You are on page 1of 12

DECIDING RETENTION & ARRANGING REINSURANCE CAPACITY

Before entering insurance business, every insurer should decide what is the limit upto which he can insure any risk : This limit consists of two parts : i - How much he would like to keep for his own account (Retention) in each policy/risk. ii - How much he would like to offload out of each risk to the reinsurers. The above two put together would be his gross underwriting capacity. This gross Underwriting Capacity indicates the limit upto which he can issue insurance policies in each class of business. Deciding ones own retention and arranging adequate and suitable

reinsurance capacity is managements important prerogative. It is the foundation on which the financial stability and results of the insurer rests. It gives the insurer required strength to write decent levels of sum insured and business and also ability to complete with other insurers in the market. If the retention is too low, then (1) The insurers capital is not put to effective use. (2) It will result in lower reinsurance capacity, as the same is related to retention and thus act as a constraint in a competitive market due to lack of gross capacity (3) A major portion of the hard earned premium goes out by way of reinsurance leaving a little surplus for investing and earning investment income and (4) Lower retention shows lack of involvement on the part of original insurer and too much reliance on the reinsurers and (5) If the original insurer tries to push everything he has accepted to the reinsurers without keeping a decent retention, then he acts more like a broker than as an insurer.

On the other hand, if the retention is too high, then the insurer runs a risk of a lower profitability and in extreme cases, negative underwriting results and net loss. Therefore the Management of an insurance company should carefully strike a balance between these two extremes and take a decision on retention levels and reinsurance capacity required.

DECIDING RETENTION

Retention represents the share in a risk which is kept for insurers own account. Hence the claims/ underwriting results of the same will be reflected in the net results of the insurer. Therefore proper care should be taken in deciding the level of retention in each class of business. The main factors to be taken into account in deciding a retention per risk may be summarised as under : 1. Class of business 2. Nature of risk 3. Location 4. Construction 5. Occupation 6. Surrounding properties 7. Insureds nature of activities 8. Loss Prevention facilities 9. Accumulation 1. Age of the Property/ Risk insured 1. Legal system 1. Technical expertise 1. Economic & Political situation 1. Climatic Conditions Retention per risk is decided based on normal risk and graded down based on the quality or adverse features of the risk.

In the case of policies with more than one section, sum insured of all sections likely to accumulate are to be added together and taken as one risk. When there is a consequential loss coverage (in Fire & Fire Lop, MB & MLOP on the same risk) besides material damage cover, then both the sum insureds should be added and taken as one risk for deciding retention as well as reinsurance. An insurer by very nature of his business accumulate risks from various sources, in the same locality/town/country etc. Therefore his real exposure is much higher than his retention on individual risks.

Therefore it becomes necessary to take into consideration the effect due to an event when more than one risk is affected or several classes of policies result in claims at the same time. Examples: Natural Catastrophic events like Cyclone, Flood, Earthquake or Riot or Strike or Civil Commotion when several claims can occur. This will result in more than one retained loss. Also such events can affect more than one class of business. For example a Cyclone/Flood Fire policies, Motor policies, Marine policies, Personal Accident Covers etc. Taking into account the above possibility, insurers should decide his retention not only in respect of any one risk but also per event, per portfolio and their operation as a whole. Generally the retention of an Insurer is decided based on the following main factors: 1. Insurers own resources ie Paid Up Capital and Free Reserves (ie. Shareholders Equity). 2. As a Percentage of Gross Premium expected to be generated in each Portfolio.

3. Class of Business - Fire, Marine Cargo, Hull, Aviation, Liability, Motor, Personal Accident, Workmen Compensation, etc. 4. Composition of the Portfolio / Size of the Portfolio. 5. Spread of Risk or Single or Large Risks. 6. Geographical Locations in which the insurer operates - Earthquake, Storm, Cyclone, Flood. 7. Past experience in a Portfolio (Either ones own or others in the same market or other markets experience suitably modified to the local circumstances). 8. Local Regulations - Both relating to Insurance & other Acts governing liability etc. Common Law, specific Acts. 9. Foreign Exchange Regulations. 1. Foreign Exchange contents in a risk (or the currency in which the policy is issued elsewhere).

1. Local Talent-Technical Skill available (New insurer or old established

company). 1. Reinsurance cost and type of reinsurance available. 1. Inflation in the country of operation - Especially in relation to liability claims under motor third party, public and product liability, Third Party Liability etc. also insurance on replacement value. Change in behavioural pattern of natural/weather conditions undergoing these days by nature on its own and said to be accelerated by the hole in the ozone layer, nuclear tests, pollution, acid rain, auto and industrial exhaust, deforestation etc. (Recently El Nino Effect)

The following paragraphs will deal with the above point in detail : 1. Paid-up Capital and Free Reserves (Shareholders Equity) : Generally, level of retention per risk could be fixed as a percentage of the paid-up capital and free reserves of the insurer for a normal risk and graded down for different risks based on adverse factors. What is a reasonable level of retention is a matter of ones own opinion/ judgement. It may vary from person to person. A careful underwriter may fix the retention at a level of 1 pct of his equity while a dare devil may fix it at 5 pct. The main idea is higher the equity base, higher could be retention. Here again, the local insurance provision regarding solvency margin should be kept in mind to see that the ratio between the net assets and net retained premium are maintained. Retention for per Event losses are generally fixed between 2 times and 5 times per Risk Retention. 2. Retention per risk can also be fixed as a percentage of the anticipated annual gross premium in a portfolio. It can vary between 0.5 pct to 5 pct according to ones own opinion. The underlying principle here is how much such losses are expected in a year and how much the insurer is prepared to bear in an accounting year for his own. 3. Spread of Business : If the insurer operates in only one locality, very much concentrated in a small area, then his retention per risk should be suitably adjusted to take care of a number of losses arising in one event.

Every insurer should anticipate that there are likely to be certain number of claims in a year which are of a particular size and frequency. His

results would be adversely affected due to increase in frequency, number and size of losses. If he has a larger portfolio and well spread, the fluctuation in the size and frequency may not affect him that much compared to the one with a small spread in whose case any small variation in the average size of claims, number of claims and frequency of claims can adversely affect his results more than that of a reinsurer with a large portfolio. The above two factors should be taken into account in deciding per risk and also catastrophic per event retentions. 4. Class/ Quality of Risk : Retention will vary for different class of risks. A superior risk will carry a better retention and the inferior a lower one. Hazardous risk, frequent loss-prone risks, risks with inherent hazardous qualities will result in a lower retention. Example: stock of cotton, jute, petrochemical industries, cargo carried on deck or in bulk, old oceangoing vessels etc. A conventional type of fire property damage risk may warrant a higher retention than the one of a high value, sophisticated and total loss capability risk like a satellite. Cargo in a ship and the ship carrying the cargo merit different yardsticks for retention. While retention on cargo insurance could be based on accumulation per bottom, the nature of packing, nature of cargo carried, age of the vessel, flag and ownership of the carrying vessel, origin and destination etc., retention on an ocean going vessel would be on the basis of year built, tonnage, classification, ownership, flag, previous claims experience and the liability provisions and coverage in the policy. In aviation insurance, all sections of coverage (hull, passenger liability, third party liability, cargo liability etc.) are added together as one risk and one retention on a combined single loss limit is followed.

There are certain categories of risks because of their individually smaller values, they are retained in full (except for statutory reinsruacne) and protected by excess of loss for major losses Example: motor, workmen compensation. However, in many markets, Q/S reinsurance also is followed in these cases due to certain considerations.

Geographical Location of Operation : If the insurer is operating in a catastrophic-prone area, i.e. earthquake, windstorm, flood, Tornado, Tsunami and the like, there is a possibility of recurring large number of claims in every event. Hence insurers in these areas should decide about individual risk retention & catastrophic loss retentions carefully so that their profitability is not jeopardized. (One advantage insurers operating in several territories has is the well spread risk and the adverse result in one country may be made good by the positive underwriting result in other territories). Insurers operating in Catastrophe-prone areas should closely follow up aggregate exposures and reinsure surplus exposures suitably. Local Regulations : The Supervisory authorities in every country specify solvency margin (ie. the ratio of shareholders funds to net premium retained and or specify a minimum surplus (net assets) over liabilities at the end of every year. In such cases, the insurers writing more and more gross premium should either arrange to increase the paid-up capital or make sufficient reinsurance to bring down the net premium to a tolerable level of premium to capital ratio. Some countries require obligatory cession to be made to the national reinsurer in all classes. In such a case, generally a Q/S cession is made irrespective of the size of the risk but with a maximum limit of cession in each class.

There are other regulations also besides the insurance regulations of a country to be taken into account by insurers before deciding a retention. Law relating to motor vehicles, workmens compensation Common Law provision, Law of Torts Company and Taxation Law Third party liability provisions and other provisions imposing legal liability on the insureds and the insurers. These things have assumed great importance nowadays in view of the high awards both in conventional insurance field like motor and also in cases of longtail liability claims cropping up after several years. Foreign Exchange Content in a Risk : Sometimes, home of the risks are required to be insured in foreign currency in view of its wholly imported and high foreign currency value. In these cases the claims are also payable in that currency. In such cases it is better to decide retention and reinsure in that currency itself to avoid the adverse effect of exchange fluctuation on claim payments and also to overcome foreign exchange constraints prevalent in the country of operation. Profitability / Past Experience : The retention may be fixed after taking into account the profitability of a portfolio so that the ultimate expected underwriting results are favourable. A correct mix of retention on highly profitable / highly fluctuating business and small profit / steady portfolio should be decided. If it is a conventional type of business, one may be able to know the past behaviour of a portfolio containing similar class of risk either from his own experience on experience of other insurers in the same market. But when it comes to a question of entirely a new type of risk or cover being introduced

in the market, then the insurer should look to the experience of other markets who are already experienced in such business and obtain from them not only their experience and profitability but also know how on details of coverage, premium rates, claim settlement procedures etc. This would help the new insurer to decide about writing the business and decide retention and reinsurance protection for such business. Local Talent Available / Technical Skill Available In the case of a new insurer setting up business for the first time or writing a latest sophisticated risk, he may have to get the technical know how and assistance from an experienced reinsurer. In return to such assistance, the reinsurer may expect some portion of the risk to be reinsured with him. Under such circumstances, even though the original insurer can retain the whole business with him, he has to part with some portion of his business in return to his reinsurer. If competent people to assess the PML reasonably are available, then retention can be decided on a PML basis rather than on sum insured basis. Types of reinsurance protection chosen has an important bearing on fixing retention level. Different forms of reinsurance have different effects on ultimate results. While Quota Share reinsurance does not change the ceding companys loss pattern, but it reduces the cost of claims. A surplus reinsurance pays a portion of every claim irrespective of its size in the same proportion the risk is reinsured. Therefore losses on smaller risks not reinsured on a surplus basis will fall on ceding companys own account and affect the results. A non-proportional form reinsurance will result in all losses upto a limit (either in every risk or collectively arising in an event) to the net account of ceding company. But a number of claims in an event will be taken care of by the catastrophe excess loss covers. Even among non-proportional insurance, a stop loss cover tends to set a limit on loss ratio of a portfolio.

Cost of arranging such covers will have a bearing on loss retention and reinsurance limits to be arranged. To summarise all the above considerations, for deciding the retention level, the underwriter must skillfully match the loss producing tendency of the risks he has accepted with his loss-bearing capacity and then transfer the balance to others by way of reinsurance.

Retention should be decided :

1. Per Risk either on sum insured basis or PML basis 2. Per event either due to accumulation of various covers in one location or due to catastrophic events. 3. Per Portfolio : Stop Loss Covers to limit claims cost or fluctuations for a Volatile Portfolio or arrange Quota Share Treaty in a large spread portfolio like Motor or Householders Insurance. 4. Per the Whole Acceptances: Arrange Umbrella XL to cover overall losses on several classes of business.

You might also like