The financial services marketplace: structures,
2.9 General insurance
In simple terms, whereas life insurance provides benefits in the event of human death or illness during a prolonged contract period (possibly for the whole of an individual’s life), general insurance provides for the payment of benefits in respect of risks to tangible and intangible non-human assets. The typical range of general insurance risks is as follows:
● motor vehicles
● property
● personal possessions
● liability
● financial loss
● creditor
● marine, aviation and transport
● accident and health.
General insurance is normally based upon annual contracts, whereby the pre- mium is paid in respect of a 12-month period of cover. Thus the cover expires at the end of 12 months, and in order to maintain cover the customer must then either renew the policy for the next 12-month period or seek cover from another supplier.
General insurance tends to be more price-led than life insurance, and is a fiercely competitive marketplace. In the UK it remains a highly diverse sector; there were
some 613 companies authorized to transact general insurance in 2004. In Australia, with a population less than one-third of that of the UK, there were some 112 general insurers as at June 2005, according to the Australian regulator APRA.
Motor vehicle insurance has become fiercely competitive, and the introduction of the telephone and Internet as means of transacting business has served to heighten the intensity of competition in this price-driven market.
Box 2.2 outlines one form of insurance that is less well known but is of consider- able importance – namely reinsurance. This is relevant to all forms of insurance, both life and general.
Box 2.2 Reinsurance – what is it and how does it work?
Introduction
In simple terms, reinsurance is insurance for the insurance providers. The obvious question is, why should an insurer, whose business is to underwrite risk, wish to insure some of the risks that it has accepted?
When it is pricing the risks that it insures, the insurer will rely on historic claims data and trends in the claims data to derive its best estimate of the future claims experience. It will rely on its underwriters to ensure that the premiums charged for insurance are in line with the risks presented. However, even if the pricing and underwriting processes are properly carried out, this will not guar- antee that a portfolio of insurance business will be profitable.
By its very nature, insurance business is unpredictable, and random varia- tions from the pricing basis in either the number of claims or the average claim size (or both) can have a very significant effect on the profitability of the portfo- lio. Reinsurance can protect an insurer’s portfolio from these sources of variabil- ity, and hence provide a more stable claims experience.
How does reinsurance work?
A portfolio of insurance business is made up of many policies covering broadly similar risks (in terms of the events covered). If the insured event occurs, the insurer is liable to make a payment to the policyholder and reinsur- ance does not affect this liability. Reinsurance works by reimbursing part of each claim to the insurer under a reinsurance arrangement (often referred to as a reinsurance treaty). The agreement will specify:
● the group of policies to which the treaty applies
● the rights and obligations of each party under the treaty
● what proportion of each claim is payable by the reinsurer
● how the reinsurance premium is calculated.
Where a treaty is in place and a policy falls within the group of policies covered by the treaty, then the insurer must reinsure the business and the reinsurer is obliged to accept the business.
Box 2.2 Reinsurance – what is it and how does it work?—cont’d
What types of treaty are there?
Treaties are either proportional or non-proportional.
Under a proportional treaty, any claim is shared in the same proportions between insurer and reinsurer. This is often referred to as quota share reinsurance.
This will damp down (but not eliminate) the effect of the claims frequency being higher than expected, or the average claim amount being higher than expected.
There are three situations where quota share reinsurance is common:
1. Where the insurer is expanding into a new business line and has little or no practical experience of the line. The reinsurer often has knowledge, pricing data and expertise, and can provide technical help to the insurer as well as helping to limit the insurer’s risk exposure.
2. Where the insurer wishes to write greater volumes of business to reduce claims volatility and to increase the portfolio of business across which it spreads its fixed costs. However, it may have capital constraints (in the form of solvency requirements imposed by the regulator). By reinsuring part of the risk, the insurer is able to reduce the capital it needs to hold to cover the same volumes of business and hence can write higher volumes of business.
3. Where the reinsurer has a lower cost of capital. This may be because it has surplus capital and is willing to accept a lower return than the insurer, or because it has a regulatory advantage in terms of the amount of capital it needs to hold to cover the same amount of risk as an insurer. The latter often hap- pens, as reinsurers have much larger risk pools than the insurers and hence lower claims volatility. Regulators therefore require reinsurers to hold lower margins against an adverse claims experience than their insurer counterparts.
If the insurer’s claims frequency is as predicted, the claims experience can still be poor if the average claim amount is higher than expected. This can arise either because all claims are higher than expected by roughly the same amount, or because there is a disproportionate number of large claims. Non-proportional reinsurance provides effective protection against the effect of a disproportion- ate number of large claims.
Under a non-proportional treaty, the reinsurer reimburses the amount of any claim in excess of a limit defined in the treaty. This limit is known as the insurer’s retention, and is usually the same for all policies covered under the treaty. As such the proportion of the total claim that is covered by the reinsurer will vary from claim to claim, and hence the name ‘non-proportional’. Non-pro- portional treaties are often referred to as surplus or excess-of-loss treaties.
There is often a limit on the amount that the reinsurer will reimburse. Once this limit is reached the insurer may meet the rest of the claim, or there may be additional layers of reinsurance with other reinsurers.
Continued