catastrophe excess of loss protects the primary insurer from an accumulation
of retained losses that arise from just one catastrophic event. Because the
attachment point and reinsurance limit apply separately to each catastrophe
occurring during a policy period, the catastrophe excess of loss reinsurance
agreement defines the scope of a catastrophic occurrence by using a loss
occurrence clause.

3.h. Aggregate Excess of Loss

Aggregate excess of loss reinsurance can be used in property or liability
insurance and covers aggregated losses that exceed the attachment point and
occur during a stated period, usually one year. The attachment point in an
aggregate excess of loss treaty can be stated as a dollar amount of loss or as a loss
ratio. When the attachment point is stated as a loss ratio, the treaty is called "stop
loss reinsurance."

3.i. Functions of Treaty Reinsurance

Stabilizing Improving Protecting Providing

Large- Catastrop Surplus Main
Type of Reinsurance Loss
Line Purpose
Experience he Relief
Capacity
To provide
Quota share No Yes No Yes surplus relief
To provide
Pro
large-line
Rata
capacity while
Surplus share No Yes No Yes
providing
some surplus
relief
To provide
large-line
Yes, to
Per risk capacity while
Yes Yes some No
(Per policy) stabilizing
extent
loss
experience
Excess
To protect
of
against
Loss Per occurrence Yes, to some
No Yes No catastrophic
(Catastrophe) extent
losses from
one event
Yes, to To stabilize
Aggregate Yes some Yes No loss
extent experience

33
SECTION 2. Types of Reinsurance and Program Design

3.j. Key Terms

Flat commission: A ceding commission which is a fixed percentage of the
ceded premiums.
Profit-sharing commission: A ceding commission that is contingent on the
reinsurer realizing a predetermined proportion of excess profit on ceded loss
exposures.
Sliding scale commission: A ceding commission based on a formula that
adjusts the commission based on the profitability of the reinsurance agreement.
Bordereau: A report the primary insurer provides periodically to the reinsurer
which includes a history of all loss exposures reinsured under the treaty.
Line guide: A document that provides the minimum and maximum line a
primary insurer can retain on one loss exposure.
Attachment point: The dollar amount above which the reinsurer responds to
losses.
Subject premium: The premium the primary insurer charges on its underlying
policies and to which a rate is used to determine the reinsurance premium.
Working cover: An excess of loss reinsurance agreement having a low
attachment point.
Co-participation provision: A provision in a reinsurance agreement that
requires the primary insurer to retain a particular portion of the losses that
exceed its attachment point.

34
 Topic 3: Types of Reinsurance

3.1. Reinsurance Calculation

Which of the following statements is true with regard to reinsurance
calculations?
I. Mountain Insurance Company has entered into a 80 percent quota share
treaty with Swift Reinsurance Company. An $80,000 loss occurs that is subject
to the reinsurance treaty. Under the terms of the treaty, Swift would
indemnify Mountain for the loss of $64,000.
II. A primary insurer has a five-line surplus share treaty with a $50 million limit.
For a specific loss exposure with coverage limit needs of $30 million, the
primary insurer's line guide permits a $5 million line. The percentage used to
cede premiums and losses to the reinsurer would be 80%.
III. The losses listed below arose from three policies and one occurrence: Policy
A, loss amount $300,000; Policy B, loss amount $400,000; Policy C, loss
amount $900,000. Given these losses, the difference between the amount of
loss a primary insurer would recover under a $750,000 xs $250,000 per policy
excess of loss reinsurance treaty versus a $800,000 xs $800,000 per occurrence
excess of loss reinsurance treaty would be $250,000.
(A) I only

(B) II only

(C) III only

(D) All of the above

Answer
I. Reinsurance cession is 80%, 0.8 x $80,000. = $64,000.
II. A specific loss exposure is $30mil., primary insurers retention is $5mil., and
reinsurance cession amount is $25mil., so the percentage of reinsurance cession is
83.33%.
III. The difference between (A) and (B) is $50,000.
Reinsurance recovery
Loss
Policy $750,000 xs $250,000 per $800,000 xs $800,000 per
Amount
policy XOL (A) occurrence XOL (B)
1 $300,000 $50,000 -
2 $400,000 $150,000 -
3 $900,000 $650,000 -
Total $1,600,000 $850,000 $800,000

35
SECTION 2. Types of Reinsurance and Program Design

3.2. Types of Reinsurance

Which of the following statements is not true with regard to types of
reinsurance?
I. Many primary insurers use excess of loss reinsurance as an alternative to
quota share reinsurance so that they do not have to cede any part of the
liability for loss exposures that can be safely retained.
II. Per occurrence excess of loss may provide surplus relief to the primary
insurer mainly because the reinsurer usually pays a ceding commission for
those policies ceded.
III. In an excess of loss reinsurance, reinsurers do not pay ceding commissions,
however the reinsurer may reward the primary insurer for favorable loss
experience by paying a profit commission or lowering the rate used in
calculating the reinsurance premium.
IV. Per policy excess of loss applies primarily to liability insurance, and per risk
excess of loss applies primarily to property insurance.
V. The attachment point in an aggregate excess of loss treaty can be stated in the
form of dollar amount of loss or in the form of loss ratio.
(A) I and II only

(B) III only

(C) IV and V only

(D) II and IV only

Answer
I. The surplus share treaty does not cover policies with amounts of insurance
that are less than the primary insurer's line. So, many primary insurers use
surplus share reinsurance instead of quota share reinsurance so that they do not
have to cede any part of the liability for loss exposures that can be safely
retained.
II. Quota share and surplus share reinsurance provide surplus relief to the
primary insurer.
The correct answer is (A) I and II only.

36
 Topic 3: Types of Reinsurance

3.3. Types of Reinsurance

Which of the following statements is not true with regard to types of
reinsurance?
I. Facultative reinsurance is the term used for reinsurance of individual loss
exposures where the primary insurer chooses which loss exposures to send
to the reinsurer, and the reinsurer can accept or reject any loss exposures
submitted.
II. Facultative reinsurance is usually chosen by newly incorporated insurers or
insurers with limited capital mainly because it is effective in providing
surplus relief.
III. Under pro rata reinsurance, the reinsurer generally pays a ceding
commission to reimburse the primary insurer for acquisition costs associated
with the underlying policies.
IV. Surplus share reinsurance is beneficial when the primary insurer needs to
increase its large-line capacity.
V. Pro rata reinsurance treaties has the benefit of enabling a primary insurer to
retain a larger proportion of the small loss exposures that are within its
financial capability to absorb, while maintaining a safer and smaller retention
on larger loss exposures.
(A) I and II only

(B) II and IV only

(C) III and V only

(D) II and V only

Answer
II. Pro rate reinsurance is generally chosen by newly incorporated insurers or
insurers with limited capital because it is effective in providing surplus relief.
V. Variable quota share treaties has the advantage of enabling a primary
insurer to retain a larger proportion of the small loss exposures that are within its
financial capability to absorb, while maintaining a safer and smaller retention on
larger loss exposures.
The correct answer is (D) II and V only.

37
SECTION 2. Types of Reinsurance and Program Design

3.4. Types of Reinsurance

Which of the following statements is not true with regard to types of
reinsurance?
I. Per policy excess of loss reinsurance is used mainly with liability insurance;
applies the attachment point and the reinsurance limit separately to the
losses occurring on each insurance policy; and is activated when a loss on a
policy exceeds the attachment point.
II. One typical feature of quota share reinsurance agreements is that the
agreement states a maximum dollar limit above which responsibility for
additional coverage limits or losses reverts to the primary insurer.
III. Under a per policy excess of loss treaty, the attachment point and the
reinsurance limit apply separately to each loss under each policy up to an
aggregate limit specified in the treaty.
IV. Under a per occurrence excess of loss treaty, the attachment point and the
reinsurance limit apply to all losses from a single event affecting liability and
property insurance within the same policy.
V. A reinsurance arrangement that is stated as "95 percent of $10 million xs $5
million" is an excess of loss reinsurance agreement with an attachment point
of $5 million, and a 5 percent co-participation provision of the $10 million
layer.
(A) I and III only

(B) II and IV only

(C) III and IV only

(D) IV and V only

Answer
III. Under a per policy excess of loss treaty, the attachment point and the
reinsurance limit apply separately to each insurance policy regardless of the
number of losses occurring under each policy.
IV. Under a per occurrence excess of loss treaty, the attachment point and the
reinsurance limit apply to the total losses arising from a single event affecting one
or more policies.
The correct answer is (C) III and IV only.

38
 Topic 3: Types of Reinsurance

3.5. Reinsurance Calculation

Which of the following statements is not true with regard to reinsurance
calculations?
Heungkuk Insurance has a 5-line surplus share treaty with Cedars
Reinsurance. The line is $100,000. Heungkuk Insurance has the following
policies:

Limit Premium Loss

Policy A $50,000 $1,000 $1,000
Policy B $400,000 $4,000 $50,000
Policy C $800,000 $16,000 $100,000

(A) The limit for Policy A will Heungkuk Insurance cede to Cedars Reinsurance
is $0.
(B) The premium for Policy B will Heungkuk Insurance cede to Cedars
Reinsurance is $3,000.
(C) The limit for Policy C will Heungkuk Insurance cede to Cedars
Reinsurance is $500,000.
(D) The loss for Policy C will Cedars Reinsurance pay is $87,500.

Answer
(D) The reinsurance percent would be 62.5% (= $500,000/$800,000), so the loss
paid by reinsurer will be $62,500.
The correct answer is (D).

39
SECTION 2. Types of Reinsurance and Program Design

Topic 4: Alternatives to Traditional Reinsurance

Are 144 Review Notes / Assignment 2. Types of Reinsurance and Reinsurance Program
Design / EO 2

4.a. Structure: Alternatives to Traditional Reinsurance

Traditional Reinsurance
Alternatives Finite Risk Reinsurance
Capital Market Catastrophe bond
Alternatives
Catastrophe risk exchange
Contingent surplus note
Industry loss warranty (ILW)
Catastrophe option
Line of credit
Sidecar

4.b. Finite Risk Reinsurance

Finite risk reinsurance is a nontraditional type of reinsurance in which the
reinsurer's liability has limitations (or "finite") and anticipated investment income
is expressly identified as an underwriting component. Because this type of
reinsurance transfers a limited amount of risk to the reinsurer with the purpose
of improving the primary insurer's financial result, it is often called financial
reinsurance.
A finite risk reinsurance agreement typically has a multi-year term, which
allows the risk and losses to be spread over several years, while being subject to
an aggregate limit for the agreement's entire term. Finite risk reinsurance is
created to cover high-severity losses. The reinsurer commonly shares profits with
the primary insurer when it has favorable loss experience or has earned income
by investing the prepaid premium.

4.c. Catastrophe bond

A bond is issued by using a condition that if the issuer suffers a catastrophe
loss greater than the specified amount, the duty to pay interest and/or repay
principle is deferred or forgiven. As long as catastrophe-related losses do not
exceed the specified amount, investors earn a fairly high interest rate and receive
a return of their principal.

40
 Topic 4: Alternatives to Traditional Reinsurance

4.d. Catastrophe risk exchange

This is a means through which a primary insurer can exchange a part of its
insurance risk for another insurer's risk. A primary insurer with a geographic
concentration of loss exposures can use a catastrophe risk exchange to reduce its
losses from just one loss occurrence.

4.e. Contingent surplus note

A primary insurer designs this so that, at its option, it can immediately obtain
funds by issuing notes at a pre-agreed interest rate. Surplus note is a kind of
unsecured debt instrument, issued only by insurers, that has characteristics of
both conventional equity and debt securities and is considered as policyholders'
surplus rather than as a liability on the insurer's statutory balance sheet.

4.f. Industry loss warranty (ILW)

This is an insurance-linked security that covers the primary insurer when the
industry-wide loss from a particular catastrophic event exceeds a predetermined
threshold. Its coverage is triggered only by industry losses.

4.g. Catastrophe option

This agreement provides the primary insurer the right to a cash payment from
investors when a specified index of catastrophe losses reaches a specified level
(the strike price).

4.h. Line of credit

This is an arrangement in which a bank or another financial institution agrees
to provide a loan to a primary insurer when the primary insurer suffers a loss.

4.i Sidecar
This is a limited-existence special purpose vehicle (SPY) that provides a
primary insurer additional capacity to write property catastrophe business or
other short-tail lines by using a quota share agreement with private investors.

41
SECTION 2. Types of Reinsurance and Program Design

4.j. Key Terms

Securitization of risk: Using securities or financial instruments (stocks, bonds,
commodities, financial futures) to fund an insurer's exposure to catastrophic loss.
Special purpose vehicle (SPV): A facility established for the purpose of
purchasing income producing assets from an organization, holding title to them,
and then using those assets to collateralize securities that might be sold to
investors.
Insurance derivative: Financial contract whose value is based upon the level of
insurable losses that occur within a specific time period.
Contingent capital arrangement: An agreement, placed before any losses
occur, that allows an organization to raise cash by selling stock or issuing debt at
prearranged terms after a loss occurs that exceeds a certain threshold.
Insurance-linked security: A financial instrument whose value is primarily
driven by insurance and/or reinsurance loss events.
Strike price: The price at which the stock or commodity underlying a call
option (such as a warrant) or a put option can be purchased (called) or sold (put)
during a specified period.

42
 Topic 4: Alternatives to Traditional Reinsurance

4.1. Alternatives to Traditional Reinsurance

Which of the following statements is not true with regard to alternatives to
traditional reinsurance?
I. An industry loss warranty is an insurance-linked security that covers the
primary insurer in case the industry-wide loss from a particular catastrophe
exceeds a predetermined threshold.
II. Under a catastrophe risk exchange, a bond is issued using the condition that
if the issuer suffers a catastrophe greater than a specified amount, the
obligation to pay interest and/or repay principle is deferred or forgiven.
III. A catastrophe risk exchange is an agreement which provides the primary
insurer the right to a cash payment from investors if a specified index of
catastrophe losses by geographic area reaches a specified level.
IV. Under sidecar arrangements, the primary insurer charges a ceding
commission and may obtain a profit commission if the book of business is
profitable.
V. A crucial characteristic that distinguishes finite risk reinsurance from other
types of reinsurance is that finite risk reinsurance transfers a limited amount
of risk to the reinsurer.
(A) I only

(B) II and III only

(C) IV and V only

(D) V only

Answer
II. Under a cat bond, investors receive their return for the risk assumed
through periodic interest payments on the principal amount assumed.
III. A catastrophe risk exchange is a means through which a primary insurer
can exchange a portion of its insurance risk for another insurer's insurance risk.
Cat option has a strike price at which the primary insurer will be able to receive
cash from its investors to enable it to pay losses from a catastrophe.
The correct answer is (B) II and III only.

43
SECTION 2. Types of Reinsurance and Program Design

Topic 5: Reinsurance Program Design

Are 144 Review Notes / Assignment 2. Types of Reinsurance and Reinsurance Program
Design / EO 3

5.a. Structure: Reinsurance Program Design

Factors Affecting Growth Plans
Reinsurance
Types of Insurance Sold
Needs
Geographic Spread of Loss Exposures
Insurer Size
Insurer Structure
Insurer Financial Strength
Senior Management's Risk Tolerance

Factors Affecting Maximum Amount the Primary Insurer Can Retain

Retention
Maximum Amount the Primary Insurer Wants to Retain
Selection
Minimum Retention Sought by the Reinsurer
Co-participation Provision

Factors Affecting Maximum Policy Limit

Reinsurance
Extra-Contractual Obligations
Limit Selection
Loss Adjustment Expenses
Clash Cover
Catastrophe Exposure

5.b. Growth Plans

A primary insurer that expects rapid premium growth is likely to need more
reinsurance for these three reasons: Rapid growth can cause a drain on a
primary insurer's policyholders' surplus. The loss ratio for a primary insurer's
new business is likely to be less stable. Growth often entails expanding into
markets with greater coverage requirements.

44
 Topic 5: Reinsurance Program Design

5.c. Types of Insurance Sold

Generally, primary insurers selling personal insurance need less reinsurance
than those selling commercial insurance because personal insurance loss
exposures need relatively lower coverage limits. Additionally, personal insurance
loss exposures tend to be more homogeneous and subject to fewer severe hazards
than commercial insurance loss exposures. As a result of homogeneity among
personal insurance loss exposures, the loss experience is generally more stable
than that of commercial insurance loss exposures and for that reason more
predictable.

5.d. Insurer Size

Typically, small primary insurers need proportionately more reinsurance to
stabilize loss ratios than large primary insurers. The loss ratio of a large primary
insurer is likely to be more stable than the loss ratio of a small one even when the
mix of business sold is similar.

5.e. Insurer Financial Strength

An insurer that is financially strong needs less reinsurance than a financially
weaker one for two reasons. First, it does not need surplus relief to increase its
premium capacity. Second, it needs less reinsurance to stabilize its loss ratio.

5.f. Factors Affecting Retention Selection

Cost is always a factor when deciding on a retention, and the cost of a
reinsurance treaty usually increases as the proportions of the retention decreases.
State insurance regulations effectively limit premium capacity to three dollars
of net written premiums for each dollar of policyholders' surplus. Large-line
capacity is restricted by a statutory provision that an insurer cannot retain a net
amount for a single loss exposure higher than 10 percent of its policyholders'
surplus.
Reinsurers sometimes require a minimum retention as a condition of providing
reinsurance. This demand is particularly likely for excess of loss treaties,
particularly catastrophe treaties. The intention of the minimum retention
requirement is to encourage the primary insurer to employ sound risk control,
underwriting, and loss adjustment practices.

5.g. Extra-contractual obligations

If a reinsurance treaty would be to provide protection against extracontractual
damages and excess of policy limit losses, the reinsurance treaty limit should be
substantially greater than the primary insurer's highest policy limit. Damages as
a result of extra-contractual obligations might be several multiples of the highest
coverage limit offered.

45
SECTION 2. Types of Reinsurance and Program Design

5.h. Clash Cover

Clash cover is a form of per occurrence excess of loss reinsurance for liability
loss exposures that protects the primary insurer against aggregations of losses
from one occurrence that affects several insureds or different kinds of insurance.
Clash cover limits should be set by taking into consideration the highest limits
offered by the primary insurer and the perceived likelihood that multiple policies
may be relating to a single occurrence.

46
 Topic 5: Reinsurance Program Design

5.1. Factors Affecting Reinsurance Needs

Which of the following statements is not true with regard to factors affecting
reinsurance needs?
I. A primary insurer that expects rapid premium growth will probably need
more reinsurance than a primary insurer that expects premium volume to
remain stable or to decrease.
II. Due to the sheer volume of business, personal lines insurers need more
reinsurance compared to commercial lines insurers.
III. Because common stock may be marketable only at a large loss in an
unfavorable market, a primary insurer that holds large amounts of it in an
investment portfolio is required to be more heavily reinsured than one that
holds short-term bonds.
IV. A primary insurer that sells only a few types of insurance is more prone to
enjoy a stable loss ratio and less need for reinsurance.
V. A wide geographic spread may stabilize the insurer's loss ratio and reduce
reinsurance needs, especially in property insurance.
(A) I and III only

(B) II and IV only

(C) I and V only

(D) II and III only

Answer
II. Generally, primary insurers selling personal insurance need less reinsurance
than others selling commercial insurance because personal insurance loss
exposures need relatively lower coverage limits. Personal insurance loss
exposures are usually more homogeneous and subject to fewer severe hazards
than commercial insurance loss exposures.
IV. A primary insurer that sells various kinds of insurance is more diversified
and therefore more prone to enjoy a stable loss ratio than a primary insurer
selling only a few types of insurance.
The correct answer is (B) II and IV only.

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SECTION 2. Types of Reinsurance and Program Design

5.2. Reinsurance Program Design

Which of the following statements is not true with regard to Reinsurance
Program Design?
I. A primary insurer that intends to grow is probably going to need additional
reinsurance for growth could lead to geographic diversification of loss
exposures.
II. Clash coverage limits must be set by considering catastrophe excess of loss
reinsurance purchased by the primary insurer.
III. LIG Insurance Company (LIG) is a small, regional personal lines insurer. 4
years ago, LIG hired a new Vice President of Marketing to grow the business.
A mix of factors led to LIG growing by 30 percent in each of the past two
years. The senior management team anticipates continued growth at this rate
for another 5 years. Pro rata reinsurance will be most beneficial in providing
the surplus relief LIG will need to support its growth plans.
IV. A regional commercial property insurer decides to increase its market share
by 20 % per year over the next three years. Currently, the insurer is
experiencing a premium-to-surplus ratio of 4 to 1. Quota share treaties will
be most effective in providing the insurer with needed surplus relief.
(A) I and II only

(B) III only

(C) I and III only

(D) II and IV only

Answer
I. A primary insurer that plans to grow is likely to need additional reinsurance
for all of the following reasons: Growth usually causes a drain on
policyholders' surplus. Variability of the loss ratio on new policies could cause
instability of underwriting results. Growth could entail expanding into
markets with greater coverage requirements.
II. Clash coverage limits should be set by considering all of the following:
Potential for multiple primary policies to be involved in a single occurrence
Potential for excess of policy limits losses Policy limits offered by the primary
insurer.
The correct answer is (A) I and II only.

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 Topic 5: Reinsurance Program Design

5.3. Reinsurance Program Design

Which of the following statements is not true with regard to Reinsurance
Program Design?
I. During the last several years, Hanwha Insurance Company has rapidly
expanded the number of properties it insures in hurricane-prone areas. It is
worried that its reinsurance program may be inadequate for its growing
catastrophe exposure. To deal with this concern, Hanwha may amend its
reinsurance program by adding a catastrophe excess of loss reinsurance
agreement, which would cover the aggregation of property losses to Hanwha
that arise from hurricanes and other catastrophic events.
II. Liability Insurer is concerned that a disproportionate number of its insureds
are positioned in states where an excessively litigious environment has led to
numerous successful lawsuits against insureds. To handle this concern,
Liability Insurer's reinsurance program could be reconfigured to include per
occurrence excess of loss reinsurance to limit the effect of anyone claim. The
reinsurance program could also deal with the possibility that more than one
insured could be sued as the result of a single occurrence and that extra-
contractual damages or excess policy limits judgments could be awarded by
including a clash cover.
(A) I only

(B) II only

(C) All of the above

(D) None of the above

Answer
The correct answer is (D) none of the above.

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SECTION 2. Types of Reinsurance and Program Design

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