Timing risk and finite reinsurance

One of the murkier parts of the reinsurance world is finite reinsurance. Even finding a good definition is difficult. But here, rather than surveying the whole topic, I want to discuss one particular application, namely hedging timing risk.

The typical situation this arises is where there either may or will certainly be claims on an insurance policy over an extended period, but their timing is uncertain and their maximum size is bounded. Suppose for instance we know that over the next ten years we will very likely have to pay out claims of £10M, but we do not know when these claims will be presented. This risk can cause significant earnings volatility: in years with no claims, our earnings look great, but if £8M or £9M of the £10M arrive all in one year, things will look less good for that year.

This earnings volatility can be hedged (for a price). Typically we transfer some assets, say £8M worth, to a reinsurer: these assets are invested. Simultaneously they write us a reinsurance policy capped at £10M on the risk, and receive a small premium to be thought of as an asset management fee. If claims arrive very early in the policy the reinsurer can lose money as the £8M will probably not have grown to £10M in the first couple of years. If the claims happen late, they make money as the assets will have grown to be worth more than £10M over eight or nine years if prudently managed. The reinsurer therefore takes some timing risk and some investment performance risk, but not much. It is a very large very well capitalised entity so it can handle the earning volatility much better than the ceding insurer.

There is even the possibility of passing some upside of good investment management and/or good claims management back to the ceding insurer via an experience account: for instance if the £8M has grown to £12M before claims of £9M leaving £3M at the end of ten years, then this could be split 50/50 between the reinsurer and the ceding insurer. With careful structuring this can mean that it is possible to transfer very little risk with a finite reinsurance policy yet achieve the desired aim of smoothing earnings, i.e. an accounting arbitrage.

This kind of technology emphasises that insurance can act as a form of capital. Without the policy, the ceding insurer would have to support the earnings volatility with equity. With it in place, capital requirements are reduced. The reinsurer is better placed to take the timing risk than the primary insurer and hence a deal is possible which makes sense for both parties.