Reinsurance Tutorials #4 - Season 2
Hi everyone!
We’ve been discussing reinsurance treaties and wordings in the last couple of videos but we haven’t mentioned one very important point: the pricing part of it!
Ever wonder how a reinsurer prices a reinsurance program? Let’s find out together! ⏬
Firstly, when it comes to the renewal of a reinsurance program or when we’ve been submitted a brand-new treaty, the client or its broker sends us a renewal package that includes all the information we need to price the submitted program; including data of course, but also “soft information” such as company guidelines, underwriting policy, business developments and much more.
This story provided by the company helps us to understand the company’s philosophy and its development plan for the future.
Now regarding the data, the most common data provided provide a historical view of premium development, losses, sums insured, top location and projections for the year to come. Of course, there is many many more information provided depending of the line of business or the type of book covered by the program; but these are the “essentials”.
So, now that we received all of this information, what do we do with it?
As you might know, in the insurance industry we calculate an insurance premium mainly based on two factors: the frequency and the severity of the losses. The premium resulting from this simple equation is called the “pure premium”, then the insurer applies additional loadings to cover its own expenses.
Well, in the reinsurance industry, this is quite the same! However, as reinsurance usually covers exceptional events, determining the frequency and intensity can be much more challenging.
If we have enough historical data, we can use the company’s own experience to quote the program: this is what we call the “experience rating”. The simplest method used is the “burning cost” method.
The burning cost approach is quite simple to understand: for each experience year, after reevaluating the premiums and the losses due to inflation, we calculate the amount of losses recovered by the treaty, and determine the ratio of “annual aggregate recoveries for the years to the estimated premium income”. In this ratio, the reinsurer has added its own costs, such as management expenses and cost of capital, in order to obtain the final rate for the program.
Quite simple, isn’t it? Yes indeed, too simple! Why? Because while the Burning cost approach may easily fit well-known and stable portfolios, it may not fit others. In these cases, the reinsurer has many other alternatives for quoting reinsurance programs.
One option to the Burning Cost approach, is the “exposure rating” method or, if there is not enough experience available, for example a property program that has never been hit by a loss, then the reinsurer could use a “scenario-based” approached.
The “Exposure rating” method does not take into consideration the company’s loss experience but rather the current exposure of its portfolio (sum insured by range, by zone), from the risk profile found in the renewal package.
For these types of portfolios, the reinsurer, depending of the line of business to be quoted and its own experience, will develop a model with a destruction rate and a distribution factor to apply on the company book that will determinate the risk premium. This is what we call a “parametric pricing”. We usually use this methodology for property or well-known lines of business.
Alternatively, if the line of business being covered is brand new, such as cyber, for example; or if we do not have a risk profile, we can use a “scenario-based approach rating”.
A scenario-based approach rating, as the name infers, is based on a hypothetical loss and an estimated return period to determine the impact on the covered book. Some of the historical losses are used as scenarios by the reinsurers to quote certain lines of business (for example, the Mount-Blanc tunnel loss that happen in France in 1999 and cost 39 lives is a scenario that is often use to quote motor liability).
For Terror programs, one of the common scenarios used in France is that of a bomb attack in the business district of La Defense in Paris.
One last category of pricing that we have not mentioned so far is the specificity of NAT CATs, or the natural catastrophe components of reinsurance programs.
The reinsurance industry uses very advanced models developed by risk management firms such as RMS, AIR and EQE.
These models are developed by main perils and per country, and incorporate the latest scientific data on the hazards. Most commonly, the hazards that are modelled are earthquake and windstorm hazards. These CAT models are the most effective way to determine correlations between the risks covered in the book and the total impact of a natural catastrophe event on the book.
The model runs hundreds of thousands of event simulations on the portfolio, using different components: the hazard itself, the book’s vulnerability (whether a structure made of concrete or reinforced concrete, for example), the geographical spread of exposure and the reinsurance conditions for the program. Once the simulation is done, then we have our risk premium!
So, there is obviously more and more to discuss when it comes to reinsurance pricing, but these are the main methods and I hope this has helped you to better understand how we process the data and what is happening “behind the scenes”.
Our industry is moving fast, constantly evolving to address the new challenges our world is facing, making insurance and reinsurance pricing more and more complex.
For example, over the last decade we’ve seen more and more parametric programs being developed on the market, using very specific and complex data (such as the quantity of snow falling during a predefined period) to trigger the reinsurance programs.
So more than ever: knowledge, technology and data are key to our industry.
Now that the pricing process is done, Clémence will explain the crucial part of a treaty renewal process: the negotiations! I
Hope you enjoyed this video and see you soon!
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