Chapter 25 Alternative Risk Transfer

Chapter 25 Alternative Risk Transfer I. Multiple Choice 1. All of the following are examples of loss sensitive policies except: a. b. c. d. retrospectively rated policies experience rated policies investment credit program excess policies Answer: d Type: K 2. Experience-rated policies are beneficial to the insurer because they help to reduce: a. b. c. d. adverse selection moral hazard fraud insurer insolvency Answer: b Type: K 3. An insurance company that is set up as a subsidiary of a parent for the sole purpose of providing insurance to the parent corporation is: a. b. c. d. a subsidiary insurance company an offshore insurance company a pure captive insurance company operating illegally Answer: c Type: K 4. Captive insurance companies in the U.S. which only insure a single parent corporation: a. will not necessarily result in reduced taxes for the parent since the tax laws tend to treat them as self-insurance funds. will always reduce the risk of the parent corporation. will reduce loss costs to the parents as compared to buying insurance from a different insurer. all of the above. b. c. d. 205 Answer: a Type: K 5. Which one of the following is not a characteristic of retrospectively rated policies? a. b. c. retro premium is a function of the actual losses sustained during the policy period retro premium is subject to a minimum and a maximum retrospectively rated policies transfer more risk to the insurer than traditional insurance policies while the insurer fully settles all claims, it may subsequently require additional premium from the insured d. Answer: c Type: K 6. Alternative risk transfer (ART) is difficult to define. ART transactions though, do tend to have certain characteristics. Which one of the following is not a common characteristic of ART? a. b. c. d. low level of retention involvement with capital market institutions and securities contracts that span multiple years contracts that cover multiple sources of risk Answer: a Type: K 7. An oil refinery has recently suffered an explosion. The refinery has estimated its cost from this explosion to be approximately $50 million dollars. Uncertainty still exists though regarding the actual amount and timing of the loss payments. An insurer has agreed, for a price, to assume all responsibility for the payment of this loss. This is an example of a a. b. c. d. retrospectively rated policy loss portfolio transfer premium financing arrangement incurred loss retro Answer: b Type: A 8. Which one of the following in not a characteristic of finite risk insurance? a. b. transfers relatively little risk from insured to insurer provides protection against the timing of insured’s loss payments 206 c. d. the typical contract length is no more than two years all of the above are characteristics of finite risk insurance Answer: c Type: K 9. Regarding captives, ‘unrelated business’ refers to a. b. c. d. insurance lines outside the captive’s scope independent loss exposures noninsurance activities selling insurance coverage to entities not related to the parent corporation Answer: d Type: K 10. When a captive insurer writes coverage on a sister corporation the transaction is a. b. c. d. considered ‘risk-reducing’ not treated as insurance for tax purposes counted as related business all of the above Answer: a Type: K 11. Multiline insurance policies a. b. c. d. provide coverage for losses generated from different risk exposures provide coverage against an aggregate measure of losses can potentially allow the insured to save on transactions cost all of the above Answer: d Type: K 12. A multitrigger insurance policy a. b. c. d. provides coverage for losses generated from different risk exposures is triggered by multiple conditions or contingencies is triggered only when two losses of the same type occur requires two insurers provide payment of large losses Answer: b Type: K 207 13. A.J. Manufacturing has an agreement with the Bank of St. Croix whereby A.J. can borrow up $3.5 million dollars should the manufacturing plant suffer a severe fire or windstorm. The interest rate on the loan is guaranteed to not be greater than 7 percent. This is an example of a. b. c. d. contingent debt contingent equity letter of credit line of credit Answer: a Type: A 14. Structured debt instruments a. b. c. d. are the same as contingency debt link interest payments to some other variable, such as commodity prices have made catastrophe bonds obsolete all of the above Answer: b Type: K 15. An important economic factor that has contributed to the trend of increased use of alternative risk transfer is a. b. c. d. interest rate volatility of the 1990s increased volatility of the underwriting cycle slow growth of GDP in the U.S. stock market drop of Oct. 1987 Answer: b Type: K II. Fill-Ins 1. When the insurer pays losses and then bills the insured for the deductible amount, the insurer will usually require that the insured provide a letter of credit . from a bank that guarantees that the insured will pay losses as promised. 2. When premiums depend on the losses that occur (or are paid) during the policy period, the policy is said to be loss sensitive (or experience rated) . 3. A captive insurer with multiple parent companies is know as a captive. 208 group 4. The insurance transactions between a pure captive and its parent corporation are not treated as insurance for tax purposes because these transaction are not regarded as risk-reducing activities. 5. In an effort to provide funding should an earthquake loss occur, MyCorporation has issued a debt instrument whereby, in the event of an earthquake, principle and interest payments do not have to be made. The debt instrument is called a catastrophe bond . III. Problems and Short Answer Questions 1. Discuss captive insurers and the issues of risk-reduction and pooling. Answer: A major incentive for forming a captive insurer is to enable a parent corporation to count insurance premiums as tax deductible and yet effectively retain the risk. Since retention does not allow for the pooling of a firm’s risk exposures, there is no perceived risk-reduction in the case of a pure captive. The parent of a pure captive can thereby not count payments to its captive as deductible for tax purposes. Type: A 2. Explain why a firm might want to finance its losses through a captive insurance company. Answer: The main reasons for using a captive are:  to reduce tax payments (insurance premiums are tax deductible and many captives are located offshore where there are more favorable tax laws)  to be able to purchase reinsurance directly from reinsurers  to reduce risk through diversification (if the captive also sells insurance to other firms) Type: K 3. M. Knot has a finite risk insurance plan with R2 insurance company. The three-year plan has the following terms;  M. Knot will pay a $1,500,000 premium at the beginning of each year  5% interest will be credited to each year’s beginning balance  insurer will receive a fee of 12% of each premium  an aggregate limit of $10 million 209 Complete the following table. Previous Year Balance Premium Insurer’s Fee Beginning Balance Claim Payments Interest End of Year Balance Year 1 Year 2 Year 3 $1,500,000 $1,500,000 $1,500,000 -$850,000 -$2,400,000 -$1,200,000 Year 1 $0 $1,500,000 -180,000 1,320,000 Year 2 916,000 $1,500,000 -180,000 2,236,000 Year 3 -52,200 $1,500,000 -180,000 1,267,800 -$850,000 66,000 916,000 -$2,400,000 111,800 -52,200 -$1,200,000 63,390 131,190 Answer: Previous Year Balance Premium Insurer’s Fee Beginning Balance Claim Payments Interest End of Year Balance Type: A 4. What are two reasons a firm may want use an incurred loss retro policy instead of an excess policy with a high attachment point? Answer: a. The firm can gain a tax advantage with the incurred loss retro. Since additional retro premium is paid when the losses are incurred, the firm is able to get an earlier tax deduction. If the losses were retained via a high attachment point the tax deduction could be taken until the losses were paid. b. The incurred loss retro policy allows the firm to effectively retain the risk, yet contract with the insurer to process claims. Type: K 5. What risks are transfer to the insurer with a loss portfolio transfer? Answer: Since the actual loss event(s) has already occurred, the risk transferred with a loss portfolio transfer is the uncertainty regarding the ultimate amount of the loss(es) and the timing of when the loss payment(s) will ultimately be made. Type: K 210