BWRR 3053 : Reinsurance

ARTICLE REVIEW
( Title of article: Enhancing reinsurance efficiency using index-based instruments )

Introduction This assignment is used to understand about the uses of an index-based instrument in order to enhancing reinsurance efficiency. Based on article reviewed, this assignment suggest that a discussion on the demonstrating the feasibility of an index-based instrument in enhancing reinsurance efficiency. Though, index-based instrument effectuated by enhancing reinsurance efficiency, those reinsurance have the potential for regulatory effect sufficient enough to suggest a positive answer to the issue of Enhancing reinsurance efficiency using index-based instrument. Reinsurance, its nature and availability, is not among those things commonly discussed when evaluating the effectiveness of insurance regulation in general. At its most reductive, reinsurance is a relatively straight forward financial transaction by which an insurance company is indemnified for all or a portion of some risk by another insurer. Risk management is one of the most important aspects of insurance and reinsurance operations. From the shareholders perspective, proper risk management practices ensure the continuation and long-term growth of die business, preserve the franchise value of the firm and reduce earnings volatility. From the policyholders and regulatory perspective, conservative risk management practices guarantee a satisfactory level of claim-paying ability, especially in the event of a major disaster. The using of index-based instrument in order to enhancing reinsurance efficiency is practical approach. The main advantage of index-based instrument is that they practically free from moral hazard, a major hurdle that discourages capital market investors from participating in insurance risk securitization, even though the natural catastrophe risk in extremely appealing asset class from a portfolio perspective. The absence of moral hazard also suggests that an indexbased instrument should command of lower margin than a comparable indemnity-based reinsurance contract, making in an attractive alternative to traditional reinsurance. The combination between indemnity contracts with index-based instruments can ideally lead to efficiency gains for purchasers.

BWRR 3053 : Reinsurance

Critiques/ Comments / Article Review The main purpose of this article is demonstrates the feasibility of reinsurance through identification of the key factors determine the efficiency of index-based reinsurance and demonstrate them and introduces a practical approach to enhancing reinsurance efficiency using index-based instruments. In the property catastrophe reinsurance market, the combined effect of these factors frequently allows the construction of an index-based hedging program that is more efficient than a traditional excess-of-loss reinsurance contract. A robust optimization model based on the genetic algorithm is introduced and shown to be effective in optimizing index-based reinsurance contracts.

The key question that the author is asking is how effective index-based instrument in order to enhance efficiency of reinsurance. Reinsurance is an effective tool for this purpose. Reinsurance is also flexible because its terms can be modified periodically to accommodate various market conditions and changing risk management objectives. In practice, due to the illiquidity of the reinsurance market, it is impossible to identify or implement the theoretically most efficient reinsurance structure. However, attempts to enhance the efficiency of reinsurance to the extent possible can creative significant tangible benefits for die hedger.

The most important information in this article concerns about the uses of index-based instrument toward reinsurance in practically approach. In the following section, the author will makes a review of the general mathematical framework of reinsurance optimization. Next, she illustrates how index-based instruments can potentially enhance reinsurance efficiency through a mathematically simple yet self-contained example in section 3. Its simplicity allows them to analytically examine the enhancing reinsurance efficiency cost and benefits of an index-based contract and arrive at the general conclusions on the optimal use of such instruments. In section 4, the author introduce model that optimizes a hedging program consisting of index-based instruments. The paper is concluded in section 5. All information is binding together in one article.

BWRR 3053 : Reinsurance

The main conclusion in this article is high feasibility of enhancing reinsurance efficiency using index-based instruments is demonstrated in this study. The author identify three key factors that determine the efficiency of an index-based contract, that are its price, the correlation between the index and the hedgers loss, and the volatility of the hedgers loss relative to that of the index. In the property catastrophe reinsurance market, the combined effect of these factors frequently allows an optimally constructed index-based hedging program to be more efficient than a traditional excess-of-loss reinsurance contract. A robust optimization model based on the genetic algorithm is introduced to construct an efficient hedging program consisting of multiple industry loss warranty (ILWs). High solution based on this approach is shown to be a satisfactory approximation to the global optimal solution. In addition, this approach can be easily extended to other types of reinsurance instruments.

The limitations that the author place in this article is most financial optimization procedures are subject to parameter risk, which can adversely affect the robustness of their solutions. The reinsurance optimization approach presented in this paper is not completely immune from this problem. It remains a challenging problem for actuarial researchers and practitioners. The concept and method proposed in this paper can be applied to designing real world reinsurance program.

The main assumptions underlying the authors thinking is concluded in three simplifications. First, it is assumed that only one loss event occurs in a year, although the analyses presented can be extended to include multiple events on an annual aggregate basis without difficulty using existing dynamic financial analysis (DFA) tools. However, not including DFA allows us to simplify the equations and focus on basis risk analysis. For the same reason, we also ignore premium reinstatement provisions frequently observed in actual transactions. Second, we do not consider the potential basis risk arising from the counterparty credit risk (i.e. the risk that the seller of the hedging contract fails to fully perform its contractual obligation). This permits us to focus on the discrepancy caused by the general lack of a one-to-one relationship between the actual loss and the index value. Third, we use binary ILW contracts in

BWRR 3053 : Reinsurance

all examples. Nevertheless, the methodology developed can be applied to other forms of indexbased instrument without substantial modification.

If I accept the authors line of reasoning, the implications are reinsurance efficiency will be enhances. Comparing all the information shown, the author makes a conclusion that the reinsurance efficiency is indeed enhanced by the use of the index-based hedging program. Unlike the simple example in section 3, this more complicated and realistic case does not permit us to decompose the efficiency gain into the pricing, diversification and correlation factors explicitly to analyze them in detail. However, in the property catastrophe reinsurance market, the net effect of these factors frequently favors index-based solutions for hedgers with diversified exposures in the peak catastrophe areas such as Florida, California and Japan.

If I reject or do not accept authors line of reasoning, the implications are we will show that the assumption and hypothesis making by author at the beginning are totally cant be applied. But theres many other ways to enhance reinsurance efficiency. Ive found three other ways related to this issue, that is; reduce unintended risk exposure, decrease recoverable leakage & promote regulatory compliance. First, reduce unintended risk exposure. By ensuring that each risk has the appropriate program associated with it at the point of sale and determining when facultative agreements may be needed, insurers reduce their exposure to excessive risks. To further minimize error prone manual methods, Reinsurance Management has calculation engines which handle complicated calculations such as total insured values, ceded premiums, and commissions. And, since exceptions do occur, Reinsurance Management provides the adaptability to make alterations such as modifying the agreement without changing the policy, or adjusting for the total insured value with a probable maximum loss amount. Second, decrease recoverable leakage. As claims occur, insurers can impose a reliable reinsurance recovery process that minimizes leakage from missed recoveries with automatic linkage of the losses to the appropriate programs. Guide wire Claim Center, with Policy Center and Reinsurance Management, determines the ceded reserve and recoverable amounts, eliminating the need for manual calculations and disparate spreadsheets. Given that adjustments

BWRR 3053 : Reinsurance

might be required to account for factors such as indexation, Claim Center provides the added flexibility to adjust the recoverable amounts as needed. And the last way should be promote regulatory compliance, as with all Insurance Suite applications, Guide wire Reinsurance Management supports audit and compliance needs such as Sarbanes-Oxley and Solvency II compliance with audit trails, tracking and archiving for transactions, business rules to enforce tight controls around certain process steps (e.g., facultative insurance placement), and security to only allow authorized users to make certain changes (e.g., only a reinsurance manager can set up agreements and programs). Additionally, the transaction data levels in Insurance Suite applications are much more granular than typical legacy systems, better supporting compliance reporting needs.

Conclusion

This article examined the effect of investment strategies on an insurers solvency situation when an index-based risk transfer instrument (using an ILW as a representative contract is purchased for hedging an insurers liabilities). Numerical results revealed that it is not only the degree, but also the type of dependence, which is important for the hedging effectiveness of an index-linked catastrophic loss instrument as well as the insurers decision regarding the portion invested in high-risk and low-risk investments.

For higher degrees or types of dependence, the probability for a payment of the indexlinked instrument increases and the fraction in low-risk investments leading to the lowest solvency capital requirement (SCR) values increases as well. Overall, the results imply that the degree and type of dependence do not solely affect the ILW hedge, but also play a considerable role with regard to the investment strategy on the asset side. Hence, a holistic view on the risk management choice for the liabilities such as an ILW contract based on a specific index or traditional reinsurance as well as decisions regarding the asset base are of high relevance for an effective risk management process.

BWRR 3053 : Reinsurance

REFERENCES

Zeng Lixin. (2005), Enhancing reinsurance efficiency using index-based instrument, Journal of Risk Finance, Vol. 6 No.1, pp. 6-16. Zeng Lixin. (2003), Hedging catastrophe risk using index-based reinsurance instruments Journal of Risk Finance, Vol. 3 No.1, pp. 246-268. Gatzert Nadine & Kellner Ralf. (2010), Risk management using index-linked catastrophic loss instruments Journal of Risk Insurance, Vol.1 No.100, pp.141-151.

BWRR 3053 : Reinsurance

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