Reinsurance and other forms of risk transfer: financial reinsurance and alternative risk transfer (ART): spread loss contracts
Under a spread loss contract an insurer might, for example, pay a reinsurer premiums of £10 million per annum for five years to provide cover of up to £25 million in any one year, and £50 million in aggregate, above the top layer of its conventional reinsurance programme. The contract may provide that these premiums less claims paid under the contract are to form a fund which will be accumulated at interest of, say, 7 per cent over the five year period. The insurer will be entitled to a profit commission of 80 per cent of any positive value of the fund at the end of the five year period. Profit commission is here used in the special industry sense of a payment back to the cedant. If there are no claims the annual payments of £10 million will accumulate, at annual rests, to a fund of about £61.5 million, and if 80% of this is returned to the insurer as profit commission the reinsurer will end up with a profit of about £12.3 million.
From the reinsurer’s point of view the worst case is that it will have to pay claims up to the contract limit in each of the first two years. If the claims had to be paid at the beginning of each year, the contract will involve a loss to the reinsurer (after taking account of interest at 7 per cent) of about £6.3 million.
It will be seen that, whatever happens, the maximum amount of profit or loss that the reinsurer can experience lies in a range between +25 per cent and -12½ per cent of the premiums. In conventional reinsurance the theoretical range (and the practical range in the case of non-proportional reinsurance) might be from +100 per cent to a negative figure of several hundred or thousand per cent. Looking at this another way the net present value of the premiums payable is £43.9 million, while the net present value of the payments that will flow to the cedant company lies in a range between £35.1 million and £48.4 million. In practice the range of possible outcomes might be even narrower than this, as it is common in contracts of this type to find a provision requiring the payment of additional premiums if the value of the accumulated fund becomes negative.
This is an example of a prospective reinsurance arrangement. The financial reinsurer carries the time and distance risk, namely, that a loss will arise or be settled earlier than expected. The risk element, as with conventional reinsurance, is that the reinsurer may be required to pay out before the end of the term. Like conventional reinsurance it provides cover relating to events that have not occurred when the contract is entered into (and may never occur).