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Chapter 2 Different types of reinsurance 2/13

C2 Finite risk solutions
The term finite risk is used to differentiate risk-based products from the investment-only type products.
Finite risk
Finite risk reinsurance combines risk transfer and risk financing while operating over periods of time reinsurance combines
longer than one year. A sum of money is paid that will cover most expected losses over, say, a period of risk transfer and risk Chapter
financing
ten years. Buyers will usually gain a rebate if the losses do not reach the expected level of required
funding. The risk is then spread over the good and, possibly, bad years, rather than taking an annual 2
assessment of the loss profile which is often too short-term. The transfer of risk usually covers only one
risk type, and all premiums and claims are usually monitored by the insurer or the party bearing the
transferred risk on an ‘experience account’. The advance payment may be significant and represent a
loss pre-funding portfolio, rather than a true premium payment.
The value is gained from a consistency of cost over the contracted parameters and removes risk from the
balance sheet because the exposure is secured. There may be substantial profit rebates and investment
income is earned on the fund and shared between the parties according to prior agreement. Since the
buyer of a finite risk programme is financing a large part of its own risk, it will want to participate in the
programme’s favourable development.

Predictability of loss experience is achieved over a period of time because losses are smoothed over the
duration of the contract. Risks that could otherwise be uninsurable may be included so risks that the
conventional insurer would otherwise decline can be packaged into one contract.
The advantages include economies of scale together with the opportunity to charge a premium for
The advantages
catastrophe loss spread over a period longer than one year. This arrangement appeals to parties who include economies
face high premiums in conventional insurance markets and want to reduce costs by removing the annual of scale
renewal cycle.
To summarise, these finite risk reinsurance contracts have certain characteristics in common as follows:

• they provide a risk financing mechanism for near certain events;
• the pricing takes the time value of money into account as investment income is allowed for in the
pricing calculation;
• the reinsurer’s maximum liability is limited, being closely related to the premium paid; Reference copy for CII Face to Face Training
• the reinsured usually participates in losses and benefits from better than expected loss experience;
• the contracts are usually multiple year; and
• transaction costs are lower than for traditional contracts.
Reinforce
Make sure you know the difference between a catastrophe bond and a catastrophe future.

C2A Advantages of capital market solutions

• Investors are attracted to the diversification benefits and above average yields of insurance-linked
securities.
• Returns of insurance-linked securities are independent of factors affecting traditional financial
markets and their returns typically exceed similarly rated investment assets.
• The weak correlation of these financial instruments with traditional financial markets enables
investors to achieve greater portfolio diversification and higher yields.
• Capital markets have the potential to be price competitive relative to reinsurers in the longer term.

C2B Disadvantages of capital market solutions
• Investments in insurance-linked securities expose investors to risks that are not typically associated
with traditional investment classes.
• Traditional reinsurers tend to take a long-term view. In contrast, capital markets often require a more
immediate return and could withdraw their support at critical times.
• Transactional costs can be high, particularly for smaller trades.