RISK ANALYSIS OF A NON-LIFE INSURER

AND TRADITIONAL REINSURANCE EFFECTS

ON THE SOLVENCY PROFILE

Nino Savelli
Catholic University of Milan
Largo Gemelli 1, Milan (Italy)
nino.savelli@mi.unicatt.it

Abstract
The main pillars of the insurance management are market share, financial strength and
return for stockholders’ capital. To increase the volume of business is a natural target for the
management of an insurance company, but that may cause a need of new capital for solvency
requirements and consequently a reduction in profitability is likely to occur.
An appropriate risk analysis is then to be carried out on the company, in order to assess
appropriate strategies, among these reinsurance coverage are extremely relevant.
At that regard risk theoretical models may be very useful to depict a risk-return framework and in
this paper some results are emphasized for the insurance risk management analysis in case
different reinsurance strategies are pursued.

1. INTRODUCTION.

As well known the main pillars of the insurance management are growth in
market share, high financial strength (or solvency) and competitive return for
stockholders’ capital. To increase the volume of business is a natural target for the
management, but that may cause a need of new capital for solvency requirements
and consequently a reduction in profitability of equity is likely to occur.
In other words the main goal for the insurance management is how to increase
return for stockholders with the relevant constraint to afford all underwritten
liabilities and to guarantee them with a relevant risk capital invested into the
company in order to fulfil minimum capital requirements approved by the
supervisory authority and, eventually, extra voluntary risk capital to face
supplementary insurance risks.
An appropriate risk management analysis is then to be carried out on the
company, in order to assess probability of ruin, clearly depending on both the
structure of its insurance and investment portfolio and the risk capital available at
 the moment of the evaluation. Once the tolerable ruin probability1 is fixed and
regarded as suitable for the company, upper limit not to be exceeded of ruin
regarded as suitable for the company is fixed, for a short-term time horizon an
estimate of the effective probability of ruin is to be assessed together with the
probability distribution of the return on equity linked to different strategies, once
parameters concerning future increase of number of policies, premium and claim
inflation, safety loading, investment return and initial level of capitalization are
assumed.
In case the ruin probability result is over the above mentioned upper limit, four
classical strategies are usually analysed by the management:
1) Careful selection of risks to be underwritten, to realize through either reducing
maximum limit of liability or coinsurance underwriting with other primary
companies or, finally, to refuse the most relevant and heterogeneous risks. The
great unfavourable effect of all these measures is to limit the gross volume of
premiums and then the market share of the company;
2) increase of safety loadings, but with the constraint of its effect on the
competitiveness of premium rates applied by the insurer in the market;
3) increase risk capital through new contribution of free capital by stockholders,
but with the relevant effect to reduce the return on equity if other variables are
still unchanged;
4) to increase risks to be transferred to reinsurer, with a consequent reduction on
the net volume of business and a likely reduction on the company’s
profitability.
As natural the management will follow the strategy with the best return for the
stockholders with the constraint to have a prefixed ruin probability to be not
exceeded. In practice, once the risk/return trade-off is obtained for each practical
strategy, the efficient frontier can be traced and the management will choose that
strategy having the maximum return and a risk not over the limit regarded
tolerable.

It is worth to emphasize that strategy 1 may be hardly applied, because the

management is usually unwilling to sacrifice premiums, also because the volume
of gross premium is one of the main figures of a company, often regarded to be
representative of the prestige and the strength of the firm on the market. Increase
of safety loadings (strategy 2) is hard as well to be applied notwithstanding
individual expected returns will be higher, reminding that a less “appeal” of
premium rates may involve on the other hand a reduction of the number of
policies and in some cases also a decrease in the volume of premiums.

1 As emphasized in Coutts and Thomas (1997) “the risk tolerance level of an individual company is
clearly a matter for its Board of Director to establish, subject to regulatory minimum standards”, and the
concept of probability of ruin may be used as a measure of this “risk tolerance”. In particular, these
authors defined five measures of ruin, according the failure of management target, the regulatory
intervention level, net worth turning negative, exhaustion of cash and investments and, finally, inability
to dispose of illiquid investments.

2
Furthermore, is not to be neglected that a relevant number of homogeneous
policies assure a low level of relative variability, and then a larger number of
policies involves a reduced variability of the loss ratio and a better stability of the
insurance results, such that insurer risk is rising according a non-convex
behaviour in respect of the premium volume.

As regards reinsurance (strategy 3), the prices requested by reinsurers for

the service to accept the transfer of risk assume to divide between insurer and
reinsurer the expected return of the reinsured risks, in a measure depending,
among other factors, on the nature and the structure of the reinsurance treaty and
the bargaining power of the players. In practice that means that both variability
(risk) and profitability (return) are reducing according the conditions of the treaty.
Sometimes the sacrifice of return may be regarded as excessive by the insurer’s
management, and other strategies may be preferred. It may occur that
notwithstanding the variability of the stochastic risk reserve (in other word the net
worth of the company) is properly reducing, the expected level of the same risk
reserve is reducing as well but in an excessive measure that may involve an
increase (and not a decrease) on the risk of ruin. This result is of clear evidence in
literature but still hard to be properly adopted in practice because of the relevant
difficulties in the estimation process of the risk profile of the company.
Finally, an increase of capital is requested to stockholders (strategy 4) only in
those cases where the needed transfer of risk implies a sacrifice of return larger
than the target return on equity.

In the next section 2 the structure of the classical risk theoretical model here
adopted is described in order to analyse the risk profile of a non-life insurer. In
section 3 the results concerning the behaviour of the main characteristics of the
risk reserve p.d.f. are reported for the time horizon. In Section 4 the results of the
simulations of the stochastic model are illustrated according the Monte Carlo
scenarios for a single-line insurer along five years; in particular, the simulation
results with evidence of the confidence region for risk reserve with the most
relevant percentiles is figured out, together with simulated p.d.f. of the risk
reserve in the first five years.
In Section 5 the results of different reinsurance strategies are exposed and its
effects on both solvency level and return on equity are analysed. Finally, in
Section 6 conclusions and improvements are discussed.

3
 2. A RISK THEORETICAL MODEL FOR THE RISK RESERVE OF A NON-LIFE
COMPANY.

The term “solvency” is commonly used when the soundness of a

company from both points of view of public supervision and company
management is considered. In this way, the somewhat different goals of
supervisory authority and company management are underlined: the former is
periodically monitoring the insurer in order to safeguard claimants, policyholders
and other creditors from its insolvency, whereas the management is responsible
for the long-term existence of the enterprise and to provide competitive capital
return.
Because of these two different meanings some authors refer to term “solvency”
in the context only of government regulation while another term “financial
strength” is adopted more generally in respect of the insurer’s financial capacity
to meet adverse fluctuations and other risks. In this paper the term “solvency”
will be mainly used whilst the term “financial strength” will be considered as an
“umbrella term” to cover the issue of the financial capacity of the insurer,
whatever may be the purpose (e.g. regulation, management or any other). It is
worth to emphasize that from the point of view of the management, solvency and
financial strength on a run-off basis is of very limited interest, and the
continuation of the company as a going-concern would normally be taken as a
goal beyond question.

Many studies have been carried out on the topic of insurance solvency and
extensive researches have been appointed by governments and various institutions
over the last decades. Among these, a particular mention has to be deserved to the
well known studies carried out by Campagne, Buol and De Mori for both life and
non-life insurance solvency, on whose results the minimum solvency margin in
the EEC countries was established in 70’s. The results of those studies are still a
relevant bench-mark also in the most recent European and North American
actuarial studies, analysing the Risk-Based Capital system applied in USA and the
reform of the EU minimum solvency margin formula2. Notwithstanding the
numerous and relevant criticism addressed to their studies it is to be recognised to
them the merit to have fixed, a long time ago, a first general criteria for the
solvency conditions and to have promoted a larger cooperation on the matter
amongst the European countries.
Anyway, notwithstanding in the assurance legislation a universal formula for the
minimum solvency margin is needed, a simply universally applicable formula is
commonly considered to be an impossible achievement. At this regard, many

2 See e.g. Report O.C.S.E. (1961), Actuarial Advisory Committee to the NAIC Property &
Casualty Risk-Based Capital Working Group (1992), Johnsen et al. (1993), Muller Report (1997).

4
 researches3 have pointed out how the simulation of comprehensive model may
represent a suitable tool for the supervisory authority, in order to perform, after
the “solvency test” (that may be regarded as a tool of “first level control”), a
“second level control” taking into account all features of the company usually
complicated which can not be simply considered in the “first level” analysis.

These studies have mainly made use of simulation techniques in order to be able
to draw some conclusions for whatever insurer.. In the present paper is
emphasized how such kind of models may be suitable for the risk management of
a non-life insurance company, with particular reference to underwriting, pricing,
reserving, reinsurance and investment. Here the attention is focused on the
reinsurance strategies only, but a whole analysis considering all the practical
aspect above mentioned are of clear relevance.

A classical risk theoretical model is here used to study the risk reserve of a
non-life insurer, specialised in a single line of industrial business, and further to
carry out a sensitivity analysis for the effect of changes in some of its parameters
regarding claim frequency and claim size variability other than reinsurance
strategies.
~
In classical Risk-Theory literature the stochastic Risk Reserve U t at the end of
the generic year t is given by the relation:

(1)
~ ~
[ ~
]
U t = (1 + j ) ⋅ U t −1 + Bt − X t − Et ⋅ (1 + j )1 / 2

~
with gross premiums volume (Bt), stochastic aggregate claims amount ( X t ) and
general and acquisition expenses (Et) realised in the middle of the year, whereas j
is the annual rate of investment return, assumed to be the (constant) risk-free rate.
Neither dividends nor taxation are considered in the model. Reinsurance will be
further introduced and discussed.
~
The gross premium amount is composed by risk premium Pt=E ( X t ), safety
loadings applied as a quota of the risk premium λ*Pt and the expenses loading as
a coefficient c applied on the gross premium:

Bt = Pt + λ ⋅ Pt + c ⋅ Bt
In case actual expenses are equal to expenses loading amount ( Et = c ⋅ Bt ), the
classical risk reserve equation (1) becomes:

3 For example Pentikainen and Rantala (1982), British Life Insurance Solvency Group (1986),
British General Insurance Solvency Group (1987), Pentikainen et al. (1989), Savelli (1991), Finnish
Life Assurance Solvency Working Group (1992).

5
(1bis)
~ ~
[ ~
]
U t = (1 + j ) ⋅ U t −1 + (1 + λ ) ⋅ Pt − X t ⋅ (1 + j )1/ 2

The gross premium volume increases yearly by the claim inflation (i) and real
growth (g):
Bt = (1 + i) ⋅ (1 + g ) ⋅ Bt −1

assumed rates i and g to be constant in the regarded time horizon.

~
The aggregate claims amount X t is given by a collective approach:

~
kt
~ ~
(2) X t = ∑ Z i ,t
i =1
~
where kt is the random variable of the number of claims occurred in the year t
~
and Z i , t the random amount of the i-th claim of the year t, and neither short-term
fluctuations nor long-term cycles are here considered in the model.
~
The aggregate claims amount X t will be assumed to be defined by a compound
~
Poisson process, where kt is a Poisson random variable with parameter
~
nt = (1 + g ) t ⋅ n0 and Z i ,t are i.i.d. Lognormal random variables with moments
about origo equal to:
~ ~
E ( Z i ,jt ) = (1 + i ) j⋅t ⋅ E ( Z i ,j0 ) = (1 + i ) j⋅t ⋅ a jZ ,0
~ ~
and with kt and Z i ,t reciprocally independent for each year t.
Under the above mentioned assumptions, if no autocorrelation is in force for all
the components of the aggregate claims amount, the main characteristics of the
~
p.d.f. of X t are:

~ ~
E ( X t ) = nt ⋅ a1Z ,t = (1 + g ) t ⋅ (1 + i ) t ⋅ E ( X 0 )
~ ~
(3) σ 2 ( X t ) = nt ⋅ a2 Z ,t = (1 + g ) t ⋅ (1 + i) 2t ⋅ σ 2 ( X 0 )
~ 1 a3Z ,t 1 ~
γ (Xt ) = ⋅ 3/ 2
= ⋅γ (X0)
nt (a2 Z ,t ) (1 + g ) t

having denoted by n0, a1Z,0, a2Z,0 and a3Z,0 the parameters of the initial insured
portfolio (i.e. at time 0).

6
3. THE PROBABILITY DISTRIBUTION OF THE RISK RESERVE RATIO IN THE TIME
HORIZON.

~
The risk reserve ratio u~t = U t / Bt is usually preferred to risk reserve
amount to be analysed, and the equation of the risk reserve ratio is given by:
~
~ ~  Xt 
(4) ut = r ⋅ ut −1 + h ⋅ (1 + λ ) − 
 Pt 

having denoted by r and h respectively the next two non negative synthetic
factors:

1+ j 1− c P
r= h= (1 + j )1 / 2 = ⋅ (1 + j )1 / 2
(1 + i ) ⋅ (1 + g ) 1+ λ B

The annual factor r is depending on the investment return rate j, the claim
inflation i and the growth rate g, on the other hand factor h is mainly depending
on the incidence of the risk premium by gross premium (P/B), constant if
expenses and safety coefficients (c and λ) are maintained constant along the time.
~ turns to:
After some manipulations, the stochastic equation of the ratio u t
~
~  t −1 t
X t t −k 
(4 bis) ut = r ⋅ u0 + h ⋅ (1 + λ ) ⋅ ∑ r − ∑
t k
⋅r 
 k =0 k =1 Pt 

In case of static portfolio (g=0) with both constant premium level and no claim
inflation (i=0) and no investment returns (j=0), denoted in the next as "Static"
Insurer, the stochastic equation becomes equal to:
~ ~
 t
X   P t
X 
u~t = u0 + h ⋅ (1 + λ ) ⋅ t − ∑ t  = u0 + (1 + λ ) ⋅ t − ∑ t 
 k =1 Pt   B k =1 B 

In the general case (no "static") the expected value of the risk reserve ratio for an
annual time horizon (t=1) is given by:

7
 ~
 E( X 1 )  1+ j P
(5) E (u~1 ) = r ⋅ u0 + h ⋅ (1 + λ ) − = ⋅ u0 + λ ⋅ ⋅ (1 + j )1 / 2
 P1  (1 + i)(1 + g ) B

In order to analyse the stochastic behaviour of the ratio u~ , the moments of the
t
~
loss ratio X k / Pk are first needed. They are easily obtained by fundamentals of
Risk Theory for the assumed compound Poisson process described in section 2 in
a more general case:
~
E ( X k / Pk ) = 1
~ 1 + c z2 1 ~
(6) σ 2 ( X k / Pk ) = = ⋅ σ 2 ( X 0 / P0 )
nk (1 + g ) k

~ ~ 1 ~
γ ( X k / Pk ) = γ ( X k ) = ⋅γ (X 0 )
(1 + g ) k

~ ~
where cZ = σ ( Z ) / E ( Z ) is representing the variability coefficient of the random
~
variable single claim amount Z , not depending on the time if the shape of the
distribution is always the same (i.e. the distribution of the claim size for each year
t is only shifted by the claim inflation rate i).
~
It is to be emphasized that variance of the loss ratio X k / Pk is reducing to zero for
positive values of the real growth g as the time horizon is increasing, whereas is
rising to infinite for negative values of g.
The same comment is made as regards skewness of the loss ratio, decreasing to
zero for g>0 and increasing to infinite in case of a reducing portfolio (g<0). In
case of independence of the claim amounts for each year, as here assumed, this
phenomenon is due to the well known law of large numbers.
~
Once the moments of the random loss ratios X k / Pk for k=1, 2,…t are derived,
the moments of the risk reserve ratio can be obtained:

1− c
u0 + ⋅ λ ⋅ (1 + j )1 / 2 ⋅ t if r = 1
1+ λ
(7) E (u~t ) =
1− c 1− rt
r t ⋅ u0 + ⋅ λ ⋅ (1 + j )1/ 2 ⋅ if r ≠ 1
1+ λ 1− r

As well known in the risk theoretical literature if r=1 the expected value of the
~ is linear as time t (linear increase if loading coefficient λ is positive)
ratio u t
whereas if r≠1 a non linear behaviour of the expected value of risk reserve ratio is
realised.

8
Only if r<1 is fulfilled a finite convergence level of the expected ratio is obtained
("equilibrium level"):

1− c λ
(8) u = lim E (u~t ) = ⋅ ⋅ (1 + j )1 / 2
t →∞ 1+ λ 1− r

The equilibrium level u is larger or not than initial ratio u0 depending on the
input parameters (λ, c, i, g and j); in case r≥1 the expected ratio diverges to
positive or negative infinite according to the sign of safety loading coefficient.
It is worth to emphasize E (u ~ ) initially depends significantly on the initial ratio
t
u0 (by the factor rt) but in case r<1 its relevance is shortly decreasing in favour of
the second element where the safety loading coefficient λ is present.

As regards the variance of the risk reserve ratio, it is given by the following
function:

2
1 − c 1/ 2  1 + cZ 2

1 + λ ⋅ (1 + j )  ⋅ n ⋅ (1 + g ) t ⋅ t if s = 1
0

(9) σ 2 (u~t ) =
2
1 − c 1/ 2  1 + cZ2 1 − s 2t
1 + λ ⋅ (1 + j ) ⋅ ⋅
 n ⋅ (1 + g ) t 1 − s 2 if s ≠ 1
0

having denoted by s2 the factor:

(1 + j ) 2
s 2 = (1 + g ) ⋅ r 2 = .
(1 + g )(1 + i ) 2

In the usual case g>0 and s<1 (and consequently r<1), the variance of u ~ is
t
decreasing to zero. On the other hand, for example, if no real growth is expected
(g=0) and s=r>1 (i.e. investment return larger than claim inflation) the variance is
increasing to infinite as the time is larger.

Finally, in the general case where both w and s are not equal to 1, the skewness of
the risk reserve ratio is given by:

1 − w 3t
1 a3 Z , 0
(10) γ (u~t ) = − ⋅ ⋅ 1 − w 3/ 2
n0 ⋅ (1 + g ) t ( a2 Z , 0 ) 3 / 2 1 − s 2 t 
 1− s2 
 

having denoted by w3 the factor:

9
 (1 + j ) 3
w3 = (1 + g ) 2 ⋅ r 3 =
(1 + g )(1 + i ) 3

and where the skewness is equal to:

1 a3 Z ,0 1 1
γ (u~t ) = − ⋅ 3/ 2
⋅ = γ (u~0 ) ⋅
n0 (a2 Z ,0 ) t t

in the particular case where g=0 and s=w=1.

In both cases the skewness of the ratio is decreasing from the negative initial
value to zero, representing a tendency to a symmetric behaviour of the p.d.f. of the
risk reserve ratio.
We remind neither taxation and dividends are included in the model. Clearly, in
case of a dividends barrier the scenarios of the risk reserve would be changed
significantly.

In the following Table 1 the parameters of three theoretical insurers

specialised in a single line of business are listed, with main reference to industrial
risks.
In Table 2 and Figures 1 and 2 the moments of the risk reserve ratio for a horizon
time of 200 years are figured out for the Medium Insurer and the "Static" Medium
Insurer. The most relevant comment at this regard is concerning the larger
standard deviation as well as skewness for the "Static" Insurer, because of a
limited dimension of its portfolio that is not increasing along the time (g=0).

In case the real growth rate is larger, for the same reason standard deviation and
skewness are both even more reduced, as depicted in Figure 3 where moments of
the risk reserve ratio are figured out in case the real growth rate is +10% instead
of +5%.
Moreover, in the Figures 4 and 5, the moments of the risk reserve ratio for the
Small Insurer and the Large Insurer are figured out. As expected variability is
rather relevant for Small Insurer, which associated to a significant negative
skewness put already in evidence that initial capital level (25%) is not a suitable
protection for large claim deviations.

10
 Parameters “STATIC”
SMALL MEDIUM MEDIUM LARGE
INSURER INSURER INSURER INSURER

Initial Risk Reserve u0 0,25 0,25 0,25 0,25

Initial Expected number of claims n0 1.000 10.000 10.000 100.000
Initial Expected claim amount m0 10.000 EUR 10.000 EUR 10.000 EUR 10.000 EUR
Variability coeffic. of Z cZ 10 10 10 10
Safety loading coeffic. λ +5% +5% +5% +5%
Expenses loading coefficient c 25 % 25% 25% 25 %
Real growth rate g + 5% 0 +5% + 5%
Claim inflation rate i 2% 0 2% 2%
Investment return rate j 4% 0 4% 4%

Initial Gross Premiums (mln Eur) B 14 140 140 1.400

TABLE 1: Parameters of three theoretical insurers.

Time “STATIC” MEDIUM INSURER MEDIUM INSURER

MEAN ST. DEV. SKEWNESS MEAN ST. DEV. SKEWNESS

0 0.250 - - 0.250 - -
1 0.286 0.072 -10.15 0.279 0.071 -9.91
2 0.321 0.101 -7.18 0.307 0.098 -6.92
3 0.357 0.124 -5.86 0.335 0.117 -5.58
4 0.393 0.144 -5.08 0.362 0.132 -4.77
5 0.429 0.161 -4.54 0.388 0.143 -4.22

10 0.607 0.227 -3.21 0.507 0.177 -2.81

15 0.786 0.278 -2.62 0.609 0.190 -2.15
20 0.964 0.321 -2.27 0.698 0.192 -1.75
25 1.143 0.359 -2.03 0.774 0.188 -1.48

50 2.036 0.508 -1.44 1.026 0.136 -0.77

100 3.821 0.718 -1.02 1.205 0.051 -0.29
200 7.393 1.015 -0.72 1.255 0.005 -0.06

TABLE 2: Moments of the p.d.f. of the risk reserve ratio u=U/B for the “Static”
Medium Insurer and the Medium Insurer.

11
Figure 1: Mean, standard deviation and skewness of ratio u=U/B for the Medium Insurer. in the
time horizon T=200.

Figure 2: Mean, standard deviation and skewness of ratio u=U/B for the “Static” Medium Insurer.
in the time horizon T=200.

12
Figure 3: Mean, standard deviation and skewness of ratio u=U/B for the Medium Insurer with real
growth +10%.

Other relevant benchmarks for the management are the expected profit compared
with the volume of business and the expected return on equity.
As regard the annual profit, its expected value is:

~ ~
~  U t − U t −1  B

E (Yt / Bt ) = E  = E (u~t ) − t −1 E (u~t −1 )
Bt  Bt
 

that in case r≠1 is given by:

 1 + j ⋅ r t −1 
1 − 
~ j ⋅ r t −1 1 − c  (1 + g )(1 + i) 
E (Yt / Bt ) = ⋅ u0 +  ⋅ λ ⋅ (1 + j )1 / 2  ⋅ 
(1 + g )(1 + i) 1 + λ   1− r 
 
 

On the other hand, as regards the return on equity, for t=1 the expected value is:

~ 1− c 1
E ( R1 ) = j + λ ⋅ (1 + g )(1 + i)(1 + j )1 / 2 ⋅ ⋅
1 + λ u0

where the first element is given by the risk-free investment return and the second
one by the underwriting profit.

13
For example, for the Medium Insurer (n0=10.000) the expected profit is 4.58% of
gross premiums for year t=1 and 4.99% for year t=5, whilst the expected return on
equity at year t=1 is 19.60%.

Figure 4: Mean, standard deviation and skewness of ratio u=U/B for the Small Insurer (n0=1.000).

Figure 5: Mean, standard deviation and skewness of ratio u=U/B for the Large Insurer
(n0=100.000).

14
4. THE RISK LEVEL OF A NON-LIFE COMPANY: SOME RESULTS OF THE
SIMULATION MODEL.

In the present section some results of the simulation model illustrated in

sections 2 and 3 are reported, in order to show the effect on the solvency level of a
non-life insurer of reinsurance strategies and changes in variability of either claim
frequency (through the parameter n0 of the number of claims Poisson process) and
claim size (through the variability coefficient cZ).

In Figure 6a the results of 200 simulations of the risk reserve ratio carried out for
a time horizon of 5 years are depicted for the Medium Insurer (10.000 policies)
with no reinsurance coverage. In this figure no more than four simulation paths of
u~t are at any time under the ruin barrier (u<0) and a range of the ratio between a
minimum of -0.40 and a maximum of +0.60 is approximately reached at the end
of the 5 years (remind that the initial ratio u0 was 0.25).
In Figure 6b other 200 simulations of the ratio are depicted for the Small Insurer
(1.000 numbers of policies). It is of clear evidence that, as expected, because of
the same initial capital level a larger portion of simulations is situated under the
ruin barrier if compared with the Medium Insurer, sometime with values
extremely unfavourable. The range of the simulation at year 5 is between -2 and
+1, with evidence of a large deviation and skewness.
In Figures 6c and 6d similar simulation figures are drawn up for the same insurers
but the standard deviation of the claim size amount is 5 times the expected claim
cost instead of 10 times as before. The values obtained for both insurers denote
respectively much less risky scenarios, with some ruins figured out from
simulations only for the Small Insurer.

15
Figure 6a: results of 200 simulations of the risk reserve ratio u=U/B for the Medium Insurer –
Gross of reinsurance (n0=10.000 and cZ=10).

Figure 6b: results of 200 simulations of the risk reserve ratio u=U/B for the Small Insurer – Gross
of reinsurance (n0=1.000 and cZ=10).

16
Figure 6c: results of 200 simulations of the risk reserve ratio u=U/B for the Medium Insurer –
Gross of reinsurance (n0=10.000 and cZ=5).

Figure 6d: results of 200 simulations of the risk reserve ratio u=U/B for the Small Insurer – Gross
of reinsurance (n0=1.000 and cZ=5).

17
In Figures 7 the results of 5.000 simulations of the risk reserve ratio U/B are
reported for the Medium Insurer. In particular, the percentiles of the probability
distribution of U/B in case of no reinsurance are those reported in Figure 7a
whereas lower and upper quartiles with extreme events are in Figure 7b. The
frequency of ruins is listed in Figure 7c whereas it is shown that ruin probability
should be not so far from 1% level. Further, the expected value of the ratio U/B is
increasing from 25% to roughly 40%.
The simulated distributions of the ratio for year 1, 2 and 5 are reported in Figures
7d, 7e and 7f. As noted by the distance between percentiles, a long left-tail is
observed at this regard.
In Figure 7g, percentiles of the loss ratio X/P are depicted, with a positive
skewness (right long-tail) and a 50% probability to get loss ratios between 95%
and 105%. In this figure each percentile line is rather stable because the structure
of the insurer’s portfolio is not modified.
Furthermore, in Figure 7h percentiles of the return on equity distribution are
figured, with an expected value around 20% and relevant losses for the most
unfavourable cases. The ROE confidence region has a reduced width as the time
horizon is extended because the associated probability distribution is always more
concentrated close to the expected value. At time t=5 the simulations obtained
95% of paths have no negative return values.

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Figure 7a: Mean and Percentiles of the risk reserve ratio gross of reinsurance - results of 5.000
simulations. Medium Insurer (u0=25%, n0=10.000 and cZ=10).
Percentiles figured out: 1%, 5%, 25%, 50%, 75%, 95% and 99%.

Figure 7b: Lower and Upper Quartiles of the risk reserve ratio (gross of reinsurance) - results of
5.000 simulations. Medium Insurer (n0=10.000 and cZ=10).

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Figure 7c: Probability of ruin (gross of reinsurance) - results of 5.000 simulations. Medium
Insurer (n0=10.000 and cZ=10).

Figure 7d: distribution of the risk reserve ratio at year t=1 gross of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).

20
Figure 7e: distribution of the risk reserve ratio at year t=2 gross of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).

Figure 7f: distribution of the risk reserve ratio at year t=5 gross of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).

21
Figure 7g: mean percentiles of the loss ratio X/P gross of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).

Figure 7h: mean and percentiles of the return on equity gross of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).

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5. THE EFFECTS OF SOME REINSURANCE STRATEGIES.

In order to show some relevant effects of the reinsurance management, two

traditional reinsurance strategies are here taken into account:
- to sign a Quota Share treaty with retention quota α=80% and a 25% fixed
commission applied to ceded premium, not depending from the loss ratio of
the year;
- to choose an Excess-of-Loss treaty with an individual retention limit
M=E(Z)+8*std(Z) and a 20% safety loading applied by reinsurer on risk
premiums.

As expected, both strategies (see simulated percentiles of Figures 8a and 8b)

reduce the risk of ruin, but they bring it into effect in a different way. In case of
the Quota Share, the probability of ruin is included between 0.4% and 0.9%,
whereas the XL approach reduces it to zero in the first year and to 0.02% for the
others. For XL as well, the shape of simulated distribution is less skewed because
only large fluctuations in the number of claims may jeopardize the insurer
stability.
On the other hand, as regards the profitability of the invested risk capital, the XL
strategy is reducing the expected return on equity between 12% and 15%, against
the 20% level in case no reinsurance coverage is applied; furthermore, at year t=5,
almost 99% of simulated returns on equity are not negative.
As regards the Quota Share strategy the effect on return is less sensitive, such that
expected returns are included between 18% and 20%. Besides, at time t=5
approximately 95% of the simulation paths arrive at a positive level.
It is to be stressed that at year t=5 the ratio U/B is increasing to 35% for quota
share and to 32% for the excess of loss.

Moreover, in order to compare the above mentioned simulation results with other
kind of reinsurance coverage, in Figure 13a and 13b are summarised 5.000
simulation results in case quota share is preferred, but with a limited retention
quota (60%) and unfavourable commissions (20% instead of 25%). For this last
condition the solvency level of the insurer is not improved and furthermore the
expected return is no more than 5%: it is clear that is not an efficient strategy,
compared with the other quota share strategy with retention 80% (probability of
ruin less than 1% and expected ROE between 18% and 20%).

Finally, in Figures 14a and 14b the results of 5.000 simulations are figured out in
case an excess of loss with a retention limit of only M=E(Z)+5*std(Z) is applied,
with a reinsurance safety loading equal to 12,5% (instead of 20%). The risk
profile for insurer is then slightly improved compared with the other XL strategy
and it has no relevant effect on the return, still close to 15% and with more than
99% of probability to perform positive ROE at the end of the period.

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Figure 8a: Mean and Percentiles of the risk reserve ratio net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10) with retention quota = 80% and
fixed commissions 25% of ceded premiums.
Percentiles figured out: 1%, 5%, 25%, 50%, 75%, 95% and 99%.

Figure 8b: Mean and Percentiles of the risk reserve ratio net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).
Reinsurance: Excess of Loss with retention limit M=E(Z)+8*std(Z) , insurer retention
quota of excess 5%, reinsurer safety loading coefficient 20%.
Percentiles figured out: 1%, 5%, 25%, 50%, 75%, 95% and 99%.

24
Figure 9a: Frequency of ruins net of reinsurance - results of 5.000 simulations. Medium Insurer
with n0=10.000 and cZ=10, retention quota = 80% and fixed commissions 25% on
ceded premiums.

Figure 9b: Frequency of ruins net of reinsurance - results of 5.000 simulations. Medium Insurer
(n0=10.000 and cZ=10).
Reinsurance: Excess of Loss with retention limit M = E(Z) + 8*std(Z) , insurer
retention quota of excess 5%, reinsurer safety loading coefficient 20%.

25
Figure 10a: distribution of the risk reserve ratio at year t=1 net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10) with retention quota = 80% and
fixed commissions 25% of ceded premiums.

Figure 10b: distribution of the risk reserve ratio at year t=1 net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).
Reinsurance: Excess of Loss with retention limit M = E(Z) + 8*std(Z) , insurer
retention quota of excess 5%, reinsurer safety loading coefficient 20%.

26
Figure 11a: distribution of the risk reserve ratio at year t=5 net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10) with retention quota = 80% and
fixed commissions 25% of ceded premiums.

Figure 11b: distribution of the risk reserve ratio at year t=5 net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).
Reinsurance: Excess of Loss with retention limit M = E(Z) + 8*std(Z) , insurer
retention quota of excess 5%, reinsurer safety loading coefficient 20%.

27
Figure 12a: Mean and Percentiles of the return on equity net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10) with retention quota = 80% and
fixed commissions 25% of ceded premiums.
Percentiles figured out: 1%, 5%, 25%, 50%, 75%, 95% and 99%.

Figure 12b: Mean and Percentiles of the return on equity net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).
Reinsurance: Excess of Loss with retention limit M = E(Z) + 8*std(Z), insurer
retention quota of excess 5%, reinsurer safety loading coefficient 20%. Reinsurer risk-
premium rate 95%*9,19%.

28
Figure 13a: Mean and Percentiles of the risk reserve ratio net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10) with retention quota = 60% and
fixed commissions 20% of ceded premiums.
Percentiles figured out: 1%, 5%, 25%, 50%, 75%, 95% and 99%.

Figure 13b: Mean and Percentiles of the return on equity net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10) with retention quota = 60% and
fixed commissions 20% of ceded premiums.
Percentiles figured out: 1%, 5%, 25%, 50%, 75%, 95% and 99%.

29
Figure 14a: Mean and Percentiles of the risk reserve ratio net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).
Reinsurance: Excess of Loss with retention limit M=E(Z)+5*std(Z) , insurer retention
quota of excess 5%, reinsurer safety loading coefficient 12.5%. Reinsurer risk-
premium rate 95%*12,94%.

Figure 14b: Mean and Percentiles of the return on equity net of reinsurance - results of 5.000
simulations. Medium Insurer (n0=10.000 and cZ=10).
Reinsurance: Excess of Loss with retention limit M=E(Z)+5*std(Z) , insurer retention
quota of excess 5%, reinsurer safety loading coefficient 12.5%. Reinsurer risk-
premium rate 95%*12,94%.

30
6. CONCLUSIONS.

A powerful sensitivity analysis may be carried on to show the most crucial

aspects for risk management decisions, and when reinsurance premium rates are
regarded excessive new capital from stockholders may be preferred.
As emphasized in this paper a reliable comparison of the results given by
different reinsurance coverages provided by the real market makes the insurer
able to identify the most appropriate strategic planning. Moreover, Monte Carlo
simulation technique could provide a useful insight of the whole risk process,
with special advantage in cases of small portfolios and large skewness of the
distribution, where the use of approximation formula is not reliable.
The risk theoretical model described is clearly a simplified version of the
complex model to be taken into account, but a suitable analysis about primary
insurance aspect has been here preferred. At this regard much attention should
be paid to short-term fluctuations in the number of claims and the investigation
on both investment and insurance long-term cycles is highly recommended.
Furthermore, a time horizon for the model is essential for optimal allocation of
risk and alternative risk transfer should be anyway analysed.
The reality is clearly much more complicated, but this kind of philosophy is of
real interest and promising improvements in the rational insurance risk
management.

31
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