RRR IN INSURANCE

RRR in Insurance - Risk, Retention & Reinsurance

In continuation of my earlier article dealing with Risk, this article deals with Retention.

RETENTION

Meaning of Retention

The meaning of retention depends on the type of treaty. A quota share retention is the part of the business which is not reinsured, and is usually expressed as a percentage. A surplus retention is part of the sum insured or MPL (Maximum Possible Loss). A surplus retention is always stated as a monetary amount and is referred to as a line. The surplus treaty capacity is expressed in multiples of number of lines. In the case of an excess of loss the retention is the maximum amount of a loss, which a primary insurer must pay – the reinsurer pays for anything over and above this. The entire set of retentions in all the reinsurance treaties of a primary insurer is usually called the reinsurance programme.

Setting Optimal Retentions

In practice retention limits for proportional and non-proportional reinsurances tend to be fixed on the basis of the market practices that have stood the test of time. There is a relationship between the size of the company’s business and the amount of loss it can safely absorb either on any one risk or in respect of the aggregate losses arising from one event or in any one year. With the increase in the premium income the relative variance of the larger claims experience will be less and it will naturally lead to higher retention of the direct insurer.

Every risk portfolio incurs losses of different magnitude at irregular intervals. The sum of all the losses in a year is described as the annual loss burden. The loss burden for any future year is estimated on the basis of the predicted claims frequency and predicted average individual claim amount. But in reality the forecasts invariably deviates from the actual. The actual problem lies in the potential variation in aggregate claims cost from the amount expected in any period due to random fluctuations in either the number or average cost of claims. When there is wide deviation of the actual loss burden from the predicted loss burden, the risk portfolio is considered susceptible to fluctuations. The main concern of the primary insurer is to effectively reduce the level of fluctuations to an acceptable level with the help of reinsurance. Basically every reinsurance treaty covers part of the primary insurer’s business, thus reducing the variance of that part. In this context, “effectively” means at the price one is prepared to pay for reinsurance to minimize fluctuations as much as possible, not as much through price negotiation, as through the skillfull use of retention. The primary goal of reinsurance is to reduce the fluctuations of the loss burden. Besides the adverse claims fluctuation, which a company can tolerate during any period is determined by its initial reserves plus its premium income.

 Professor R.E.Beard has illustrated this reinsurance process and the fixing of retentions with the simple example of a life assurer that writes 1000 one-year term assurances each with a $100 sum assured and all for lives aged 50 years with an expected mortality rate of 0.00700. If investment income and expenses are ignored the company will need to charge a risk premium of $0.70 to obtain a total premium income of $700 which is sufficient to pay the seven expected claims. If less than seven lives die during the year, the company will earn a mortality profit whereas if more than seven lives die the company would be insolvent unless it had sufficient reserves to cover the extra claim. Thus the ability of the company to withstand fluctuations in its mortality experience is a function of the size of its reserves, which must be provided either by policyholders in the form of premium loading or by the shareholders as share capital. In practice companies are not in a position to increase the size of the premium loading they can charge due to competition. If a company tries to reduce its probability of ruin by increasing its premium, then it is likely to loose business to its competitors.

In the case of property insurances fixing retention based on the total sum insured may lead to over-reinsuring in the sense, the probability of a total loss may be zero. Therefore retentions for large insurances are fixed according to underwriter’s judgment regarding potential sizes of the loss rather than the sum insured. In the case of property insurance the sum insured is the upper limit of liability for an insurer. But in the case of liability insurance, even if a limit is placed on the insurer’s liability in the form of indemnity, the size of the portfolio has far less meaning as a guide to a company’s loss exposure. 

Keeping a decent amount of retention helps the company to garner good capacity to underwrite larger risks. Many companies adopt graded down retention for different risks. Sometimes an insurer may be forced to underwrite a risk which is not falling within their appetite, but still underwritten on an accommodation basis. In such cases they may grade down the retention to a lower level and accordingly they could use only the reduced surplus capacity. For example, if a company's retention is Rs.10 crores with 20 lines, the capacity of the treaty is Rs.200 Crores. In respect of a risk if the company decides to retain only Rs.5 Crore, then the surplus capacity also will get reduced to Rs.100 Crores. However, when the insurers use graded down retention, the table of 'graded down risk categories' have to be agreed with the reinsurer in advance.

The retention limits are based on the underwriting criteria. It varies with every class of business. No company can pass on 100% of the risk it has underwritten to a reinsurer, which will amount to 'fronting'. As the business grows, the retention also grow. The cost of reinsurance depends on the retention as well. Higher the retention lower the cost.