Reinsurance Analytics Philipp Arbenz, Peter Antal

Reinsurance Analytics
Philipp Arbenz, Peter Antal
December 25, 2021
Version December 2021
Excess of Loss
Quota Share
Cover +
Deductible
Re
in
su
Reinsurer 1
Reinsurer 2
Reinsurer 3
Reinsurer 4
re
r 1
Retention
Quota Share
75% Deductible
Re
in
su
2
rer
re
u
r
ins
3
Re Retention
Reinsurance Analytics, HS 2021 P. Arbenz
Contents
1 Preliminaries 3
1.1 Purpose and Scope of this Lecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Organizational aspects (Autumn Semester 2020) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3 Primary insurance vs Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2 Reinsurance Contracts 6
2.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2 Proportional Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.3 Non-Proportional Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.4 Reinsurance Structuring and Wordings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.5 Advanced Non-Proportional Contract Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3 Reinsurance Market 15
3.1 History of Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3.2 Lines of Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.3 Reinsurance Ecosystem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.4 MTPL Reinsurance Policy Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3.5 Basis of Attachment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
4 Experience Pricing 34
4.1 Reinsurance Pricing Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.2 Burning cost analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
4.3 Frequency-Severity Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
4.4 Frequency models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
4.5 Selection of Frequency Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
4.6 Excess Frequencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
4.7 Severity Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
4.8 Experience pricing recipe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5 Exposure Pricing 46
5.1 Exposure pricing in property (re)-insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
5.2 MBBEFD - Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
5.3 Increased Limit Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
6 Insurance Linked Securities 57

6.1 ART and ILS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
6.2 Construction of ILS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
6.3 Trigger types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
6.4 Comparison table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
6.5 Non-life Cat Bond example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
6.6 ILS Example - Life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
7 Swiss Solvency Test 66

7.1 Capital & Solvency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
7.2 Determining the Required Risk Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
7.3 The Swiss Solvency Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
7.4 Internal Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
7.5 Division of capital and performance measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
7.6 The Loading for Profit and Capital Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
7.7 Slide Version of this Section . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
8 Natural Catastrophe Modelling 96
9 Exercises 131
2
1 Preliminaries
1.1 Purpose and Scope of this Lecture
Definition 1.1. Reinsurance is insurance that is purchased by an insurance company, in which some part of its
own insurance liabilities are transferred on to another insurance company.
Reinsurance allows insurance companies to protect themselves against accumulation, catastrophe, and tail risks.
This course provides an introduction to reinsurance from an actuarial point of view. The objective is to under-
stand the fundamentals of risk transfer through reinsurance, and the mathematical approaches associated with
low frequency high severity events such as natural or man-made catastrophes.
Topics covered include:
• Reinsurance Contracts: Different forms of reinsurance and their mathematical representation.
• Reinsurance Markets: History of the reinsurance market, and how to cover extreme events such as Nat-
ural catastrophes (like Earthquakes, Hurricanes, etc.), Casualty accumulations (like Asbestos 1990s, Faulty
hip implants 2010s, etc.), Specialty insurance events (like Costa Concordia 2012, Deepwater Horizon 2010,
Tenerife B747-B747 collision 1977, etc.)
• Experience Pricing: Modelling of low frequency high severity losses based on historical data, and analytical
tools to describe and understand these models
• Exposure Pricing: Loss modelling based on exposure or risk profile information, for both property and ca-
sualty risks
• Natural Catastrophe Modelling: History, relevance, structure, and analytical tools used to model natural
catastrophes in an insurance context
• Solvency Regulation: Regulatory capital requirements in relation to risks, effects of reinsurance thereon,
and differences between the Swiss Solvency Test and Solvency 2
• Alternative Risk Transfer: Alternatives to traditional reinsurance such as insurance linked securities and
catastrophe bonds
This lecture does not cover topics which are already taught in other actuarial lectures at ETH Zurich (Non-life
insurance, loss reserving, etc.). Furthermore, a basic knowledge on statistics and probability theory is expected.
Example 1.2. The following table illustrates events which need to be, or dont need to be (re)insured.
Event Bicycle theft House burning down Hurricane damage
Loss order of Magnitude ∼ 1’000 EUR ∼ 1’000’000 EUR ∼ 1’000’000’000 EUR

How to protect? → Retain risk → Insurance Too big for insurance alone!
→ Reinsurance
Table 1: Different events and insurability. Image sources: wikimedia.org, Hurricane: Lannis Waters / Post file photo
3
1.2 Organizational aspects (Autumn Semester 2020)

• Lecturers:
– Weeks 1-12, P. Arbenz, Reinsurance Contracts and Markets, Experience Pricing, Exposure Pricing, Nat-
ural Catastrophe Modelling, Alternative Risk Transfer
– Weeks 13-14, P. Antal: Solvency Regulation
• Questions: During lecture (oral or EduApp feedback channel), by email
• Documents: All materials will be on polybox (link will be shared by email)
• Exercises: There are weekly exercise series, but no exercise classes. Solutions will be made available one
week later. Examquestions can be close to exercises. Can be handed in voluntarily.
• Exam: Oral, 20 minutes, with both lecturers. During official ETH Examperiod.
• Content to be known for exam: Lecture notes, Presentations, Exercise series.
The following documents can serve as additional (non-compulsory) literature. The book by P. Parodi has an ac-
tuarial focus, and many of the pricing and modeling topics are described therein. The other three documents are
more qualitative.
Pricing in General Insur- Reinsurance: A basic The essential guide to Lloyd’s Quick Guide - An
ance, guide to Facultative and reinsurance, Introduction to who we
Pietro Parodi, 2014 Treaty Reinsurance, SwissRe, 2015 are and what we do,
MunichRe, 2010 Lloyd’s, 2011
available at ETH Library and available online available online, and for available online
ETH D-MATH Library free as print
Table 2: Possible additional Literature.
4
1.3 Primary insurance vs Reinsurance

Primary Insurance (PI) assumes premiums P P I ,i from insureds i with a total P P I = ∑k P P I ,k , and pays losses (in-
demnifications) X P I ,i with a total X P I = ∑k X P I ,k .
P P I ,1
♀ X P I ,1
P P I ,2
♂ X P I ,2
P P I ,3 Primary PR I
♂♂♂ X P I ,3 Insurance XR I
Reinsurance
P P I ,4
♂ X P I ,4
P P I ,5
♂♀ X P I ,4
Figure 1: Illustration premium and insured loss flows primary insurance and reinsurance.
From an actuarial perspective, the main challenge is to understand - i.e. stochastically model - the primary in-
sured loss X P I through random variables X A , N , X i :
N
XPI = X A + ∑ Xi ,
i =1
where X A are the Attritional Losses (i.e., the sum of small losses), X i : are the large losses (e.g., above some thresh-
old).
Primary Insurance vs Reinsurance

• Large number of similar contracts • Single, uniquely worded reinsurance contracts
(however, many standardized clauses)
• Large frequencies of small events, large amounts • Typically low frequencies of large events, small
of data. amounts of data.
• Premium usually determined through algo- • Each reinsurance contract is priced by itself, usu-
rithms, based on few parameters (Motor: age, size ally based on ceding insurance specific experience
of car, etc). Pricing denotes the calibration of how and/or exposure data.
these parameters affect premium.
Table 3: Overview table Primary insurance vs Reinsurance

severity
severity
time time
Figure 2: Illustration frequency and severity of losses primary vs reinsurance.
5
2 Reinsurance Contracts
2.1 Overview
The following table provides an overview on the common proportional and non-proportional reinsurance contract
types.
Proportional Non-Proportional
Name Quota Share Surplus Per Risk Per Event Stop Loss
Excess-of-Loss Excess-of-Loss
Abbreviation "QS" "SP" "XL" "XL" "SL"
Market Common Common in Common common Common in
Practice few LoB’s (declining) few LoB’s
Table 4: Overview on proportional and non-proportional reinsurance contract types
In the literature, one sometimes encounters "ECOMOR" and "Largest Claim reinsurance" contracts. These types
are practically inexistent and appear only in academic literature.
Proportional: Overall loss Non-proportional: Only losses

ratio is relevant exceeding a certain amount
are relevant
Figure 3: Illustration proportional vs non-proportional reinsurance
2.2 Proportional Reinsurance

Definition 2.1. A quota share ("QS") is a proportional reinsurance contract, through which the primary insurance
cedes premiums and losses with a cession rate α ∈ [0, 1] to the reinsurer. I.e., P RE = α ⋅ P P I and X RE = α ⋅ X P I .
Under a quota share, all premiums and losses are ceded with a constant proportion α: independent of premium
developments, loss amounts, and policy limits. This means that for instance it does not matter whether the total
loss is the consequence of the one big event, or an aggregation of numerous small losses. The following figure
illustrates quota shares.
PP I P RE = α ⋅ P P I
Primary
Insureds Insurance X RE = α ⋅ X P I Reinsurance
XPI
PI
C = C (P RE , X RE )
Figure 4: Illustration quota share with share α.
The second type of proportional reinsurance contracts is surplus reinsurance, where the cession rate is not con-
stant, but varies across policies k, depending on the sum insured. The sum insured reflects the maximum possible
loss per policy.
6
Definition 2.2. A surplus ("SP") contract is a proportional reinsurance contract, where the cession rate αk ∈ [0, 1]
varies by policy k. The share αk is a function of the sum insured SI k , the Retention R > 0 and the number of lines
NL (usually integer, > 0):
1
αk = min {max {SI k − R, 0} , N L ⋅ R } .
SI k
The folloing figure illustrates surplus reinsurance contracts. Maximum loss is reduced to R for policies with SI k ≤
(N L + 1) ⋅ R.
PP I P RE = ∑k αk ⋅ P P I , k
Primary
Insureds Insurance X RE = ∑k αk ⋅ X P I , k Reinsurance
XPI
PI
C = C (P RE , X RE )
Figure 5: Illustration surplus with cession shares αk .
Definition 2.3. In a proportional reinsurance contract, the commission is a part of the premium which is returned
to the cedant.
Depending on perspective, the commission has the following role:
• In theory, the commission C reimburses the primary insurance for expenses such as acquisition costs;
• In practice, the commission determines the contract profitability, and determines whether a contract is ex-
pected to be profitable to the (re)insurer or not.
The simplest, most common, version of the commission is the so called Fixed commission, with commission rate
cr ∈ [0, 1], such that
C = cr ⋅ P RE = cr ⋅ (α ⋅ P P I ).
Fixed Commission Profit Commission Sliding Scale Commission

Commission is a fixed portion 0% ≤ Commission is a fixed portion 0% ≤ Commission varies inversely with
cr ≤ 100% of reinsurance premium pr ≤ 100% of the (technical) profit the loss ratio, capped from below
P RE . E.g., cr = 20% (P RE − X RE ) and above.
C = pc ⋅ (P RE − X RE ) C = P RE ⋅ c c ssc ( X RE /P RE )
+
C = cr ⋅ P RE
cr max
cr
cr mi n
(P RE − X RE ) l r mi n l r max (P − X )
Loss RE RE
Table 5: Overview commission clauses
Lemma 2.4. A proportional reinsurance contract is expected to be (technically) profitable to the reinsurer in case the
sum of expected loss ratio and expected commission ratio is less than 100%.
7
Proof.
E[ X RE ] + E[C ]
E[P RE − X RE − C ] > 0 ⇔ E[P RE ] > E[ X RE ] + E[C ] > 0 ⇔ 1 > = LR + C R = UW R
E[P RE ]
In particular, this implies that for profitability assessment, the expected commission needs to be considered and
not the commission at expected loss:
E[C (P RE , X RE )] ≠ C (E[P RE ], E[ X RE ])].
Both quota share (QS) and surplus (SP) operate proportionally on premiums and losses, but for SP the factor varies
between policies. This is illustrated in the following figure and table:
Quota Share Surplus

Acts on maximum loss / sum insured: proportinally non-proportionally
Acts on loss proportinally proportionally
Table 6: QS vs SP on sum insured and losses.
Before Reinsurance Quota Share 60% Surplus R=10m, NL=2
RI RI
30m
20m
SI1
L1 SI2 L
2
SI3 10m
SI˜ 1 ˜ SI˜ 1 ˜
L˜1 SI2 L˜ L˜1 SI2 L˜
L3 SI4 L4 ˜3
2 SI ˜3
2 SI SI˜ 4 L˜4
L˜3 SI˜ 4 L˜4 L˜3
α1 = α2 = α3 = α4 =
α = 60% 60% 65% 47% 0%
Figure 6: Illustration quotqa share and surplus contracts
A Surplus contract is a proportional reinsurance contract, where the cession share applied to each underlying pol-
icy varies depending on sum insured.
8
Exposure/Sum Insured
140
Above surplus 120

lines: not reinsured Typically reinsured through
through surplus 25% facultative reinsurance
100 14%
10%
80
Reinsured
through 50% 57% 60% 67% Reinsured through surplus
Surplus
2 lines = 60 60
62%
57%
40 40%
25%
Surplus 20
retention 25% 29% 30% 33% 38% 43% 60% 75% 100%
1 line = 30 Retained
0
Figure 7: Illustration surplus
2.3 Non-Proportional Contracts

In a non-proportional reinsurance contract, the reinsurance covers losses exceeding a certain "deductible" D,
up to a "cover" C.
Definition 2.5. The Layer function with deductible D and cover C for a loss X is given by:
L D,C ( X ) = min {max { X − D, 0} ,C } = min { X − D, 0} − min { X − (D + C ) , 0} .
Non-proportinal reinsurance contracts are paying a reinsured loss which is defined through the layer function, but
there are differences in how the loss going into the layer is defined.
Other names used for the parameters of L D,C (⋅) are:
• "priority" or "retention" for D,
• "limit" for C,
• "exit point" for D + C.
Note that an XL differs to a surplus in that an XL operates non-proportionally on loss, whereas a Surplus acts
proportionally on loss, with factor depending on sum insured.
Definition 2.6. A Per Risk Excess-of-Loss is a non-proportional reinsurance contract, where the reinsurance layer
is applied to each "risk", i.e., every primary insured object:
X RE = ∑ L D,C ( X r )
r i sksr
The term "per risk" usually means for each insured object, sometimes also each primary policy.
Definition 2.7. A Per Event Excess-of-Loss is a non-proportional reinsurance contract, where the reinsurance
layer is applied to the losses caused by the same "event" e. I.e., losses from different underlying policies caused by
the same event are aggregated:
X RE = ∑ L D,C ( ∑ X e,i )
events e losses caused
by event e
9
Reinsured loss Primary Insurance loss before/after reinsurance
D D+C D D+C
Gross loss Gross loss
Figure 8: Illustration loss before/after reinsurance layer.
Per Event XL’s are also called Cat XL’s, since they are usually purchased for protecting against catastrophes.
From a legal point of view, it is notoriously difficult to clearly define what an event is, and there have been numer-
ous court cases on this aspect.
Definition 2.8. A Stop Loss (or an Aggregate XL) is a non-proportional reinsurance contract, where the reinsur-
ance layer is applied to the whole loss of a portfolio:
X RE = L D,C ( ∑ X P I ,k )
k
The losses from all underlying policies are first aggregated. I.e., stop loss also protects against an increase in attri-
tional losses.
The difference between a stop loss and an aggregate XL is the parametrization of the layer. For a Stop Loss, the
layer is usually specified in terms of loss ratio: D = D LR ⋅ P P I , C = C LR ⋅ P P I , as P P I is generally only known later.
E.g., "Stop loss 20% xs 100% Loss Ratio".
Non-proportional reinsurance contracts have in common that the reinsured loss is determined by applying a rein-
surance layer L D,C (⋅) to a certain loss amount. The three variants differ by the way how the loss amount going
into the layer is determined. The following table provides a comparison.
Per Risk Excess-of-Loss Per Event Excess-of-Loss Stop Loss

Layer applied to: losses by insured object losses aggregated by event whole portfolio
Description Protects against losses Protects against accumula- Protects portfolios against ac-
from single (large) expo- tions originating from catas- cumulations of large losses
sures and risks trophic events, such as nat- and/or (frequency) accumu-
ural or man made cat lations of small losses
Table 7: Comparison of non-proportional reinsurance contract types
10
2.4 Reinsurance Structuring and Wordings

Definition 2.9. A reinsurance program is a collection of reinsurance covers, combined together into a single
contract to form a comprehensive reinsurance protection.
For instance, a program can be:
• A Tower of XL’s, e.g. a 5xs5, 10xs10, and 10xs20;
• A Bouquet of QS’s (e.g. a combination of a motor QS, a liability QS, and a property QS);
• XL reinsuring retention net of QS
• QS reinsuring retention net of XL
Example 2.10. The following figure illustrates the XL Reinsurance Structure of the International Group of Protec-
tion & Indemnity Clubs (IGP&I, a group marine insurance clubs.
Figure 9: IGP&I reinsurance structure. [Source: https://www.igpandi.org/reinsurance]
Definition 2.11. A reinsurance share denotes the fraction of a contract which is covered by a single reinsurance
company.
Most reinsurance contracts (or programs) exceed the risk appetite and risk capacity of single reinsurance compa-
nies. Therefore, reinsurance coverages are generally split into "shares", denoting fractions of the contracts being
covered by different reinsurance companies.
11
For instance, if a reinsurer has a 30% share of an XL cover, then the reinsurance premium and recovery are calcu-
lated and then multiplied with 30% to obtain the premium/loss covered by this specific reinsurer.
Reinsurances are generally tightly managing their capacity - the maximum event loss sustained by a single contract
(also quota shares have event limits).
The following figure illustrates reinsurance shares.
Excess of Loss
Quota Share
Cover +
Re Deductible
i ns
Reinsurer 1
Reinsurer 2
Reinsurer 3
Reinsurer 4
ur
er
1
Retention
Quota Share
75% Deductible
Re
in
r2
su
ure
re
ins
r
Retention
Re
3
Figure 10: Illustration of reinsurance shares for proportional and nonproportional contracts
The usual way to define and restrict the scope of coverage for a reinsurance contract is to specify Exclusions and
Limits in the wording.
Definition 2.12. Reinsurance coverage exclusions is a list of risks or event types which are not covered in the
reinsurance arrangement.
The following clause illustrates the case of a marine reinsurance contract excluding a certain peril region of natural
catastrophes:
"[...] Coverage: All business underwritten by the reinsured and allocated to their Marine account. [...]
Exclusions: Excluding all losses emanating from named windstorms occurring in the Gulf of Mexico. [...] "
Definition 2.13. A limit denotes maximum reinsured amount for a (set of ) risks or event types
The following clause illustrates the case of a marine reinsurance contract limiting losses due to marine liability:
"[...] Marine Liability interests subject to a maximum limit of 20 mio USD for any one risk. [...] "
12
2.5 Advanced Non-Proportional Contract Features

Definition 2.14. A premium clause in non-proportional reinsurance contracts determines the way how the rein-
surance premium P RE is calculated based on the underlying portfolio.
As opposed to proportional reinsurance, where the reinsurance premium is simply P RE = α ⋅ P P I , it is not intrinsi-
cally clear how P RE is calculated for non-proportional reinsurance contracts.
Common premium clauses are:
• Fixed premium, where e.g. P RE = 123EU R.
• Fixed premium rate, where P RE in-/decreases linearly with P P I . E.g., P RE = 2% ⋅ P P I .
• Base Premium and Reinstatements, where the initial base premium provides coverage for the limit C only
once. After the cover is used up, the payment of a "reinstatement premium" will "reinstate" the cover.
• Swing rate (or variable rate), where the premium increases linearly with the loss experience, and is con-
strained by a minimum and maximum, respectively: P RE = min{max{p mi n , f ⋅ X RE }, p mi n }
The most common form is the fixed premium rate.
Example 2.15. Reinstatement premium: For a layer specifying a reinstatement premium, the base premium pro-
vides coverage only for the first event. After the cover has been (partially) used up, the reinstatement premium
needs to be (partially) paid to "reinstate" the coverage. Usually, a limited number of reinstatements is specified,
effectively limiting to total loss potentially covered by the reinsurance. Usually, a full reinstatement premium is
equal to a base premium and "Pro rata to amount", i.e., if cover is partially used (FGU loss above D, but below D +
C), reinstatement premium is scaled down linearly.
Recovery
Losses
Reinstatement
(full) Reinstatement
(only partial)
Premium
payments
t=0 t=1
time
Base premium
Figure 11: Illustration reinstatements
Definition 2.16 (Gearing Effect). The gearing effect denotes the effect that loss inflation inflates losses above a
threshold overproportionally compared to to the groundup losses.
Lemma 2.17. For a layer with unlimited cover, the losses to layer are always more affected by loss inflation than the
groundup losses.
13
Proof.
E[L D,∞ (g X )] = E[(g X − D ) ] = g E[( X − D /g ) ] ≥ g E[( X − D ) ] = g E[L D,∞ ( X )].

+ + +
Definition 2.18. A Stabilization clause is a coverage adjustment clause for non-proportional reinsurance where
the deductible and limit (D,C ) is multiplicatively adjusted to (g ⋅ D, g ⋅ C ) in order to share loss inflation risk
between the cedant and reinsurer.
The factor g applied to the layer (D,C ) → (g ⋅ D, g ⋅ C ) depends on a proxy to loss inflation (e.g. usually wage index
in MTPL) and timing of payment. Different versions of variants exist on calculation, which is why no details are
12
provided here .
Before loss inflation After loss inflation
⋅g
g ⋅ (C + D )
C+D
⋅g
g ⋅D
D
"uninflated" loss amount and Ultimate "inflated" loss amount:

real factor g are not observable! observable: at (court) decision time
Figure 12: Illustration of stabilization clause
Definition 2.19. An Annual aggregate deductible (AAD) or an Annual aggregate limit (AAL) specifies an outer
layer, which is applied on the sum of all losses after the application of the inner layer L D,C :
N
X RE = L A AD,A AL (∑ L D,C ( X i ))
i =1
Applying an outer layer through an AAL and/or an AAD to the reinsured losses reduces the loss to the reinsurer.
The loss reduction is realized in terms of actual value, expectation, and volatility.
E [L A AD,A AL (∑ L D,C ( X i ))] ≤ E [∑ L D,C ( X i )]
Therefore, the price of a reinsurance cover including AAD/AAL is generally lower than one without.
Note that the presence of an AAL limits the maximum possible loss for the reinsurer to this amount. AAD’s and
AAL’s may also be applied alone, e.g. an AAD without an AAL may absolutely make sense.
1
https://www.irmi.com/articles/expert-commentary/reinsurance-index-clause
2
http://www.gccapitalideas.com/2008/09/08/indexation-clauses-in-liability-reinsurance-treaties-a-comparison-across-europe/
14
3 Reinsurance Market
3.1 History of Reinsurance
3.1.1 The First Reinsurance Contract - Genoa 1370
Ships and Marine transport always represented signif-

icant financial risk: Ships are expensive to build and
maintain; Cargo carried represents large concentration
of values; And crews are expensive to train and operate,
too. Already Babylonians (3000 BC) had a system of ma-
rine insurance.
Unsurprisingly, the first contract resembling a reinsur-
ance contract was covering marine risks: "The treaty,
written in Latin, concerned the cargo of a ship sailing
from Genoa to Belgium for which the direct ’insurer’ trans-
ferred the more hazardous part of the voyage from Cadiz
(in Andalusia) to Belgium to another ’insurer’ who thus
provided ’reinsurance coverage.’ (Genoa, 1370) " [Source: Gerathe-
wohl, Reinsurance Principles and Practice, p649]
Figure 13: Port of Genoa, 1597.
3.1.2 Great Fire of London 1666
The Great Fire of London was a massive conflagration

that swept through the central parts of London from 2-4
September 1666. Most of the medieval City of London in-
side the old Roman city walls were consumed by the fire,
which destroyed around 13’200 houses, many churches,
and most of the buildings of the City authorities. At that
time, London contained around two-thirds of the wealth
of the British empire. London was essentially medieval in
its street plan, an overcrowded warren of narrow, wind-
ing, cobbled alleys. It had experienced numerous fires
in the years before since buildings of wood and thatch
were common. In addition, hazardous occupations like
smithies and glaziers were allowed to operate in the mid-
Figure 14: Great Fire of London 1666. Image source: wikimedia.org
dle of the city.
Firefighting was already well organized through fire brigades. However, they were not able to deal with the size
of the fire. In the end, the fire was stopped by the wind setting down and the Tower of London garrison using
gunpowder to destroy buildings in order to create effective firebreaks.
Soon after this fire, in 1667, the first insurance company "The Insurance Office" was founded.
15
3.1.3 Great Fire of Hamburg in 1842
The fire destroyed ca 20% of all buildings in Hamburg.

Several insurance companies got into financial trouble:
Publicly owned "Hamburger Feuerkasse" needed to raise
capital, paid back through taxes over the next 40 years.
Several private insurance companies went bankrupt: e.g.
"Association Hamburgischer Einwohner" (18 mio Mark
claims vs 0.5 mio Mark capital).
Many British insurers faced enormous losses and subse-
quently retreated from the German market. At that time,
insurance industry was already very international.
The foundation of Cologne Re in 1853 – the world’s oldest
reinsurance company (Kölner Rück) is associated with
the fire, but the aim to keep reinsurance premiums in the
country appears to have been the more relevant driver. Figure 15: Great Fire of Hamburg 1842. Source: wikimedia.org
3.1.4 Great Fire of Glarus 1861
On 10/11 May 1861, two thirds of the cantonal capital

Glarus was destroyed by one of the biggest conflagration
in the history of Switzerland. Several hundred buildings
burned down - two thirds of the city. Around half of the
population (ca 3000 inhabitants) were left homeless.
After the fire, the city was rebuilt within a short period of
time, with a city plan favoring large and wide streets to
avoid further fires. Wooden buildings and wooden roof
covers were forbidden.
The fire is sometimes associated with the foundation of
Swiss Re in 1863. The aim to reduce the outflow of rein-
surance premiums to foreign (French/ English) reinsur-
ers is a more plausible reason for its creation. SwissRe
was the first reinsurance company outside Germany.
3.1.5 San Francisco Earthquake 1906 Figure 16: Glarus after the fire. Source: altglarus.ch
"The earthquake shook down in San Francisco hundreds of thousands of dollars’ worth of walls and chimneys. But
the conflagration that followed burned up hundreds of millions of dollars’ worth of property." [Jack London / Collier’s
Weekly issue / May 6, 1906] Fire following earthquake had been excluded from many insurance contracts, but deter-
mining the cause of the fire was often impossible.
The event and the exorbitant claims proved to be a game-changer for the reinsurance industry. The reliability of
the(foreign) reinsurance industry was proven.
Figure 17: Illustrations of the San Francisco earthquake: The Call Chronicle Examiner headlines [Source: click-
americana.com], and the fire in Sacramento Street [Source: Wikimedia.org]
16
3.1.6 Lloyd’s of London
Lloyd’s is not a reinsurance company, but rather a very large coinsur-

ance market. In the UK, reinsurance was prohibited from 1745 to 1884
(c.f. ’Revenue Act’), which lead to risk being spread through coinsurance
instead.
The market is formed by a large number of partially mutualized "syn-
dicates", which provide (re)insurance coverage. Syndicates are backed
by capital providers, so called "names", which ultimately bear losses or
gain profits.
In the past, names were often "individual names": Wealthy individu-
als participating in the (re)insurance market with their own wealth as
risk capital. After many individuals suffered enormous losses during the
1990’s due to Asbestos related claims, the Lloyds market has largely tran-
sitioned to "corporate names". These are companies with professional
risk management providing risk capital to Lloyds syndicates.
Lloyd’s is the largest specialist (re)insurance market today, e.g. for Ma-
rine business.
Figure 18: The Lloyd’s building in Lon-

don (Lime Street) Source: wikimedia
3.2 Lines of Business

So called "Lines of business" are used separate and group different types of business. Reinsurance companies
usually use such lines of business to organize the corporate stucture, but also the actuarial analyses and data
generally aligns to such a segmentation.
Contract natures (QS, XL, etc) can generally be used in all lines of business, even though some lines tend to certain
forms. For instance, reinsuring property catastrophe risks through quota shares makes less sense than thorugh
XL’s.
For most lines, both treaty and facultative reinsurance is common.
Property & Casualty Reinsurance Life Reinsurance

Contract natures Contract natures are the same: QS, SP, XL, SL.
Difference in definitions ("Event", "Risk", etc)
Contract types Contract types are the same:
Treaty (for portfolios of risks)
Facultative(for single large risks)
Underlying risks and LoB’s Standard lines, Specialty lines, etc. Mortality, Longevity, Morbidity, etc.
Table 8: Lines of businesses vs Contract natures vs Contract types in Life/Nonlife.
17
3.2.1 Non-Life Reinsurance LoB’s – Standard Lines
Motor: This line provides protection to vehicle owners in

relation to the operation of cars, buses, trucks, motorcy-
cles, etc. Two sublines are typically separated: Motor own
damage (MOD/"Motor hull") and motor third party liabil-
ity (MTPL). Both subproducts are often sold together by pri-
mary insurers, therefore also often reinsured together.
Motor own damage insurance covers the damage, destruc-
tion and loss of a vehicle. For instance, the damaging of a
vehicle as a result of a traffic accident, fire, hail, or theft.
MTPL insurance covers compensates the driver, passengers
or other people are injured in an accident involving the in-
sured vehicle.
In many countries, buying MTPL insurance is compulsory
for vehicle owners. In Europe, the Green card system ensures
consistent application of MTPL insurance, and ensures that
Figure 19: Motor accident [Source: wikimedia]
cross-border vehicle trips are appropriately insured. Most
European countries prescribe a insured limit of 100 mio
EUR. MTPL insurance losses above 10 mio EUR have become more frequent than in the past, since several coun-
tries (in particular France and UK) started to award annuities to victims who get disabled in vehicle accidents.
Deadliest motor accident so far: The Los Alfaques disaster was a road accident and tanker explosion which oc-
curred on 11 July 1978 in Alcanar in Spain. The tanker truck was loaded with 23 tons of highly flammable liquefied
propylene. 217 people (including the driver) were killed and 200 more severely burned.
Property: This line protects the physical property and

equipment against losses from fire, natural perils, theft, and
other perils.
Property insurance is one of the oldest types of insurance.
Historically, property insurance became popular when the
devastating effects of conflagrations and large fires in cities
became evident. In the 19th century and before, most
houses were built with wood, and heated with open fire -
making them very vulnerable to fire. With the emergence of
fire proof building techniques and professional firefighting
techniques, the risk of fire has diminished.
Nowadays, buying property insurance is compulsory in
many countries, or is even provided by state-funded/subsidized
systems. Many countries regulate the coverage which needs
to be provided: Switzerland for instance requires the inclusion of allFigure 20:perils
natural Building
withon
thefire
exception of earth-
[Source: wikimedia]
quakes.
Covered perils usually includes fire, explosion, lightning, but is inconsistent on others. Natural perils such as flood,
storms, earthquakes, tornadoes are usually included in standard covers in Europe, but need special covers in the
US. Special perils like riot, strike, terrorism, bush/forest fire, aircraft damage, nuclear activity are often excluded or
treated specifically.
Liability/Casualty: Liability insurance protects the insured against claims resulting from injuries and damage to
persons and/or third-party property. It usually only covers claims due to negligence, i.e. excludes intentional
damage, contractual liabilities, and criminal prosecution.
Legal systems and rules have a strong influence on determining which persons or companies are liable in which
events to third parties. This defines for instance environmental liability costs. In some countries (notably the US),
legal costs for a liability claim to go through courts can be higher than the actual claims.
There are various subtypes of liability insurance: General TPL (GTPL), Motor TPL, Employer’s TPL, Product liability,
Corporate liability, directors & Officers (D&O) liability, Executives & Officers (E&O) liability.
18
Private persons usualy purchase MTPL and GTPL policies to protect

against claims due to negligence.
Employers TPL covers bodily injuries and deaths of employees of a com-
pany. Such claims can become particularly sever in case pollution or
serial injuries are involved, like it was the case for asbestos.
Product liability protects those manufacturing products against liability
claims. The potential scale of such events is illustrated by the Diesel
scandal, or the benzene contamination in the Perrier mineral water.
Corporate liability describes is the third party liability of legal entities
such as companies. Different legal systems have wildly varying views
on whether corporations or the persons working for the corporation are
held liable for certain events.
A 2015 study by insurance broker Aon identified 86 corporate liability
losses in excess of usd 1bn since 1989. Some 57 of these losses were in
excess of 2bn usd and 13 over 10bn usd, mostly from pollution incidents
and regulatory actions. The largest overall liability catastrophe so far are
asbestos related claims, mounting to ca 100 bio USD in total. The largest
corporate liability loss in recent times was the 2010 Deepwater Horizon
explosion and oil spill which looks set to cost energy company BP a total
of 61.6bn usd , covering multiple liability settlements with federal and
state authorities, shareholders, property owners and consumers.
Figure 21: Illustration corporate liabil-
ity: Defective hip implant [Source: wikimedia]
3.2.2 Non-Life Reinsurance LoB’s – Specialty Lines
Marine (Hull, Liability, Cargo): Marine insurance covers the loss or

damage of ships, cargo, and related third party liability. In addition, almost any type of transport insurance, cover-
ing goods which are transported from some point of origin to destination falls also into the marine category.
Marine insurance is one of the oldest types of insurance, as
since the medieval ages, ships represented significant con-
centration of value and also risk.
The hull component of marine insurance is usually reala-
tively easy to evaluate, since incsured values of ships are
predetermined. Nowadays, there are many ships with value
larger than 100 mio USD, in particular large cruise ships and
container transport ships.
The cargo component insures cargo transported on ships,
but also while in transport on land. There is often a very high
uncertainty on where which cargo is at a given point in time.
In addition, cargo is moved on a daily basis, so maintaining
data on exposure is very difficult.
The liability component insures against legal liability to-
wards third parties, such as passengers and the public. The
Figure 22: Illustration Marine: Costa Concordia ac-
latter is relevant for environmental liability, which can be
cident 2012 [Source: wikimedia]
very severe in the case of (oil) pollution risks associated with
oil.
Most of the marine risks are insured through so called "P&I Clubs" (where P&I stands for property and indemnity),
which are associations of shipowners, which are specialized clubs mutualizing and pooling risks.
Because of the high limits of potential liability, particularly when pollution is involved, P&I clubs also pool their
risks in the International Group of Protection and Indemnity Clubs ("IGP&I"). The IGP&I itself reinsures itself on
in the reinsurance makret.
The biggest marine insurance event so far was the grounding of Costa Concordia in 2012, which has cost ca 1.5 bio
USD, mostly on the cleanup operation.
19
Aviation & Space: Aviation and space insurance covers

first party and third party losses associated to the oper-
ation of aircraft (planes, helicopters, etc) and the opera-
tion of satellites.
Aviation insurance can be separated into "hull" and "lia-
bility". The hull part covers losses associated to material
damage to the aircraft, equipment, and machinery. The
liability part covers damages of passengers, but also fa-
talities, injuries, and property damage on ground due to
a crashing aircraft.
The Montreal Convention (2005) has introduced unlim-
ited liability to airlines. In addition, the convention pro-
vides a large amount of discretion on where a claimant
may make his claim (take off location, landing location, Figure 23: Illustration Aviation: Crash landing of
airline location, airline owner location), which makes British Airways Flight 38 in 2008 [Source: wikimedia]
"jurisdiction shopping" possible. Therefore, such court
cases often end up to be taken to the United States, where courts are known to be very generous on compensa-
tions.
The frequency of aircraft crashes is very low compared to the number of aircraft trips, and even lower on mid-air
collisions. Therefore, this is a "low frequency high severity" line.
Space (re)insurance covers the launch and operation of space crafts (i.e., satellites). It is not uncommon for launch
vehicles to fail, and the value of satellites often goes into the hundreds of millions of USD, so there is a significant
amount of risk involved here. There are also risks of systematic failure of satellites, such as due to a solar storm or
simultaneous defects (serial losses).
The deadliest event so far happened in 1977, when two Boeing 747 passenger jets (KLM & Pan Am) collided on the
runway at Los Rodeos Airport (Tenerife, Spain), killing 583 people.
One of the biggest near-misses, happened in San Francisco 2017. One of two landing strips was closed, aircraft
approached towards taxiway where 4 aircraft waited - full with passengers and kerosene. If pilot wouldn’t have
pulled up in the last second (min separation 5 meters), all aircraft would have exploded (killing ca 1000)
Engineering: This line of business covers various types of risks

and events associated to the construction and commissioning of
buildings, machinery, and other types of infrastructure projects.
Some of the segments in this line are "Contractors/Construction
All Risks" (CAR), "Erection All Risks" (EAR), and "Machinery
Breakdown".
Hazards being covered are usually both natural catastrophes
(earthquake, flood, wind, but also sand storms, etc), and man-
made catastrophes (like explosions and fire).
As opposed to other lines, engineering insurance protection is
often underwritten for the entire duration of the construction
project instead of only one year.
One peculiarity of Engineering insurance is that the exposed val-
ues and relevant hazards significantly change over the duration of
engineering projects: At the start of a construction, there is "only"
the exvacation in progress, and risks are limited to those affecting
ground work like flood. In the middle of e.g. a skyscraper erection
project, when the concrete is poured, there is exposure to storm
damage. At the end of a construction project, expensive materials
and tools are used for the outfitting of a building, which implies
higher exposures and signficant fire risks.
Figure 24: Illustration construction work.
20
Agriculture: This line covers the insurance

of agricultural products, and in general
production processes associated to grow-
ing plants and breeding of animal. Ar-
eas distinguished in this line are crop in-
surance, livestock/bloostock, aquaculture,
forestry, and greenhouses.
Agriculture is strongly influenced by natu-
ral hazards, but the relevant perils are very
different compared to property insurance.
In property, perils like storms, flood, and
earthquake dominate. The peils relevant
for agriculture are rather frost, hail, and
insufficient/excessive rain. With respect
to rain and flood, singular extreme events
(flood/storm) are less relevant than longer
periods of too much or too few rain.
Agriculture (re)insurance is sold in almost
all countries in the world. In order to deal Figure 25: Illustration Agriculture: Drought indicator map during
with weak insurance industries and the fact 2011-2012 US drought. [Source: US Drought Monitor]
that loss adjusters are often unavailable or inexistent, agriculture insurance is often done through innovative prod-
ucts that remove the necessity of traditional insurance infrastructure. For instance, insurance can be provided
through weather derivatives and index products. Satellites can remotely measure plant growth by observing near-
infrared reflection from space.
Credit & Surety: This line is usually separated in credit

and surety (re)insurance.
Credit insurance indemnifies compensates the in-
sured against the risk of not being paid when supply-
ing goods or services to a customer. The customer may
not pay due to insolvency, legal problems, or other is-
sues. The debtor may also be prevented from paying
its obligations due to the political situation, e.g. when
wars, riots, or other crises evolve. Credit insurance is
often bought when commercial transactions occur in-
ternationally, and the credit risk is difficult to manage
or mitigate.
Surety insurance can be viewed as a contract between
the insurer and the insured, that guarantees a third
party that if the insured does not fulfill the contract,
the surety will compensate the third party. Figure 26: Illustration Credit & Suret: Enron stock price
A peculiarity of Credit & Surety (re)insurance is that crash shortly before bankrupcy due to fraud [Source: wikimedia]
its results strongly correlate with the economic state.
When financial or political crises occur, defaults and commercial interruptions are much more likely to occur than
in a normal economic situation. Therefore, this line usually shows strong and long cycles, with low loss ratios in
good economic times, and high loss ratios during financial crises.
21
3.2.3 Life Reinsurance – Risk Drivers
Mortality shocks denote sudden occurrence of large number of unexpected deaths.

Such mortality shocks may for instance come from pandemics or man-made accidents.
Figure 27: Left: Illustration of a Pandemic - Influenza ward at Camp Funston, Kansas during 1918 Spanish flu
outbreak. Right: 2015 Tianjin Explosions - 173 confirmed deaths, ca 800 injured [Image sources: Wikimedia.org]
Longevity & Mortality trends denotes the risk of long term mortality rates deviating from today’s expectations.
This is more or less the risk of having insureds living longer or shorter than expected. Note that the (Re)insured
population may turn out to exhibit very different mortality trends compared to general population. This risk driver
affects mainly longevity swaps, annuity and long-term care covers.
Figure 28: Mortality trend illustration: Life expectancy at birth by region [Source: UN 2008]
22
Morbidity risk is the risk of negative trends or unforeseen improvements in medical diagnosis and treatment.
Changes in morbidity lead to number and duration of medical treatments different to expectation. As opposed to
mortality (number of deaths per population), morbidity is the number of sick persons per population. The lines of
business affected are: Disability insurance, Long-Term Care, Critical Illness, Medical & Health
Morbidity: Incidence per a population
Numerator: Incidence

Denominator: Population
♀ ♀
♀ ♀ ♀
Figure 29: Morbidity Illustration
Policyholder behavior Risk denotes the risk of lapsation, policy options, or adverse selection.
Within policyholder behavior risk, we can distinguish:
• Lapse: risk of termination of policies earlier than expected,
• Policy options: risk related to policyholder options,
• Adverse selection: risk of asymmetric information between insured and insurer.
3.3 Reinsurance Ecosystem

3.3.1 Emergence and Evolution of Sustainable Reinsurance Markets
Insurance markets evolve naturally when risk carriers (persons, companies) aim to reduce risk by transferring
them. However, reinsurance market is not automatically sustainable in case a primary insurance company exists.
Instead several conditions need to be satisfied:
Definition 3.1. A sustainable reinsurance market for a given line of business and location exists if:
• Concentration of material exposures
• Presence of hazards which cannot be controlled or managed
• High insurance penetration
• Stable legal environment and high trust in reinsurance companies
As the examples in the history section show, these conditions may emerge over time. For some line of business,
these conditions may prevail, whereas for others only at another point in time.
The following table illustrates some trends in the reinsurance market, which are largely implied by the emergence
or disappearance of sustainable reinsurance markets:
23
Trend Details
"Old markets" maturing • Reduction in standard line business(motor, property)
• Increased regulation (e.g. solvency regimes)
New and emerging markets • More people, urbanization, more concentrations
• Closing the insurance gap: Insurance penetration increasing in emerg-
ing markets
Cyber risks Security breach expense and liability, extortion, reputational damage, data
restoration, business interruption, loss of future profits, public relation ex-
penses, theft/leak of data
New risks and emerging perils • Business Interruption
• Product liability
New forms of risk transfer • Alternative risk transfer (ART) & Insurance linked securities (ILS)
Table 9: Currently observed trends in the reinsurance market
3.3.2 Chains of Risk Transfer
The flow of risk does not end at the reinsurer, but is often passed on to the financial market (through ILS) or to
Retrocessionaires.
The choice of "risk transfer channel" depends on the risk type, as well as the availability and efficiency of risk
transer technique. Of course, profit margins are required by all participants in the value chain.
♀ Primary
Insurance Insurance linked securities (ILS)
Financial
ILS Market

Primary
` Insurance
Reinsurance Reinsurer Another
Reinsurer
Retro-
♂♀ Primary
Broker cession
Insurance "Retro-
cessionaire"
♂
Figure 30: Illustration chains of risk transfer
3.3.3 Treaty vs Facultative Reinsurance
When considering the number of risks ceded through a reinsurance arrangement, two types can be distinguished:
facultative reinsurance and treaty reinsurance. Facultative reinsurance is designed to cover single risks or defined
packages of risks. On the other hand, treaty reinsurance covers a certain book of business of the ceding company
- e.g. all motor policies of a primary insurer.
Insuring large corporations is technically usually insurance (and not reinsurance), but due to the large amounts
and limits involved, many reinsurers are also operating in this market.
24
Treaty Reinsurance Facultative Reinsurance

• A reinsurance cession covering a block of the ceding • Reinsurance transacted on an individual risk basis,
company’s book of insurance business. negotiated on a risk by risk basis.
• All policies with a defined characteristic are ceded, • A defined single risk, or a group of single risks is
without the reinsurance having the right to decline ceded. The reinsurer has the right to decline single
single risks ("obligatory"). risks (hence called "facultative").
• Usually restricts the ceded risks in terms of maxi- • May cover the risks excluded in a treaty, i.e., act on
mum limits and covered events through exclusions. top of a treaty.
• Usually long term relationships, emphasizing rein- • Rather short term relationships, depending on un-
surers profitability over a period of time derlying risks.
Table 10: Treaty vs Facultative reinsurance]
3.3.4 Reasons to Buy Reinsurance
The usual primary motivation for explaining the existence and the business case of reinsurance companies is risk
transfer. I.e., the transfer conscious transfer of uncertain outcome of insurance business to a reinsurance, thereby
reducing the risk due to "known-unknowns". This is most prominently the case when peak risks, concentration
risks, or natural catastrophe risk is transferred - where most insurance companies know very well what can go
wrong.
However, there are also other motivations than risk transfer. The reduction or limiting of capital requirements is
a very common is another common reason for purchasing reinsurance. Such capital requirements do not only
arise from the regulator supervising the insurance group, but also local regulators of local entities, rating agencies,
clients, and others.
In addition, many reinsurers - with global knowledge base and footprint - are providing support and services to
local insurers.
Motivation Examples
Risk transfer • Reduce uncertainties (known-unknowns)
• Protection against model risk (unknown-unknowns)
• Increasing underwriting capacities
• Reduce timing risks, earlier recognition of profits
Risk financing • Reduction in Capital required (by clients, rating agencies, regulators). Reinsur-
ance can replace equity or debt.
• Access diversification pools - Decrease in profits, but (if properly done) in-
crease in RoE(return on equity)
Service & Risk Mgmt • Support in risk assessment, pricing, risk management, claims, product devel-
opment, etc
• Allowing startup companies to build business and accelerate profitable growth
Table 11: Reasons to Buy Reinsurance [Source: SwissRe Essential guide to reinsurance and SCOR Investor Day 2018]
For the risk financing view, one can consider the capital reduction in relation to the profit reduction. Seen only
in terms of expectation, reinsurance is generally unprofitable for primary insurances. However, considering the
reduction in risk capital and the corresponding reduction in cost of capital, reinsurance can very well be efficient
when well designed: namely when the savings in capital costs are higher than the expected reinsurance cost. The
academic perspective - the reduction of some risk measure or ruin probability is not practially relevant.
25
Capital/Capital costs
Current return on
Capital (∼ RoE)
Before Reinsurance
After
Reinsurance
Profit
Figure 31: Illustration of cost-of-capital efficient reinsurance contracts.
3.3.5 Reinsurance Companies
Reinsurance market is dominated by few globally operating "Tier 1" reinsurance companies: The top 5 reinsurance
companies write more than half of all reinsurance premiums, with numerous small reinsurance companies (many
specialized, local, or monoliners) making up the rest.
Rank Company Premium Capital Loss ratio Combined ratio

1 Munich Re Company 45.846 36.845 74.7% 105.6%
2 Swiss Re Ltd. 36.579 27.258 78.7% 109.0%
3 Hannover Rück S.E. 30.421 14.543 72.8% 101.9%
4 SCOR S.E. 20.106 7.588 70.2% 100.2%
5 Berkshire Hathaway Inc. 19.195 451.336 80.8% 106.2%
6 China Reinsurance Corp. 16.665 15.772 68.0% 101.8%
7 Lloyd’s 16.511 45.01 73.7% 107.6%
Table 12: Top 5 reinsurance companies in 2020 by gross written premium (Life/Non-Life) and capital (Shareholder
funds) (Source: Reinsurance News). Figures in mio USD.
Many of the global reinsurers are operating offices and/or legal entities in Switzerland.
26
Top 5 Swiss Non-Life Reinsurers Top 5 Swiss Life Reinsurers

Rank Company Premium Company Premium
1 Schweizerische Rück. AG 15.7 Schweizerische Rück. AG 8.2
2 Swiss Re Corporate Solutions Ltd 3.3 New Reinsurance Company Ltd. 4.7
3 Catlin Re Schweiz AG 1.6 Swiss Re Nexus Re 1.9
4 MS Amlin AG 1.4 Kot Insurance Comp. AG 0.03
5 UNIQA Re AG 1.2 Intercona Re AG 0.03
Table 13: Booked Premiums of Swiss reinsurers for 2020 in bio CHF. [Source: FINMA Versichererreport]
3.4 MTPL Reinsurance Policy Example
MTPL Reinsurance Policy
Reinsured: Small Swiss Insurer (SSI), Bern, Schweiz.
Reinsurer: Very Large Reinsurer (VLR), Bern, Schweiz.
Period: Losses occurring during the 12 months period commencing 1st January 2022 to
31st December 2022, both days inclusive.
Class: Motor Third Party Liability (MTPL) (including Green Cards).
Territorial scope: Switzerland and all countries related to the Multilateral Agreement and to Motor
Green Cards.
Type: Excess of loss.
Limit and Priority: Layer 1:

CHF 30,000,000 ultimate net loss each and every loss in excess of CHF 20’000,000
ultimate net loss each and every loss
Maximum Annual Aggregate Limit Recoverable: CHF 60,000,000.
Layer 2:
CHF 50,000,000 ultimate net loss each and every loss in excess of CHF 50,000,000
ultimate net loss each and every loss
Maximum Annual Aggregate Limit Recoverable: CHF 50,000,000.
Premiums: Layer 1:
Deposit premium of CHF 500’000 payable in four equal installments on 1 st Febru-
ary, 1 st April, 1 st July and 1 st September and adjustable at 31 st December 2022 at
7% of Gross net earned premium income.
Layer 2:
Deposit premium of CHF 200’000 payable in four equal installments on 1 st Febru-
ary, 1 st April, 1 st July and 1 st September and adjustable at 31 st December 2022 at
3% of Gross net earned premium income.
Accounts: Annual, as soon as possible after the end of the period.

However, possibility to require a cash loss.
Information: each loss reaching or above 75% of the priority of the treaty.
27
General conditions: • All Settlements payable in CHF.
• Review Clause: The terms and conditions of this Agreement pertaining to

claim deposits will be reviewed by leading Reinsurers and the Reinsured if
there are material changes referring to this matter in the Swiss Law either in
the text of the law or in the interpretation thereof.
• Excluding:
– obligatory reinsurance and retrocession treaties; insurance and faculta-

tive reinsurance on an excess of loss basis; binding authorities, broker
covers, captive pools.
– War and Civil war exclusion clause.
– Terrorism exclusion clause as per attached.
– Nuclear energy risks exclusion clause NMA1975(a).
– Industries, Seepage, pollution and contamination clause.
– List of specific Motor exclusions as presented below.
• Ultimate net loss clause.
• Net retained lines clause.
• Claims co-operation clause.
• Follow the Fortunes clause as attached.
• Follow the Settlements clause as attached.
• Downgrading clause as attached.
• Replacement clause as attached.
• Acts in force clause.
• Rates of Exchange Clause as attached.
• Full Index Clause as attached.
• Electronic Data Exclusion as attached.
• Local jurisdiction clause.
Brokerage: 5%.
Information: Estimated Gross Net Earned Premium Income 2022: CHF 10’000’000.
Reinsurers Share: 20%.
E.& O. E.
28
SPECIFIC EXCLUSIONS
Exclusion of motor casco and as below:
1. Vehicles of armed forces.
2. Vehicles running on rails or cables, waterborne vessels, aircraft, hovercraft or any other vehicles not
designed to run on terra firma.
3. Contractor’s plant and equipment not on a public road.
4. Loss or damage to or liability for goods conveyed in connection with any trade or business on any
vehicle insured by the Reinsured (including goods in transit).
5. Vehicles used airside on airports or airfields.
6. Racing (including test runs), speed trials, trial runs and endurance tests.
7. Unless specifically agreed by the leading reinsurer, the ownership, operation, maintenance or use of
any vehicle, the principal use of which is:
• the transportation of high explosives such as nitro-glycerine, dynamite and/or similar explosives.
• the bulk transportation of liquefied petroleum or gasoline (use of a tank truck for the transporta-
tion of fuel oil is not excluded).
• the transportation of chemicals or gases in liquid, compressed or gaseous form.
TERRORISM EXCLUSION CLAUSE
This Agreement does not cover any liability assumed by the Reinsured for loss or damage directly or indirectly
occasioned by, happening through or in consequence of Terrorism.
For the purpose of this Clause an act of terrorism means an act, including but not limited to the use of force or
violence and/or the threat thereof, of any person or group(s) of persons, whether acting alone or on behalf of
or in connection with any organization(s) or government(s), committed for political, religious, ideological, or
ethnic purposes and with the intention to influence any government and/or to put the public, or any section
of the public, in fear.
This Clause also excludes loss, damage, cost or expense of whatsoever nature directly or indirectly caused by,
resulting from or in connection with any action taken in controlling, preventing, suppressing or in any way
relating to the above. Notwithstanding the above this Exclusion shall not apply where Terrorism cannot be
excluded from obligatory insurance policies under the conditions imposed by the Swiss Ministry of Finance
or any other government ministry, or any other legal act.
In that case, in respect of loss caused by Terrorism, the maximum amount of liability collectible per each and
every loss event is the minimum statutory motor third party liability limit of the country where the loss occurs
or:
• CHF 50 million from ground up whichever is the smaller for Layer 1.
• CHF 80 million from ground up whichever is the smaller for Layer 2.
ULTIMATE NET LOSS CLAUSE
The words Ultimate Net Loss shall mean the sum actually paid by the Reinsured in respect of each and ev-
ery loss each and every risk including expenses of litigation, if any, and all other loss expenses in connection
therewith of the Reinsured (excluding, however, office expenses and salaries of officials of the Reinsured)
but recoveries, including recoveries from all other reinsurances which inure to the benefit of this Agreement
whether collected or not, shall be first deducted from such loss to arrive at the amount of liability, if any, at-
taching hereunder.
All recoveries received subsequent to a loss settlement under this Agreement shall be regarded as if recovered
29
or received prior to the loss settlement and all necessary and appropriate adjustments shall be undertaken by
the Reinsured and the Reinsurers.
Nothing in this clause shall be construed to mean that losses are not recoverable from the Reinsurers until the
Ultimate Net Loss to the Reinsured has been determined.
Notwithstanding anything contained herein to the contrary it is understood and agreed that recoveries under
all Underlying Reinsurances (if applicable) are for the sole benefit of the Reinsured and shall not be taken into
account in computing the Ultimate Net Loss or losses in excess of which this Agreement attaches nor in any
way prejudice the Reinsured’s right of recovery hereunder.
NET RETAINED LINES CLAUSE
This Agreement shall only protect that portion of any insurance or reinsurance which the Reinsured, acting in
accordance with its established practices, retains net for its own account. The Reinsurers’ liability hereunder
shall not be increased due to an error or omission which results in an increase in the Reinsured’s normal net
retention nor by the Reinsured’s failure to reinsure in accordance with its normal practice, nor by the inability
of the Reinsured to collect from any other inuring reinsurers any amounts which may have become due from
them whether such inability arises from the insolvency of such other reinsurers or otherwise.
ELECTRONIC DATA EXCLUSION
Notwithstanding any provision to the contrary within the Policy or any endorsement thereto, it is understood
and agreed as follows:
(a) This Policy does not insure loss, damage, destruction, distortion, erasure, corruption or alteration of
ELECTRONIC DATA from any cause whatsoever (including but not limited to COMPUTER VIRUS) or
loss of use, reduction in functionality, cost, expense of whatsoever nature resulting therefrom, regard-
less of any other cause or event contributing concurrently or in any other sequence to the loss. ELEC-
TRONIC DATA means facts, concepts and information converted to a form useable for communica-
tions, interpretation or processing by electronic and electromechanical data processing or electroni-
cally controlled equipment and includes programmes, software and other coded instructions for the
processing and manipulation of data or the direction and manipulation of such equipment. COM-
PUTER VIRUS means a set of corrupting, harmful or otherwise unauthorised instructions or code in-
cluding a set of maliciously introduced unauthorised instructions or code, programmatic or otherwise,
that propagate themselves through a computer system or network of whatsoever nature. COMPUTER
VIRUS includes but is not limited to ‘Trojan Horses’, ‘worms’ and ‘time or logic bombs’.
(b) However, in the event that a peril listed below results from any of the matters described in paragraph
(a) above, this Policy, subject to all its terms, conditions and exclusions, will cover physical damage
occurring during the Policy period to property insured by this Policy directly caused by such listed peril.
Listed Perils: Explosion, Fire.
NMA2915
RATES OF EXCHANGE CLAUSE
In respect of losses in a currency other than that in which the monetary limits of this treaty are stated, the
Reinsurers liability shall be calculated as follows.
(a) the amounts of deductible and cover set out in the Schedule shall be converted into the currency con-
cerned at the rate of exchange ruling on the commencement date of each treaty year.
(b) any amount of loss in excess of the deductible shall be indexed in the currency in which the loss was
settled according to the index clause.
FOLLOW THE FORTUNES CLAUSE
30
Within the limits of this agreement, the Reinsurer shall in all circumstances follow the fortunes of the Com-
pany as regards all business signed by the cedant under the scope of this agreement. The obligations and
rights of the Reinsurer shall begin and end simultaneously with those of the Company, but always within the
terms of this agreement. Reinsurer will follow the fortunes of the Company, including when the instructions
to pay are dictated by a competent Swiss court of Justice or arbitration.
FULL INDEX CLAUSE
Base index: In the event of any loss hereunder the retention of the Company and the limit of liability of the
Reinsurers shall be adjusted by reference to an index, as hereinafter defined, applying at the month of January
in the manner hereinafter set out. The index of the above-mentioned date shall be called the Base Index.
Actual Amount of Loss Development: In respect of each and every loss settlement made under this treaty, the
Company shall submit a list showing in respect of each and every loss, any settlement payments, indicating
the amount(s) paid and the date(s) of payment, as well as any separately calculated loss reserve. The sum of
each and every loss settlement payment, if any, plus the current loss reserve, if any, shall for the purpose of
this clause be termed the “Actual Amount of Loss Development”.
Adjusted Amount of Loss Development: The “Adjusted Amount of Loss Development” shall be calculated in-
dividually for each and every loss settlement by the following means:
Base index
(i) Paid Loss on Day “X” ∗ = Adjusted Paid Loss
Index on Day “X”
Base index
(ii) Current O/S Loss ∗ = Current Adjusted O/S Loss
Index on Current Day
(iii) All Adjusted Paid Losses + Current Adjusted O/S Loss = Adjusted Amount of Loss Development
(where “X” designates the date of the respective payment and/or corresponding reserve, if any).
However, the above calculation shall only apply in respect of those loss developments where there is a varia-
tion of more than 10% (ten percent) between the base index and the index on the date of the loss development.
In respect of all other loss developments the "Adjusted Amount of Loss Development" shall always be equal
to the “Actual Amount of Loss Development".
The retention of the Company and the limit of liability of the Reinsurers shall then be multiplied by the fol-
lowing fraction:
Actual Amount of Loss Development

Adjusted Amount of Loss Development
Index:
a) In respect of an award resulting in continuing regular payments the index or indices to the applied shall
be that/those to which an award is linked.
b) For all other loss developments the index to be applied shall be:
i For losses settled within Switzerland: the index to be applied shall be the wage index appearing in
the monthly Bulletin of Statistics published by the Swiss Statistical Bureau (or by the International
Monetary Fund).
ii For losses settled outside Switzerland: Wage Index for the country in which the claim is settled
appearing in the statistics published by the International Monetary Fund.
In the event that the publications does not contain a Wage index for the territory concerned then the
index to be applied shall be that for the Cost of Living or Retail Prices. If the publication does not
contain any indices for the territory concerned, then an alternative publication shall be mutually agreed
between the Company and Reinsurers.
31
c) The index at the date of loss development shall be the last available index appearing in the publications
mentioned above for the month in which payment(s) is/are made.
Date of loss development shall: The date of loss development shall be deemed to be as follows:
a) The date upon which a loss reserve is set.
b) The date upon which a payment made by the Company is accepted.
DOWNGRADING CLAUSE
Reinsurer with an S&P or A.M. Best IFS Rating below A Minus: Unless otherwise agreed by the Cedent, the Rein-
surer shall at all times during the period of this Contract maintain an Insurer Financial Strength (IFS) rating
from Standard & Poor’s ("S&P") or from A.M. Best Company ("A.M. Best") equal to or greater than a rating of A
minus. In the event that a rating given to a Reinsurer by both S& P and A.M. Best differ to the extent that one of
the ratings is inferior to the other then the rating of S& P shall prevail. In the event that the IFS rating category
applied to the Reinsurer is explicitly downgraded to an IFS rating category lower than S& P A minus during
the period of this Contract, then at the sole option of the Cedent, the Cedent may elect to cancel the partic-
ipation of that Reinsurer or impose to that Reinsurer to deposit in cash the Loss Portfolio Withdrawal/Reserve.
Date of Cancellation: The effective date of such cancellation shall be determined at the sole discretion of the
Cedent provided that the date so determined shall not be earlier than the date that the notice of cancellation
is served by the Cedent to the Reinsurer.
Serving Notice of Cancellation: All notices of cancellation served in accordance with any of the provisions
above shall be served following the provisions Immediate Termination Clause in this Contract.
Transfer of the deposit in cash: The effective date of such transfer shall be determined at the sole discretion of
the Cedent provided that the date so determined shall not be earlier than 7 days as from the day the request
notice concerning deposit in cash has been sent by the Cedent to the Reinsurer.
Additional Provisions: The Cedent may also elect to cancel the participation of any individual subscribing
Reinsurer who elects during the period of this Contract to withdraw or revoke its IFS Rating from S & P or
A.M. Best.
Premium calculation: In the event of this contract being cancelled at any date other than the Expiry date of
this Contract, then the premium due to Reinsurers shall be calculated based on a prorata temporis allocation
of the annual Premium (or of the minimum premium, whichever is the greater, or the flat premium, if appli-
cable). Any Reinstatement Premium, however, shall not form part of this calculation and will not be subject
to return to the Reinsured.
REPLACEMENT CLAUSE
In the event of a reinsurer being cancelled at any date other than the Expiry date of this Contract, then the
other reinsurers still participating to the contract agree to analyze with the Company the possibility to take
over the share released or part of it.
FOLLOW THE SETTLEMENTS CLAUSE
Within the limits of this agreement, claim settlements by the Reinsured shall be in all circumstances binding
upon the Reinsurer, providing such settlements are within conditions of this Agreement and providing the
Reinsured for its part has actually paid by transferring the necessary funds or is about to pay the Insured.
32
3.5 Basis of Attachment

Definition 3.2. A reinsurance contract Basis of Attachment defines which reinsurance contract period covers a
given primary loss. These different bases have not only legal consequences, but also affect actuarial modelling.
• Risk attaching: Inception date primary insurance policy determines RI period. A single event may lead to
reinsurance losses in different reinsurance contract years for different primary insurers.
• Loss occurring: Event date determines RI coverage period. There might be ambiguity around defining the
date and time of a loss causing event. For instance, in liability insurance, an employee exposed to toxic
materials may not know the exact time of exposure (asbestos e.g., over multiple years.)
• Claims made: Date of claim reported to PI determines RI period. Claims made contract have no IBNyR
(Incurred but not yet reported) losses after the contract period. I.e., there is no unceratinty around the loss
frequency after the coverage period, but only about the loss severity.
Example 3.3 (Basis of attachment for Motor third party liability (MTPL) claims). Consider the following situation:
• Primary MTPL insurance policy has a coverage period from 1.9.2017 to 31.8.2018. An accident occurs on
1.6.2018. A whiplash claim is made a year later, 1.6.2019
• The primary insurance buys reinsurance coverage each year, covering calendar years. I.e., it purchased con-
secutive reinsurance policies: 1.1.2017 - 31.12.2017, 1.1.2018 - 31.12.2018, 1.1.2019 - 31.12.2019.
Question: Which reinsurance policy (2017, 2018, or 2019) responds to the claim?
• 2017 reinsurance policy if on risk attaching basis (The inception date 1.9.2017 of the primary policy falls into
the year 2017)
• 2018 reinsurance policy if on loss occurring basis (the event happened during 2018)
• 2019 reinsurance policy if on claims made basis (the claim was reported during 2019)
Coverage periods
reinsurance
policies 1.1 - 31.12
primary policy x x whiplash claim
2017 2018 2019 2020
Figure 32: Illustration of reinsurance basis of attachment possibilities
Example 3.4. Typical MPTL (re)insurance limits
• In France and UK coverage is unlimited by law for MTPL.
• In CH the limit is usually 100 million CHF.
• In Germany and most other European countries 100 million EUR.
33
4 Experience Pricing
4.1 Reinsurance Pricing Preliminaries
One could define, reinsurance pricing simply as the calculation of a "fair" premium for a reinsurance contract.
However, the following process-centric definition is much more appropriate:
Definition 4.1. Reinsurance pricing is a process – It involves understanding the reinsurance contract and embed-
ded risks, obtaining relevant data, assessment of all involved costs of the contract, and finally negotiations and a
commercial decision whether and how to proceed with the business opportunity.
The terms reinsurance rating and reinsurance costing are almost synonymous with reinsurance pricing.
Step 1: Step 2: Step 3: Step 4:

Understand the risk Obtain relevant data Assess costs Commercial decision
• Covered portfolio • Premium history • Premium cash flow Consider:
• Coverage period • Loss history • Loss models • Technical profitability
• Exclusions, limits • Premium rate changes • Large loss events • Uncertainty
• Contract features • Exposure data • Commissions • Client relationship
• Hours clauses • Risk profiles • Brokerage & Taxes • Legal risks
• Legal aspects • Run-off patterns • Internal Expenses Decide:
• Loss settlement process • Market indices • Reinsurance/retro costs • Write business
• Accounting rules • Loss inflation • Cost of Capital • Decline
• Broker involvement • Yield curves • Investment income • Renegotiate
Table 14: Reinsurance pricing as a process
Different types of reinsurance pricing can be distinguished, with almost all possible combinations of the following
pairs appearing in practice:
Life vs Non-Life
Relevant risks: Mortality, Longevity, Morbidity Lines of Business: Standard/Personal (motor, prop-
erty, liability), Specialties (marine, aviation, etc).
Treaty vs Facultative
A reinsurance cession covering a block of the ced- Reinsurance transacted on an individual risk basis,
ing company’s book of insurance business. negotiated on a risk by risk basis.
Proportional vs Non-Proportional
A share of all losses is reinsured, both small and Only losses above a certain threshold reinsured and
large. Trends and inflation affecting the sum of relevant. Inflation specifically affecting large losses
small losses also relevant. in focus.
Short-tail vs Long-tail
A type of insurance where claims are usually made A type of insurance where the determination of
during the term of the policy or shortly after the ultimate loss amount usually takes a long time.
policy has expired. (excess mortality, property) (longevity, liability, MTPL)
Experience vs Exposure
Pricing based on the loss experience of the specific Useful for business with no or little loss experience.
company in the past. Or if loss experience is not relevant for predicting
future behaviour.
Table 15: Treaty vs Facultative reinsurance]
In academic literature, one often encounters so called Premium principles as the basis for premium calcula-
tion. For instance, the expected value principle (P RE = E [ X RE ] + θ ⋅ E [ X RE ]), the standard deviation principle
34
(P RE = E [ X RE ] + θ ⋅ st d [ X RE ]), or others. In practice, premiums are calculated based on a combination of ex-

pected loss and loadings (taking into account profit expectations, capital costs, internal expenses, etc.). See also
Albrecher/Beirlant/Teugels"Reinsurance: Actuarial and Statistical Aspects", Section 7.1.
4.2 Burning cost analysis

Most widespread pricing technique which does not use any (stochastic) modeling techniques.
Definition 4.2 (Burning cost analysis). Burning cost analysis denotes the technique of applying past year’s loss
experience to today’s (re-)insurance contracts to get an estimate of the expected loss.
Example 4.3. Problem: Price an 15xs10 XL contract. Data: Losses occurred in years 2012-2016 exceeding 5 mio
EUR (5 mio being the "Reporting Threshold", i.e. the sum above which losses are reported).
Year Groundup Losses Losses to XL by year

2017 12, 9.5 2, 0 2
2018 (none) (none) 0
2019 18 8 8
2020 13, 7, 11 3, 0, 1 4
2021 14 4 4
18
∅= 5
= 3.6
Table 16: Illustration of a burning cost analysis, applied to price a 15xs10 XL contract based on historical losses.
Estimated expected Loss in 2017: 3.6 mio.
Definition 4.4 (Rate-on-line). The Rate-on-Line is defined as:

pr emi um
RoL =
l i mi t
Interpretation: If a layer is either loss-free or fully exhausted, and premium is equal to risk premium, then the RoL
is the probability of having a loss. RoL is often used to communicate premium rates, e.g. by used by underwriters.
5
Example 4.5. If premium in Example 4.3 above would be 5, then RoL = 15
= 33.3%.
Remark 4.6. Qualitative properties of burning cost analysis:
Pro’s Pro or Con Con’s

Simple No explicit modelling of probabilities/frequencies of loss amount Assumes stable risk profile
Efficient No consideration of inflation (of insured values)
Effective Significant unused capacity (at least in this example)
ignores IBNR’s
Table 17: Qualitative properties
Definition 4.7 (Unused capacity). Loss coverage capacity above largest historical loss.
Example 4.8. In Example 4.3, the unused capacity is between 18 and 25. If premium is determined through burn-
ing cost analysis, then the coverage for the unused capacity is free.
Remark 4.9. A naive approach would be to multiply 1) layer applied to average severity with 2) average frequency
to get an estimate of expected loss to layer. However, layer applied to expected loss is not the same as expected
loss to layer, i.e. both operations are not commutative!
N
Lemma 4.10. For a Frequency-Severity model ∑i =1 X i and an unlimited layer L D,∞ (⋅), we have
N
E [∑ L D,∞ ( X i )] ≥ E[N ]L D,∞ (E[ X i ])
i =1
35
Proof.
N
E [∑ L D,∞ ( X i )] = E[N ]E [L D,∞ ( X i )] = E[N ]E [( X i − D ) ]
+
i =1
≥ E[N ]L D,∞ (E[ X i ]) = E[N ](E[ X i ] − D )

+
The first equality follows from the first Wald identity. The inequality is a consequence of Jensen’s Inequality, since
L D,∞ (⋅) is a convex function.
Example 4.11. Using the empirical data from Example 4.3, we have
E[N ]E [( X i − D ) ] = 1.4 ⋅ 2.57 = 3.6 > E[N ]L D,∞ (E[ X i ]) = 1.4(12.07 − 10) = 2.89
+ +
Definition 4.12 (Loss inflation). Insured values tend to increase over time, which is called loss inflation. Inflation
does not refer to monetary inflation exclusively, it can also be line of business specific.
Example 4.13. Suppose that the loss observed in 2017 was 12. In past years, price inflation was 2% per annum
(p.a.). Loss from 2017 revalued to today’s value in 20122
2022−2017 5
12 ⋅ (1 + 2%) = 12 ⋅ (1 + 2%) = 13.25
Definition 4.14 (Exposure change). Exposure change denotes the changes in the underlying risks in the insured
portfolio, such as number or value of insured buildings.
Exposure correction denotes the adjustment of the model or price due to take into account exposure change.
Example 4.15 (Burning Cost Analysis - Advanced Version). Suppose that the number of insured objects in 2012
was 120 and in 2017 was 150. To correct for this exposure growth, rescale reinsured losses by adjusting with a
multiplicative factor 150/120 = 1.25.
Year Losses Inflation Inflation Revalued losses Loss to layer Exposure Exposure Annual Adjusted
FGU p.a. factor factor loss annual loss
5
(1 + 2%) 150 3.738 ⋅ 1.25
2017 12, 9.5 2% 13.25, 10.49 3.25, 0.49 120 = 1.25 3.738
= 1.104 120 = 4.673
2018 - 2% 1.08 - - 120 1.25 - -
2019 18 2% 1.06 19.101 9.10 130 1.15 9.10 10.50
2020 13, 7, 11 2% 1.04 13.53, 7.28, 11.44 3.53, 0, 1.44 140 1.07 4.97 5.32
2021 14 2% 1.02 14.28 4.28 145 1.03 4.28 4.43
2022 150 ∅ = 4.98
Table 18: Burning cost analysis (extended)
4.673 + 0 + 10.503 + 5.321 + 4.425

∅= = 4.98 ≫ 3.6
5
Remark 4.16.
• Additional qualitative properties of the advanced burning cost analysis version compared to simple variant:
Takes into account inflation, and exposure changes.
• Changes in underlying hazards cannot be taken into account.
• If no (inflated) losses hit the layer, then the burning cost is zero, which obviously can then not be used as a
basis for real pricing.
• In case the assumptions underlying the burning cost analysis are not met, more advanced loss modeling
approaches need to be used to price reinsurance contracts. For instance if data is not reflective of future
behaviour, if underlying risks have changed significantly, or if unused capacity is too large.
Example 4.17 (Gearing Effect). In Example 4.15, the loss of 12 in year 2017 inflated to 13.25 (+10.4%), but the loss
to the layer increased significantly more: From 2 to 3.25 (+62.4%).
36
4.3 Frequency-Severity Models

Definition 4.18 (Frequency-severity loss model). A frequency-severity loss model is given by
N
S = ∑ Xi ,
i =1
where
• N ∶ Ω → N is a random variable modelling the frequency,
• X i : Ω → R+ are iid random variables modelling the severity,
• N ⊥ { X i , i ∈ {1, ...., N }}.
Theorem 4.19 (Wald equalities). Under the assumptions of Definition 4.18 and if v ar ( X i ) < ∞ and v ar (N ) < ∞,
then
• E[S ] = E[N ] ⋅ E[ X i ]
2
• v ar (S ) = v ar ( X ) ⋅ E[N ] + v ar (N ) ⋅ E[ X ]
2
• if N ∼ Poi sson (λ) then v ar (S ) = λ ⋅ E[ X ].
Proof. See Lecture Notes "Non-Life Insurance: Mathematics and Statistics" by Prof. Mario Wüthrich.
Definition 4.20 (Attritional model). An "Attritional frequency-severity model" is given by:
N
S = A + ∑ Xi
i =1
where
• A = "attritional losses", i.e. "sum of all small losses"
• N and X i : "large losses", e.g. all losses above a certain threshold.
4.4 Frequency models

Definition 4.21 (Binomial distribution). A random variable N ∶ Ω ↦ N has a binomial distribution, denoted N ∼
Bi n (n, p ) with n ∈ N and p ∈ (0, 1), if
n k n −k
P[ N = k ] = ( k ) p (1 − p ) .
We have E[N ] = np and v ar (N ) = np (1 − p ) < E[N ].
Theorem 4.22 (Interpretation Binomial). A binomial random variable N ∼ Bi n (n, p ) can be written as a sum of
independent Bernoulli random variables:
n
d
N = ∑ Bi ,
i =1
where
1 with probability p,
Bi = {
0 with probability 1 − p.
Proof. Exercise.
37
Definition 4.23. A random variable N ∶ Ω ↦ N has a Poisson distribution N ∼ Poi sson (λ) with λ > 0, if
k
−λ λ
P [N = k ] = e .
k!
We have E[N ] = v ar (N ) = λ.
Theorem 4.24. N ∼ Poi sson (λ) is the limiting distribution for Bi n (n, p ) if n → ∞ and np = λ.
Proof.
n k n −k 1 n! k n −k
lim (k )p (1 − p ) = lim ⋅ ⋅ p (1 − p ) =
n →∞ n →∞ k! (n − k )!
n −k k
1 1 k k λ λ −λ λ
= lim ⋅ (n − k + 1)(n − k + 2)⋯n ( n ) λ (1 − n ) (1 − n ) =e
n →∞ k! k!
ÍÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò ÑÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò ÒÏ ÍÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò ÑÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ï ÍÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò ÑÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ï
n →∞
n →∞ n →∞
−−−−→1 −−−−→e −λ −−−−→1
Poisson processes have many interesting properties in general, but they will not be covered in the scope of this
lecture.
Definition 4.25 (Negative Binomial distribution). A random variable N ∶ Ω ↦ N has a negative binomial distribu-
tion N ∼ Neg Bi n (r, β) with r > 0 and β > 0, if
r k
k +r −1 1 β
P [N = k ] = ( k )( ) ( ) ,
1+β 1+β
where
k +r −1 Γ(k + r )
( k )=
Γ(r )k!
is a generalization of the binomial coefficient (k +kr −1) for k + r − 1 ∈ R, using the Gamma function Γ(⋅).
We have E[N ] = r β and v ar (N ) = r β(1 + β) > E[N ].

−1
Remark 4.26 (Parametrization). Note that there exist different parameterizations with e.g. p = (1 + β) , e.g. in
Antal’s script and wikipedia. However, this lecture follows the notation in the Pricing book by Pietro Parodi.
Theorem 4.27. Suppose N is Poisson distributed, conditionally on Λ: N ∣Λ ∼ Poi sson (Λ), with Λ ∼ G amma (θ =
β, α = r ). Then, unconditionally, N ∼ Neg Bi n (r, β).
Proof. See exercises.
The theorem above has a natural interpretation: Λ represents some sort of "parameter risk", which increases the
volatility of the frequency.
4.5 Selection of Frequency Models

Definition 4.28 (Panjer class). The "Panjer class" of counting distributions Ω ↦ N is given by the Binomial, Pois-
son, and Negative Binomial distributions.
Remark 4.29. Selection of frequency distributions in the reinsurance context:
• There are many classes of counting distributions, even if those three are predominantly used.
• In North American literature, also the term "(a, b, 1) class" is used.
38
• The Panjer class is the set of frequency distributions for which the Panjer algorithm can be used. The Panjer
algorithm is nowadays largely obsolete, being replaced by standard simulation techniques.
• "Reinsurance context" implies rare and extreme events. This means typically 5-20 years of data and 0.1-3
events per year. This implies that generally it is not possible to rely on Panjer factor empirical data to select
a frequency distribution (reinsurance data is not reliable for estimation purposes).
Generally only "small data" available, and one cannot rely on data only.
• The Panjer class covers the potential ratios of variance/mean:

⎧
⎪< 1 if N ∼ Bi nomi al ,
v ar (N ) ⎪
⎪
=⎪
⎨
⎪= 1 if N ∼ Poi sson,
E[N ] ⎪
⎪
⎪
⎩> 1 if N ∼ Neg Bi n.
v ar (N )
Distribution E[N ]
Appropriate if
Binomial <1 Appropriate for portfolio with (finite) small number of risks that create similar
events with equal probability p.
Poisson =1 Useful for large n and small p, or if the expected number of events is much smaller
than the theoretically possible maximum number of events. Also in situations
where the event arrivals can be assumed to be independent, with expected number
λ per time period.
NegBin >1 Appropriate frequency distribution if there is a systemic "risk driver" in the back-
ground which drives the (conditional) expectation. Note: Negative binomial is not
a "more conservative version" of Poisson.
Table 19: Selection criteria for frequency distributions.
Example 4.30. The frequency of hurricanes is often modelled with a negative binomial distribution with rate
driven by sea surface temperature (2005: Katrina, Rita, Wilma, 2017: Harvey, Irma, Maria).
Example 4.31. In the following example, AAL stands for aggregate annual deductible.
The example illustrates that negative binomial puts weight on extreme frequency events. In this case, this leads
to R having a larger mean than E[R˜∗ ]. This shows that even though the negative binomially distributed Ñ has a
∗
larger standard deviation than N , it should not be seen as "more conservative version of Poisson", since expected
loss can also decrease.
N ∼ Poi sson (1) Ñ ∼ Neg Bi n (r = 1/2, β = 2)

E[N ] = 1, v ar (N ) = 1 E[Ñ ] = 1, v ar (Ñ ) = 3
d
X i ∼ P ar et o (α = 3, x 0 = 1) X˜i = X i
N
S = ∑i =1 X i E[S ] = E[S̃ ]
v ar (S ) < v ar (S̃ )
N
R = ∑i =1 L D,C ( X i ) E[R ] = E[R̃ ]
D =C =2 v ar (R ) < v ar (R̃ )
N
R = L D,A AL (∑i =1 L D,C ( X i )) E[R ] E[R˜∗ ]
∗ ∗
>
v ar (R ) v ar (R˜∗ )
∗
A AL = 4 <
Table 20: Example illustrating the difference between Poisson and negative binomial
4.6 Excess Frequencies

Excess frequencies are an often used concept to analyze frequencies for reinsurance layers, and frequently used to
communicate with underwriters and management.
39
N
Definition 4.32. As usual S = ∑i =1 X i . We define
N
• Excess frequency at D: ND = ∑i =1 1{ X i > D },
• Expected excess frequency: λD = E[ND ],

1
• Return period at D: RP D = λD
.
• Exit frequency at D + C (for a layer L D,C (⋅)): λD +C = E[ND +C ].

N
Lemma 4.33. Let S = ∑i =1 X i (as usual), then
λd = E[ND ] = E[N ]P[ X i > D ].
Proof. Immediate consequence of the Wald equality and the definition of ND :

N
λd = E[ND ] = E [∑ 1{x i > D }] = E[N ]E[1{x i > D }] = E[N ]P[ X i > D ].
i =1
N
Theorem 4.34. Let S = ∑i =1 X i be a frequency/severity model as usual. Let D > 0 be some threshold (e.g. deductible
of an XL), and define as in Definition 4.32
N
ND = ∑ 1{ X i > D }
i =1
as well as Q = P [ X i > D ] ∈ [0, 1]. Then:
1. If N ∼ Bi n (n, p ) then ND ∼ Bi n (n, pQ ),
2. If N ∼ Poi sson (λ) then ND ∼ Poi sson (λQ ),
3. If N ∼ Neg Bi n (r, β) then ND ∼ Neg Bi n (r, βQ ).
Proof. Proof for 2.: Conditionally on N , we have that ND is binomially distributed:

m
ND ∣{N = m } = ∑ 1{ X i > D } ∼ Bi n (m,Q ),
i =1
hence
∞
P[ND = k ] = E[P[ND = k ∣N ]] = ∑ P[ND = k ∣N = m ]P[N = m ]
m =1
m k m −k
m −k (1 − Q )
∞ ∞
m k m −k −λ λ −λ k λ
= ∑ ( k )Q (1 − Q ) e =e Q ∑λ
m =k
m! k! (m − k )! m =k
ÍÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò ÒÑÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò ÒÏ
e λ(1−Q )
k
−λQ (λQ )
=e .
k!
For the two other distributions (binomial and negative binomial) one can use the moment generating function to
prove the statement, see Lecture Notes of Peter Antal.
N
Theorem 4.35. As usual, S = ∑i =1 X i . For some layer L D,C (⋅), we have
N ND
d
∑ L D,C ( X i ) = ∑ L D,C ( X̃ i )
i =1 i =1
d
with ND being the excess frequency at D and X˜i = X i ∣ X i > D.
40
Proof. Let X˜i ∼ X i ∣ X i > D, Y˜i ∼ X i ∣ X i ≤ D, and B i ∼ B er noul l i (P[ X i > D ]), all being independent. Then,
d
X i = B i X˜i + (1 − B i )Y˜i ,
since
P[B i X˜i + (1 − B i )Y˜i ≤ z ] = E[P[B i X˜i + (1 − B i )Y˜i ≤ z ∣B i ]]

= P[B i = 1]P[ X˜i ≤ z ] + P[B i = 0]P[Y˜i ≤ z ]
= P[ X i > D ]P[ X i ≤ z ∣ X i > D ] + P[ X i ≤ D ]P[ X i ≤ z ∣ X i ≤ D ]
= P[D < X i ≤ z ] + P[ X i ≤ z, X i ≤ D ]
= P[ X i ≤ z ].
By plugging this into the loss to the layer, we get

N N
d
∑ L D,C ( X i ) = ∑ L D,C (B i X˜i + (1 − B i )Y˜i )
i =1 i =1
N
= ∑ L D,C (B i X˜i ) + L D,C ((1 − B i )Y˜i )
i =1
N
= ∑ B i L D,C ( X˜i ) + (1 − B i ) L D,C (Y˜i )
i =1 ÍÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò ÑÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ï
=0p.a.s.
#{i =1,...,N ∶B i =1}
= ∑ L D,C ( X˜i )
i =1
ND
d
= ∑ L D,C ( X̃ i ).
i =1
The second and third equality follow from the fact that B i = 0 ⇒ (1 − B i ) = 1 and vice versa.
Corollary 4.36. Let λD and λD +C be the expected excess frequency at D and D + C , respectively. Then
λD +C = E[ND +C ] = λD P[ X i > D + C ∣ X i > D ].
Proof.
E[ND +C ] = E[N ]P[ X i > D + C ] = E[N ]P[ X i > D + C ∣ X i > D ]P[ X i > D ]
= λD P[ X i > D + C ∣ X i > D ]
Note that the corollary above is independent of any distributional assumptions.
4.7 Severity Distributions

In a reinsurance context, the same severity/loss distributions are used as in other insurance branches: Lognormal,
Pareto (several versions), (Log)Gamma, etc.
The following theorem provides a formula for the mean which bases exclu In case a distribution is a mix o In a
reinsurance context, loss distributions are often a mix of continuous and discrete distributions. This is due to the
deductibles, limits, etc being applied. Therefore, the following theorem to calculate means is very useful, since it
does not rely on densities.
Theorem 4.37 (Darth vader rule). For a positive random variable X ∶ Ω ↦ [0, ∞) with cdf F ∶ R ↦ [0, 1], the mean
can be calculated as
∞
E[ X ] = ∫ 1 − F X (t )dt .
0
41
Proof.
∞ ∞ ∞ ∞ ∞ ∞
E[ X ] = ∫ xdF (x ) = ∫ ∫ 1{t < x }dt dF (x ) = ∫ ∫ 1{t < x }dF (x )dt = ∫ 1 − F X (t )dt .
0 0 0 0 0 0
Note that no densities are required.
Other lectures cover the topics on selection and calibration (QRM, EVT, Nonlife insurance, stats, etc). Therefore,
for simplicity, use only Pareto distribution in this lecture.
Definition 4.38 (Pareto distribution). A random variable X ∶ Ω → R has a Pareto(x 0 , α) with x 0 > 0, α > 0 distribu-
tion, if:
y −α
P [X ≤ y ] = 1 − ( x ) for y ≥ x0 .
0
Remark 4.39.
• Exceedance probability
y −α
P[ X > y ] = ( x )
0
• Moments are given by

α k
k ⋅ x0 for k < α,
E[ X ] = { α−k
∞ for k ≥ α.
• Conditionally on being larger than some threshold, Pareto is again Pareto: if X ∼ P ar et o (x 0 , α) and D > x 0 ,
then
X ∣ X > D ∼ P ar et o (D, α).

−α
Or, equivalently if P[ X > t ] = (t /x 0 ) then
−α
( Dt ) if x > D,
P[ X > t ∣ X > D ] = {
1 else.
• "Infinite means" are only theoretical problems (as there are generally limits in (re)insurance contracts), e.g.
100 mio MTPL France/Europe and 3-5 mio TPL in CH
Lemma 4.40. Exceedance probabilities for Pareto distributions scale with power α. If X ∼ Pareto(x 0 , α), then
P[ X > t x ] −α
=t .
P[ X > x ]
Proof. Immediate consequence of the definition of the Pareto distribution:
−α
P[ X > t x ] 1 − (1 − (t x /x 0 ) ) −α
= =t .
P[ X > x ] 1 − (1 − (x /x 0 )−α )
N
Corollary 4.41. As usual, S = ∑i =1 X i . Let X ∼ Pareto(x 0 , α). Then, the previous lemma translates into the following
identities for expected exceedance frequencies and return periods at D and D + C , respectively:
−α
D +C
λD +C = λD ⋅ ( ) ,
D
+α
D +C
RP D +C = RP D ⋅ ( ) .
D
Example 4.42. The following example illustrates the scaling behaviour of Pareto distributions, and the role of the
α parameter:
Example 4.43. The following α’s are typical values:
42
Distribution P[X > 10] P[X > 100]

1
X ∼ Pareto (x 0 = 1, α = 1) 10% 1% = 10% ⋅ ( )
10
√ 1 2
X ∼ Pareto (x 0 = 10, α = 2) 10% 0.1% = 10% ⋅ ( )
10
Table 21: Pareto exceeding probability scaling behaviour
Line of Business typical α

Earthquake/storm ≈1
Fire ≈2
Fire industrial ≈ 1.5
Motor third party liability ≈ 2.5
General third party liability ≈ 1.8
Occupational injury ≈2
Table 22: Typical Pareto α’s (Source: Antal / Reinsurance Analytics script)
4.8 Experience pricing recipe

In this section, we consider a simple step-by-step approach for modeling the losses for a simple XL C xs D. In
addition, we make some assumptions on simplicity of the underlying risks:
• Non-proportional (only losses above a certain threshold are relevant)
• Short-tail (run-off is fast, no loss development is necessary)
• Non-Natural catastrophe (for Nat cat, dedicated models are used)
• Experience pricing (we assume the past losses to be reflective of future exposure, risk and uncertainty)
These simplifying assumptions on the underlying risks are not unrealistic or rare. In case one or many of those
assumptions are not met, there are extensions of the pricing approach below to account for the additional com-
plexity.
Recall pricing 4-step process described earlier: Understand the risk – Obtain relevant data – Assess costs – Com-
mercial decision. We will now consider in more detail how Step 3 can be executed in this simple situation:
• Step 3a: Selection of modelling threshold (MT)
• Step 3b: Selection and calibration of frequency distribution at the MT.
• Step 3c: Selection and calibration of severity distribution
• Step 3d: Application of frequency/severity model to reinsurance program
• Step 3e: Sense checks
Example 4.44. Consider the problem of pricing an XL program consisting of three layers: 5 xs 5, 10 xs 10, 10 xs 20.
Suppose we have the same loss data as in the burning cost analysis example.
• Exposure assumed constant (no adjustment necessary) + losses already indexed.
• Why is coverage from 5 to 30 mio split into 3 layers? Easier to sell layers if they are split up (also different
clauses for each layer).
• Unused capacity:
– 5xs5: none.
– 10xs10: between 18 and 20.
43
30
10xs20
Year loss
20
2017 12, 9.5
2018 0 10xs10
2019 18
2020 13, 7, 11 10
2021 14 5xs5
0
2017 2018 2019 2020 2021
Figure 33: Program and losses
– 10xs20: "non-working layer" → need stochastic modelling.
• Observation: not all potential events are covered in data ⇒ need stochastic loss modelling.
Suppose we want to price a reinsurance program with the layers 5xs5, 10xs10 and 10xs20
• Step 3a: Selection of modelling threshold (MT)
– MT needs to be lower than the lowest deducible

– MT needs to be larger than the reporting threshold
– Lower modelling threshold gives more data points but not necessary more useful information
– Lowest deductible 5
– Reporting threshold 3
– For simplicity and illustration, we choose MT = 5. This also implies that the modelled frequency is
directly the frequency at the attachment point.
• Step 3b: Selection and calibration of frequency distribution at the MT.
– Empirical expected frequency:
#l osses > 5 7
= = 1.4.
#year s 5
– Suppose no systemic risk driver behind the frequency, thus select N ∼ Poi sson (1.4).
– The empirical variance to mean ratio is v arˆ (N )/Ê[N ] = 0.93. However, the sample size is clearly too
small to judge from the fact that this ratio is below 1 that a binomial distribution is more appropriate.
Sample sizes in reinsurance are generally too small to make judgments on the frequency distribution
class based on data.
• Step 3c: Selection and calibration of severity distribution (generally, use distribution with support starting at
MT).
– usually distributions with support starting at modelling threshold are used

– X i ∼ Pareto (x 0 = 5(= M T ), α =?), how to determine α?
– Rigorously: Extreme Value Theory. On the blackboard: maximum likelihood:
n −1
xi
α̂ = n ⋅ (∑ ln ( x )) = 1.184
0
i =1
– X i ∼ Pareto(x 0 = 5, α = 1.184)
44
• Step 3d: Evaluate reinsurance program based on selected frequency/severity model.
– Simulate from frequency/severity model and apply groundup losses to reinsurance structure to evalu-
ate the distribution of the reinsured losses. Calibrate premium based on expected loss and loadings.
– Calculate expected reinsured loss distribution.
N D +C D +C
t −α
E [∑ L D,C ( X i )] = E[N ]E[L D,C ( X i )] = E[N ] ∫ (1 − F X (t ))d t = E[N ] ∫ (x ) dt
D D 0
i =1
t
1 −α »»D +C x
α
)»»»
1 −α 1−α
= E[N ] ⋅ 0 ((D + C )
α
= E[N ]x 0 ( −D )
1 − α »»D 1−α
N
Layer D C E[∑i =1 L D,C ( X i )] E[ND ] E[ND +C ]
5 xs 5 5 5 4.56 1.40 0.62
10 xs 10 10 10 4.01 0.62 0.27
10 xs 20 20 10 2.12 0.27 0.17
Table 23: Model statistics per layer
• Step 3e: Sense checks
1. Compare to burning cost analysis

2. Test sensitivity to indexation and trending assumptions.
E.g. Marine 5% per year (past losses get inflated significantly).
Historically, MTPL losses are rarely exceed 40 mio, but with indexation they can easily go above 100
mio.
3. Is the frequency at the attachment point plausible? Through the calibration approach, the modelled
expected frequency is equal to the empirical average.
4. Is the frequency at the limit point of the of the program plausible? (has a big impact on the expected
loss and hence on the premium charged to client. Many reinsurance companies have pricing guide-
lines, prescribing minimum frequencies at the limit in order to avoid the risk of underpriced unused
capacity.)
45
5 Exposure Pricing
Experience pricing relies on historical loss data ("experience") to predict future loss behaviour. In case historical
losses is scarce, unavailable, or unrelated to future losses, so called exposure pricing approaches can be used.
Definition 5.1 (Exposure pricing). The term exposure pricing denotes pricing techniques based on risk profiles or
other policy policy data, and which do not rely on loss experience.
Such approaches can also be used if a portfolio is inhomogeneous or rapidly changing. For instance, for startup
insurance companies.
Overall, there are two types of exposure pricing:
(a) Exposure pricing for property: In this case, sum insured or probable maximum losses (PML) exist.In this
case, so called "exposure curves" are used.
(b) Exposure pricing for casualty/liability: No maximal groundup liability (analogous to sum insured) exists.
In this case, so called "Increased limit factors" are used.
The following document may serve as potential additional literature: "Exposure models in reinsurance" by Michal
Bosela (VIG Re).
5.1 Exposure pricing in property (re)-insurance

Example 5.2. The following table shows a typical example for exposure data received for reinsurance pricing pur-
poses.
Band min SI max SI Premium average SI LR

1 500 k 1 mio 10 mio 750 k 60 %
2 1 mio 1.1 mio 5 mio 1.05 mio 60 %
3 1.1 mio 1.2 mio 4 mio 1.15 mio 60 %
4 1.2 mio 1.3 mio 1 mio 1.25 mio 60 %
Table 24: Banded premium and SI information.
5.1.1 Definition Exposure Curves
Example 5.3. Consider the following set of losses, and the corresponding sum insureds:
30 30
30
25
20
20
Loss
15
Sum insured
12
10
10
0
1 2 3 4 5
Figure 34: Example of five losses together with the corresponding sum insured.
We can make two observations:
• The portfolio appears to be very inhomogeneous in terms of sum insureds {SI i } = {30, 10, 20, 30, 12}
46
• There is a significant probability to observe a full limit loss X i = SI i : I.e., P[ X i = SI i ] > 0.

These two observations imply that neither making the assumption of i.i.d. losses is sensible nor the tail extrapola-
tion of loss experience. I.e., a classical frequency-severity model cannot be calibrated directly on this loss history
without adjustments or corrections.
To circumvent the problems with the homogeneity assumption, we can transform the problem by translating
losses to amounts relative to the sum insured. We do this by defining a damage ratio (or loss degree):
Definition 5.4 (Damage Ratio). For a loss X i limited by a sum insured SI i , we define the damage ratio as
Xi
Zi = .
SI i
This definition can be used to replace the direct stochastic modelling of X i as a random variable with the modelling
of Zi . I.e., let Zi ∶ Ω → [0, 1] being the iid damage ratios. This approach automatically takes care of inhomogeneous
portfolios in terms of SI i .
Example 5.5. The damage ratios in Example 5.3 are given by 83%, 100%, 75%, 10%, 100%.
0.8
0.6
0.4
0.2
1 2 3 4 5
Figure 35: Damage ratios for our set of losses.
Definition 5.6 (Exposure curve). For a random damage ratio Z ∶ Ω ↦ [0, 1], we define the "exposure curve" G (⋅)
as
λ
1
G (λ) = ∫ 1 − F Z (t )dt for λ ∈ [0, 1],
E[ Z ] 0
with G (λ) = 0 for λ < 0, G (λ) = 1 for λ > 1.
5.1.2 Exposure Curve Examples
Example 5.7. A given insurance portfolio produces:

• 10% of claims that are total damages,
• 50% of claims are 60% partial damages,
• and 40% of claims are 25% partial damages.

I.e., P[ Z = 100%] = 10%, P[ Z = 60%] = 50%, P[ Z = 25%] = 40%, E[ Z ] = 50%. This leads to
⎧
⎪ 0, t < 25%,
⎪
⎪
⎪
⎪ 40%, 25% ≤ t < 60%,
F Z (t ) = ⎪
⎨
⎪
⎪
⎪ 90%, 60% ≤ t < 100%,
⎪
⎪
⎪
⎩ 100%, 100% ≤ t
and
⎧
⎪d , 0% ≤ d ≤ 25%,
1 ⎪ ⎪
⎪
G (d ) = ⋅ ⎨10% + 60% ⋅ d , 25% ≤ d ≤ 60%,
50% ⎪⎪
⎪
⎪
⎩ 10% + 36% + 10% ⋅ d , 60% ≤ d ≤ 100%.
47
Degree of Damage Distribution F Exposure Curve G

100% 100%
100% ⋅ d
Reduction of the Expected Claim [in%]

90% 90%
80% 80%
60% ⋅ d
Cumulative Probability
70% 70%
60% 60%
50% 50%
40% 40%
30% 30%
20%
40% ⋅ d 20%
10% 10%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Degree of Damage Deductible [in%]
Figure 36: Exposure curve as in Example 5.7. (Example inspired by "Exposure Rating in Reinsurance", Michal
Bosela)
Example 5.8. A given insurance portfolio produces:
• 10% of claims that are total damages,
• and 20% of claims are 10% partial damages
I.e., P[ Z = 100%] = 10%, P[ Z = 80%] = 40%, P[ Z = 40%] = 30%, P[ Z = 10%] = 20%, E[ Z ] = 56%. Then
⎧
⎪ 0, t < 10%,
⎪
⎪
⎪
⎪
⎪
⎪ 20%, 10% ≤ t < 40%,
⎪
F Z (t ) = ⎪
⎨
⎪ 50%, 40% ≤ t < 80%,
⎪
⎪
⎪
⎪ 90%, 80% ≤ t < 100%,
⎪
⎪
⎪
⎪ 100%, 100% ≤ t
⎩
and
⎧
⎪ d, 0% ≤ d ≤ 10%,
⎪
⎪
1 ⎪⎪
⎪ 2% + 80% ⋅ d , 10% ≤ d ≤ 40%,
G (D ) = ⋅⎨
⎪
56% ⎪
⎪ 2% + 12% + 50% ⋅ d , 40% ≤ d ≤ 80%,
⎪
⎪
⎪
⎩2% + 12% + 32% + 10% ⋅ d , 80% ≤ d ≤ 100%.
5.1.3 Properties of Exposure Curves
Lemma 5.9. Interpretation: G (λ) is the ratio of the expected loss for an insurance limited at λSI, divided by the
unlimited loss ("scaled limited expected value"):
E[min{ X i , λSI }]
G (λ) = .
E[ X i ]
48
Degree of Damage Distribution F Exposure Curve G

100% 100%
Reduction of the Expected Claim [in%]

90% 90%
80% 80%
Cumulative Probability
70% 70%
60% 60%
50% 50%
40% 40%
30% 30%
20% 20%
10% 10%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Degree of Damage Deductible [in%]
Figure 37: Exposure curve as in Example 5.7. (Example inspired by "Exposure Rating in Reinsurance", Michal
Bosela)
Proof.
E[min{ X i , λSI }] E[min{ Z , λ}] 1 ∞ 1 λ

= = ∫ 1 − Fmin{ Z ,λ} (t )dt = ∫ 1 − F Z (t )dt .
E[ X i ] E[ Z ] E[ Z ] 0 E[ Z ] 0
Example 5.10. Suppose you want to insure a building with
E[ X i ] = 100 000,
′
SI = 10Mi o, D = 0, C + D = 5Mi o.
This leads to (C + D )/SI = 0.5 and D /SI = 0. Combined with G (0.5) = 0.7, we obtain
E[L 0,5Mi o ( X i )] = 0.7E[ X i ] = 70 000.

′
0.7
0.5 1
Figure 38: Exposure curve as in Example 5.10.
Lemma 5.11. For exposure curves as in Definition 5.6, we have
1. G is a monotonically increasing concave function with G (0) = 0 and G (1) = 1,

1
2. E[ Z ] = ,
G ′ (0 )
49
G (x )
′
3. F Z (x ) = 1 − ,
G ′ (0 )
G (1 )
′
4. P[ Z = 1] = ,
G ′ (0 )
5. When only full losses are possible (i.e., if P[ Z = 1] = 1) then we get the straight line G (x ) = x.
1
Proof. The identities G (0) = 0 and G (1) = 1 follow from E[ Z ] = ∫0 (1 − F Z (t ))dt . Taking the derivative of
x
1
G (x ) = ⋅ ∫ (1 − F Z (t ))d t
E[ Z ] 0
leads to
1
G (x ) = ⋅ (1 − F Z (x )),
′
E[ Z ]
1 1
G (0 ) = ⋅ (1 − F Z (0)) =
′
.
E[ Z ] E[ Z ]
We have G (x ) > 0, therefore concavity of G. Using these results, we can derive

′
G (x ) G (1 )
′ ′
P [ Z = 1] = lim P [ Z ≥ x ] = lim (1 − F Z (x ) = lim = ,
x →1 x →1 x →1 G ′ (0) G ′ (0 )
where G (1) is meant as a left-derivative.

′
Remark 5.12. Note that there is a one-to-one correspondence between the exposure curve and the loss distribu-
tion. I.e., given G (⋅) and E[ X ], there is a frequency-severity model which represents the same loss model.
5.1.4 Application of Exposure Curves to Risk Profiles
Theorem 5.13. Given a portfolio of n risks with sums insured {SI i , ...., SI n }. Suppose the loss X i can be written as
X i = B i ⋅ Zi ⋅ SI i ,
where B i ∼ Bernoulli i.i.d., Zi ∶ Ω → [0, 1] i.i.d., and B i ⊥ Zi . Then

n n
C +D D
E [∑ L D,C ( X i )] = ∑ E[ X i ] [G ( )−G ( )]
SI i SI i
i =1 i =1
Proof. Representing X i in terms of the damage ratio, and using the definition of G (⋅), we get
E[L D,C ( X i )] = E[min{ X i ,C + D }] − E[min{ X i , D }]

SI i
= (E [min {B i Zi SI i , D + C }] − E [min {B i Zi SI i , D }])
SI i
D +C D
= SI i (E [B i min { Zi , }] − E [B i min { Zi , }])
SI i SI i
1 D +C 1 D
= E[B i ]SI i E[ Zi ] ( E [min { Zi , }] − E [min { Zi , }] ).
ÍÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò ÑÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ï E[ Zi ] SI i E[ Zi ] SI i
=E[ X i ] ÍÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò ÑÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ï ÍÒÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò ÑÒ Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ò Ï
C +D D
definition of G ( ) =G ( )
SI i SI i
Remark 5.14.
• The loss to the layer CxsD depends only on E[ X i ] and the exposure curve applied to values depending on
layer & SI.
50
• Replaced the task of estimating E[L D,C ( X i )] with estimation of E[ X i ] and G(⋅).
• Exposure rating gives us a mathematically consistent pricing of reinsurance contracts
Corollary 5.15. Suppose, in addition to the assumptions of the theorem:
• Loss ratio is known: E[ X i ] = LR ⋅ P i

˜ 1 , ...., SI
• There are "Premium bands", i.e., a small subset {SI ˜ K } with n ≥ K such that:
˜ 1 , ...., SI
SI i ∈ {SI ˜ K} for all i .
Then
n K
D +C D
E [∑ L D,C ( X i )] = LR ⋅ ∑ (G ( )−G ( )) ⋅ ∑ Pi
˜
SI k ˜
SI k
i =1 k =1 ˜ k}
{i ∶SI i =SI
where
• The exposure curve evaluated for the band k is:
D +C D
G( )−G ( )
˜k
SI ˜k
SI
˜ k is
• The aggregated premium for band k, for policies with SI i = SI
P̃ k = ∑ Pi .
˜ k}
{i ∶SI i =SI
Proof. Using the results of Theorem 5.13, we get
n n K
C +D D C +D D
E [∑ L D,C ( X i )] = ∑ E[ X i ] [G ( )−G ( )] = ∑ ∑ LR ⋅ P i ⋅ [G ( )−G ( )]
SI i SI i ˜
SI k ˜
SI k
i =1 i =1 ˜ k}
k =1 {i ∶SI i =SI
K
D +C D
= LR ⋅ ∑ P̃ k (G ( )−G ( )) .
˜
SI k ˜
SI k
k =1
Example 5.16. Primary insurances often provide premium and SI information on a banded base. For this example,
suppose we are given the banded information as in Table 24.
Suppose we want to price 0.2 xs 1 Mio XL with the following data provided.
We have D = 1mi o, C = 0.2mi o, D + C = 1.2mi o. We use SI˜ = average SI.
D +C D D +C D
Band ˜
SI G( ) G( ) LR LR ⋅ ∑ P ⋅ (G () − G ())
˜
SI ˜
SI ˜
SI ˜
SI
1⋅2
1 750 k = 1.14 > 1 >1 1 1 60 % 0
0.75
2 1.05 mio >1 0.952 1 0.98 60 % 60 k
3 1.15 mio >1 0.87 1 0.94 60 % 144 k
4 1.25 mio 0.96 0.8 0.99 0.92 60 % 42 k
E[∑ L D,C ( X i )] = 246k
Table 25: Computation of the expected loss to layer.
Therefore, by applying the different calculation steps of the corollary, we find an expected total loss for this port-
folio to the 0.2xs1 mio XL of 246’000.
51
5.1.5 Detailed Illustration
In this example, we consider a larger set of losses and sum insureds to construct the corresponding exposure curve.
20
19
17
15 15
Observations
13
11
10
9
7
5 5 Losses
Losses 3 Sum insured
Average = 6.85
1 1
0 5 10 15 20 0 5 10 15 20
Losses Losses and Sum insured
20
19
Average = 39.1%
17
15 15
Observations
13
11
10
9
5 5
1 1
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Degree of damage by observation Degree of damage ordered
Figure 39: Top Left: Losses, Top right: losses and sum insured, Bottom left: degree of damage by observation,
Bottom right: degree of damage ordered by size.
52
Spread / Diversified risks

100%
less likely to have a total loss
Reduction of the Expected Claim [in %]

90%
Reinsurer 80%
20%, 42.6% Concentrated risks
70% more likely, if there is a
60% loss, that it is a total loss
50%
40%
Cedent
30%
20%
10%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Deductible [in %]
Figure 40: Exposure curve. Interpretation: With a deductible of 20% of the SI PML, the indemnity is reduced by
42.6% of the risk premiums.
5.2 MBBEFD - Distributions

Problem: Where does the exposure curve G(⋅) come from?
Solution: calibrate exposure curve to industry data, which comes from (industry) loss data, which is similar to the
risks insured.
Quote from Bernegger 1993 paper:
Distributions functions of the type (3.1) defined on the interval [0, ∞] or [−∞, ∞] are very well
known in statistical mechanics (maxwell-Boltzmann, Bose-Einstein, Fermi-Dirac, and Planck distri-
bution). The implementation of these functions in risk theory does not mean that the distribution of
insured losses can be derived from the theory of statistical mechanics. However, the MBBEFD dis-
tribution class defined in (3.1) shows itself to be very appropriate for the modelling of empirical loss
distributions on the interval [0, 1]. (Bernegger 1993)
Definition 5.17 (MBBEFD exposure curves). The class of MBBEFD exposure curves is given by (b ≥ 0, g ≥ 1):
⎧
⎪ x if g = 1 or b = 0,
⎪
⎪
⎪
⎪ ln(1+(g −1)x )
⎪
⎪ if b = 1 and g > 0,
G b,g (x ) = ⎪
ln(g )
⎨
⎪ 1−b
x
⎪
⎪ if bg = 1 and g > 0,
⎪
⎪ 1 −b
⎪
⎪ ln [
(g −1)⋅b +(1−g b )b
x
] ⋅ ln(1g b )
⎪
⎩ 1 −b
and b > 0 and b ≠ 1 and bg ≠ 1 and g > 1.
Remark 5.18. Properties of MBBEFD distributions:

• MBBEFD curves were invented by Bernegger (Swiss Re) in 1993: MB: "Maxwell - Boltzmann", BE: "Bose -
Einstein", FD: "Fermi - Dirac". bg > 1 (FD), bg = 1 (BE), bg < 1 (MB)
• Only depend on 2 parameters and are suitable for many property insurance branches
• Choice of the exposure curve is often subjective, i.e., requires in-depth knowledge of the analysed portfolio
• The underlying cdf is given by F (x ) = 1 − G (x )E( Z ), which equates to

′
⎧
⎪ 1 if x = 1,
⎪
⎪
⎪
⎪
⎪
⎪ 0 if x < 1 and (g = 1 or b = 0),
⎪
⎪
⎪
F b,g (x ) = ⎨ 1 − 1−(g1−1)x if x < 1 and b = 1 and g > 1
⎪
⎪
⎪
⎪ x
⎪
⎪ 1−b if x < 1 and bg = 1 and g > 1
⎪
⎪
⎪
⎪ 1 − (g −1)b 11−−x b+(1−g b ) if x < 1 and b > 0 and b ≠ 1 and bg ≠ 1 and g > 1.
⎩
53
Because of a positive probability for a total loss 1/g the density function f b,g is only defined in [0, 1).
• The probability of a total loss P [ Z = 1] can be nicely expressed as
G (1)
′
1
P [ Z = 1] = = g.
G ′ (0)
1
• The expected damage ratio is given by E[ Z ] = G ′ (0 )
, which is equal to
⎧
⎪ 1 if g = 1 or b = 0,
⎪
⎪
⎪ ln(g )
⎪
⎪
⎪ g −1 if b = 1 and g > 1,
E[ Z ] = ⎪
⎨
⎪ b −1
⎪
⎪ if bg = 1 and g > 1,
⎪
⎪
ln(b )
⎪
⎪ ln(g b )(1−b )
⎪
⎩ ln(b )(1−g b )
if b > 0 and b ≠ 1 and bg ≠ 1 and g > 1.
• The parameter b has no direct interpretation → derived iteratively from E[ Z ]. Possible calibration method:
match g and b with empirical values for P[ Z ] and E[ Z ]. Alternative: maximum likelihood estimation.
• MBBEFD curves are not sensitive to inflation (take SI or MPL) + they were estimated on a market portfolio
which is different from the analyzed portfolio.
• What if there is no data to calibrate an MBBEFD exposure curve? Take a curve in the literature. Swiss Re Yc
curves are very common among non-proportional underwriters.
Definition 5.19 (Swiss Re exposure curves). The "Swiss Re curve" with concavity parameter c ≥ 0 is given by
MBBEFD(b c , g c ) where:
α+βc (1+c )
bc = e ,
(γ+δc )c
gc = e ,
where α = 3.1, β = −0.15, γ = 0.78, δ = 0.12.
Example 5.20. Popular "SwissRe" curves: c = 0 corresponds to a total loss and a 45 degree (straight line) exposure
curve.
Name c Type of business

"Swiss Re 1" 1.5 Personal lines
"Swiss Re 2" 2 Commercial lines (small scale)
"Swiss Re 3" 3 Commercial lines (large scale)
"Swiss Re 4" 4 Industrial lines
Lloyd’s Y5 Industry 5 Industrial
Table 26: Regularly used Swiss Re curves.
5.3 Increased Limit Factors

• Property exposure pricing: models based on max loss/sum insured and damage ratio distribution between
0 and 100%.
• Liability insurance (GTPL, MTPL): no "maximum" loss exists. The maximum insured value has no relation
to the value of some object. Loss indemnifications are determined by courts (MPL can be much higher than
SI). Therefore SI cannot be used as reference value.
54
N
Definition 5.21 (Increased Limit Factor). Let ∑i =1 X i be a Frequency-Severity model with the usual assumptions.
Then, I LF B (L ) is the increased limit factor at limit L and with basis limit B (L > B ).
E[min{ X i ; L }]
I LF B (L ) =
E[min{ X i ; B }]
L
∫0 1 − F X (t )dt
= B
.
∫0 1 − F X (t )dt
Example 5.22. Application in practice:
• Application to increased limits

N
E [∑ min{ X i ; L }] = E[N ]E[min{ X i ; L }]
i =1
E[min( X i ; L )]
= E[N ]E[min( X i ; B )]
E[min( X i ; B )]
N
= E [∑ min( X i ; B )] I LFB (L )
i =1
• Application to increased layers:

N
E [∑ min {( X i − D ) ;C }] = E[N ] (E[min( X i ; D + C )] − E[min( X i ; D )])
+
i =1
N
= E [∑ min{ X i ; B }] (I LFB (D + C ) − I LFB (D ))
i =1
• By using an ILF curve, we replace the task of estimation of the expected loss under limit L with the estimation
of the expected loss under limit B plus an ILF curve.
Lemma 5.23. For t > B , we have:

B
d
F X (t ) = 1 − (∫ 1 − F X ( y )dy ) I LF B (t ).
0 dt
Proof. Immediately follows after taking the derivative of I LF B (x ):
1 − F X (t )
I LF B (t ) =
′
.
E[min( X , B )]
Note: Even if I LF B (x ) is known, the severity distribution F X (t ) is known only up to constant.
Definition 5.24 (Riebesell curve). A Riebesell curve with parameter δ > 0 is given by an ILF where doubling the
limit increases the expected loss by a factor (1 + δ):
E [L D,2C ( X )] = (1 + δ)E [L D,C ( X )] .
Remark 5.25. Comments on ILF curves
• Sources for ILF curves:
– US: The "Insurance Service Office" (ISO) provides ILF curves for the US market
– Europe: often "Riebesell" curves are used.
• For arbitrary limit increase factors a > 1 under a Riebesell curve, we get
log2 (a )
E [L D,aC ( X )] = (1 + δ) E [L D,C ( X )] .
55
• I LF B (L ) curves depend on basis B, which is a nominal amount ⇒ affected by inflation (Riebesell is im-
mune). ILF curves are valid only for specific business (due to dependence on severity) and specific point in
time (due to claims inflation).
• Riebesell curves are not affected by this issue (Riebesell parametrisation is inflation resistant).
i
• E[L D,2i C ( X i )] = (1 + δ) E[L D,C ( X i )] → this is inflation-resistant.
• Estimation of ILF curves based on industry data (similar to exposure pricing, but with enlarged set of indus-
try loss data).
• For pricing unused capacity: exposure rating calibrated to the lower limited layer, then extended to the un-
used capacity through ILF.
Lemma 5.26. If a portfolio satisfies the Riebesell equality with parameter δ, then the severity F X (t ) follows F X (t ) =
x −α
1 − ( ) for some α < 1.
δ
Proof. Mack and Fackler (2003)
Surprising that α < 1, implying infinite mean severity. Does not make sense theoretically, but practically no issue
since unlimited layers exist only in rare cases (motor France and UK), where such an approach should anyway not
be used.
56
6 Insurance Linked Securities

6.1 ART and ILS
This section covers insurance linked securities (ILS), which belong to the broader class of alternative risk transfer
techniques (ART).
The traditional Reinsurance market can effectively and efficiently deal with many types of risks to which insurance
companies are exposed to. However, the reinsurance market can be:
1. too small for some risks, or
2. too restricted on risk categories, or
3. too expensive.
Example 6.1. Consider the case of an industrial manufacturing company (e.g. a car producer). Such a company is
today typically exposed to many types of risks: Political risks, Economic risks, financial market risks, FX risk, legal
risks, environmental risks, energy availability, regulatory risks, reputational risks, shortage of talent, supply-chain
risks, cyber risks, accident and health risks, natural catastrophes.
Of those risks, only few are "insurable", i.e. have standard (re)insurance protection schemes: NatCat, accident &
health. Other risks, such as supply-chain risks and cyber risks can be insured up to a certain degree, albeit with
probably very high premium costs. However, many of those risks are not insurable at all.
In these cases, alternative risk transfer constructions can help risk bearing entities to transfer risk to the insurance
and capital market.
Definition 6.2. Alternative Risk Transfer (ART) refers to techniques allowing risk-bearing entities such as insur-
ance companies to transfer risks through approaches differing from standard (re)insurance mechanisms.
Hence, the term alternative risk transfer is very broad. Even worse, it is often used inconsistently: The defini-
tion above is not agreed upon on an industry-wide basis. One may think of ART representing the risk transfer
techniques which differ from the usual QS or XL reinsurance contracts. The differing feature can be on the legal
construction, risk scope, market placement, contract duration, recovery mechanism, or a combination of those.
The need for ART constructions was initially a consequence of a series of (re)insurance capacity shortages dur-
ing 1970s to 1990s, when it was difficult for insurance companies to obtain protection against certain types of risk
through traditional reinsurance. For instance, the creation of the Swiss elementary perils pool (Elementarschaden-
pool) and the Swiss nuclear pool (Schweizer Nukearpool) can also be seen in this context.
Example 6.3. Since 2006, the capital deployed to alternative risk transfer market has increased from 4% to 16%.
Alternative capital Traditional capital 650

625
575 565 595 605 604
600
540
511
Capital in bio USD
471 456
410 400
400 385
340 556
516 507 530
511 493 514
467 490
447 428
200 368 388 321 378
64 72 81 89 97 95 94
17 22 19 22 24 28 44 50
0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Figure 41: Global reinsurance and ART/ILS Capital. Source: "Aon Benfield: Reinsurance Market Outlook 2021."
Definition 6.4. Insurance Linked Securities (ILS) are securities, i.e. financial instruments on the capital market,
whose value is driven by events which are potentially linked to insurance losses.
57
Hence, ILS are a subset of ART. The term insurance-linked security encompasses catastrophe bonds and other
forms of insurance risk-linked securities. The distinguishing feature of ILS compared to the broader set of ART is
that ILS are securities on the capital market.
The key difference between reinsurance markets and ILS markets is the securitisation. This makes insurance risk
an investible asset class that broader capital markets can access. Furthermore reinsurance is based on a pledge
("promise") supported by a rating leading to counterparty credit risk. ILS circumvents this pledge by fully collat-
eralising the limit amount with the goal to eliminate counterparty credit risk.
There are two main reasons for the commercial viability of ILS:
• The size of the capital market is larger than the insurance market by multiple orders of magnitude. In addi-
tion, investors are less constrained on risk categories. Therefore, the potential capacity of risks bearers is a
lot less constrained in the capital market.
• The fact that ILS are usually collateralized up to the full limit loss eliminates credit risk and avoids potential
capital charges due to credit risk for investors.
• Investors find ILS attractive since the risks underlying ILS typically show a low level of correlation to the
usual other financial instruments such as bonds and stocks. The occurrence of a large natural catastrophe
is usually not coinciding with drops in capital markets. Financial crises do not cause natural catastrophes,
and natural catastrophes are very unlikely to cause systemic financial crises. According to basic financial
investment theory, investing in uncorrelated risks reduces the overall risk in a portfolio. In other words, ILS
diversify very well and even more are theoretically zero-beta investments in investment lingo.
Within ILS, usually four categories of transactions are separated:
• Collateralized reinsurance: A reinsurance contract where the full limit amount is collateralized, implying
that it can be written with a counterparty which does not have a formal regulatory license as reinsurer.
• Industry loss warrants: An ILS having a payout linked to the overall undustry loss for a certain event type.
• Catastrophe Bonds ("Cat bonds") are ILS, which transfer the risk related to catastrophes (natural or man-
made) through a bond.
• Quota share sidecars: A financial entity that solicits private investment (e.g. from hedge funds) in a quota
share treaty in order to spread risk, such that private investors can participate in reinsurance risk even with-
out a reinsurance license.
Among those four categories, collateralized Re takes the highest share.

Cat bonds are a specific type of ILS to create risk-linked securities which transfer specific risks from the issuer (or
"sponsor") to investors on the capital market. They represent a specific form of securitisation that aims to achieve
a higher level of liquidity than traditional reinsurance by means of transparency and exchange listing.
Cat bonds are usually placed in a special format complying with rule 144A of SEC in the US. Compliance with rule
144A provides higher liquidity than a placement without this rule.
Cat bonds transfer specific risks, usually natural or man-made catastrophes to investors. The investor provides
the principal at inception, and usually earns an attractive return above risk-free on that investment under the
condition that a specified qualifying event does not occur. In case such an event occurs, the investor loses the
principal, which is received by the sponsor (usually an insurance or reinsurance company) to cover their losses.
Example 6.5. The following figure illustrates the relation of ART, ILS, and Cat bonds.
• Examples for ART constructions which are not ILS: Captives, contingent capital, Sidecars.
• Examples for ILS constructions which are not cat bonds: longevity swaps.
58
All forms of risk transfer which are not

through standard reinsurance contracts
Alternative Risk Transfer
with reinsurance companies
Insurance Linked Insurance risk transfer

Securities through securitization
onto capital market
Cat Bonds
Transfer of catastrophe risk
through a bond
Figure 42: Relation of ART, ILS, and Cat bonds.
6.2 Construction of ILS

This section covers the contractual construction of ILS, which is different to the legal construction of normal rein-
surance contracts.
In the reinsurance market, transactions are done between well-known, well-capitalized, and well-credit-rated
companies: the insurance and the reinsurance company. There is a high level of trust, a level playing field, with the
goal of entering and maintaining a long lasting contractual relationship. Therefore, reinsurance is done through
direct contractual relationships between the risk carrier (usually an insurance company) and the reinsurer:
reinsurance contract
Risk carrier ⇐=================⇒ Reinsurance company
Even if it is theoretically possible to eliminate credit risk for normal reinsurance contracts, this risk is usually ac-
cepted by the reinsured due to the credit rating and pledge by the reinsurance company to honor its liabilities and
maintain a long term relationship.
On the capital market, actors do not necessarily know each other, capitalization is unknown or unclear, and actors
may not have a credit rating by rating agency. Hence, there is little trust, no pledge by a reinsurance company, and
an unknown or high credit risk for potential counterparties. Therefore, a direct contractual relationship as in the
reinsurance market is not feasible in case a risk carrier (insurance company) intends to transfer risk to an investor
on the capital market.
hhhh ((
reinsurance contract
h(((
Risk carrier (
⇐=(
==(
===
(==(==h
==h
=== h Investor
==h
h ⇒
not feasible
Instead of entering a direct contractual relationship, two measures are taken:
1. An additional company is placed in between the risk carrier and the investor. This is a special company,
called "Special purpose vehicle" (SPV), which provides contractual certainty for both risk carrier and in-
vestor. SPV’s are nothing dubious but rather a way of efficiently establishing a lagally conform structure for
the purpose of the transaction.
2. The maximum claim possible under the ILS is fully collateralized. I.e., the investors provide funds ("collat-
eral") which are posted in a collateral account. This collateral is fully returned to the investors only in case
no claim is made.
Risk carrier ⟺ Special Purpose Vehicle (SPV) ⟺ Investor
59
Construction of ILS: The following figure illustrates the steps performed to enter an ILS transaction:
• An SPV entity is created.
• The sponsor (usually an insurance company) enters a reinsurance agreement with the SPV, pays a premium.
• The investors (usually there is more than one) invest in the notes issued by the SPV and pay the principal.
• The SPV puts the received funds (premium and principal) into a collateral account, collateralizing the full
limit amount of the reinsurance agreement. The funds are are usually invested in deep, liquid, and safe
investments such as treasury bonds.
Special Purpose Investment

Sponsor Premium
Investors
vehicle (SPV) (Principal)
(insurance company)
= cash flow
Investment of funds received
Collateral account
Figure 43: Creation of an ILS transaction.
Concluding ILS Transactions - In case covered event occurred: Suppose a covered trigger event occurred during
a risk period which partially or fully impairs the notional of the cat bond transaction. In this case:
• The collateral account is closed. Investments are liquidated, the proceeds and the investment return is trans-
ferred to the SPV.
• The bond "defaults", the investor does not receive his investment (principal) and interest.
• Available funds are used to cover the sponsor’s losses.
Principal
not returned
Sponsor Reimbursement SPV Investors
Payment
Liquidation of assets
+ Investment return
Collateral account
Figure 44: Cashflows if event happened.
Concluding ILS Transactions - In case no covered event occurred: The following figure illustrates the steps per-
formed when the ILS transaction matures and no covered event has occurred during the risk period:
• The collateral account is closed. Investments are liquidated, the proceeds and the investment return is trans-
ferred to the SPV.
• The investor does receive back his investment (principal) plus the investment return earned.
60
Principal
Sponsor SPV Investors
+ return
Liquidation of assets
+ Investment return
Collateral account
Figure 45: cashflows if event did not happen.
6.3 Trigger types

The triggering mechanism ("Trigger") determines whether, and if yes how much, the ILS construction pays to the
sponsor. Trigger types are usually grouped into four categories:
• Indemnity: The payment is aligned to the actual (monetary) loss incurred by the sponsor.
• Modelled loss: Payment based on applying the physical signature of the real event which occurred to a
contractually agreed (Nat cat) model.
• Industry index: Payment is based on the total insurance industry loss due to a specific event or a specific
series of events.
• Parametric: Payment is directly linked to a physically measurable quantity (such as wind speed, earthquake
magnitude, or storm surge gauge). It is often combined with a double trigger.
All of these trigger types see applications. The trigger type chosen depends on multiple aspects, such as availability
of models, reinsurance market capacity, reinsurance prices (hard vs soft market), availability of sensors for para-
metric coverage, tolerance of the sponsor to basis risk, availability of loss adjusters, or availability of industry loss
indices. As of 2019, www.artemis.bm reports around 2/3 of the outstanding ILS capital to be of indemnity type.
Definition 6.6. Basis risk denotes the mismatch between the payout of the contract and the actual loss indemnity
which the sponsor intended to protect itself against.
Basis risk is an inherent property of non-indemnity based covers, since the payout is dependent on exogenous
variables, and not the actual incurred. However, the magnitude of the involved basis risk can vary significantly,
and depends on the design of the cover.
High Parametric
Index
Basis risk
Modelled
loss
None Indemnity
Low High
Transparency
Figure 46: Transparency vs basis risk comparison of different triggers.
• Sponsors may prefer indemnity triggers, since they leave them with no basis risk. However, they are less
favored by investors, since quantifying the risk can be difficult, the post-event claims settlement process is
long and subject to loss creep, and significant loss adjustment expenses may incur.
61
• Triggers based on modelled loss introduce basis risk compared to an indemnity trigger, since the recovery is
not directly linked to the incurred loss amount of the sponsor. On the other hand, this trigger type reduces
the risk of moral hazard, and claims are generally settled quickly. The remodeling of the occurred event
needs to be performed by a trusted third party. Therefore, such a third party needs to exist and potential
fallback solutions need to be contractually agreed.
• Industry index triggers depend on industry insured losses that are reported to an index provider. Typically
reported losses are representative for the market but need to be extrapolated by predefined methods to rep-
resent genuine market losses. The basis risk can be significant, since the market share of the sponsor mul-
tiplied with the industry loss can be very different to the sponsor’s actual loss experience. For the investor,
this structure is more transparent.
• Parametric triggers typically face the highest basis risk for the sponsor, since there is no direct relation-
ship to loss amounts stemming from a catastrophe event. In that sense, a pure parametric product is a clean
financial derivative. Investors appreciate this trigger, since there hardly any risk of moral hazard and loss set-
tlement is typically very fast. However, parametric triggers may be exploited for model arbitrage as specific
trigger mechanisms might be underappreciated by a cat model. Furthermore, ILS managers fear payouts
where there are no losses or casualties reported by the media as such losses are hard to communicate to
investors.
6.4 Comparison table
Traditional Reinsurance
Alternative Risk Transfer
Multi-year Cat
QS XL ILW
Reinsurance Bond
weather reinsurance
Usual properties: derivatives sidecars Usual properties:
• Counterparty: Index based collateralized • Counterparty:

Reinsurance Reinsurance reinsurance contingent capital market
capital
• Short and long • Mostly short tailed
Longevity XXX/AXXX
tailed business business
swaps securitization
• Credit risk exposed • No/less credit risk
• Reinsurance market • Basis risk exposed
• Little/no basis risk
Figure 47: Overview traditional reinsurance vs alternative risk transfer.
62
6.5 Non-life Cat Bond example

We now consider the case of a cat bond, which is the stereotypical case of an ILS in non-life insurance.
Consider an insurance company, having issued insurance policies for two buildings in some city through which
a hurricane has just passed through. The hurricane damages both buildings. The following figure illustrates the
situation.
Hurricane path
Insured building II
Sum insured = 1 mio
Damage = 800 k
Insured building I max wind speed = 140 km/h
Sum Insured = 2 mio

Damage = 1.5 mio
max wind speed = 120 km/h
* Meteorological
station
max wind speed: in km/h 100-150 150-200 150-200
Figure 48: Hurricane passing through city example.
Then, the following table illustrates how the different trigger types can be used to construct a cat bond protecting
this insurance company.
Trigger Indemnification based on

Indemnity Based on insured loss (800 K + 1.5 mio = 2.3 mio)
Modelled loss Use NatCat model: Hazard =140 kmh & 120 kmh, respectively, Exposure = two insured
buildings, Vulnerability = based on insured buildings
Index Based on total insured loss of all insurance companies active in this city
Parametric Based on max wind speed measured at meteorological station
Table 27: Comparison of trigger types based on example
63
6.6 ILS Example - Life insurance

A traditional life reinsurance structure protecting against an accumulation of losses due to a single event works
analogous to per-event reinsurance in Non-life. For instance, an XL may have the payout
∑ L D,C ( ∑ X i ,e ) ,
events e losses caused by evente
where X i ,e are monetary loss amounts.

Plausible events triggering such a life reinsurance cover could be:
• Pandemy (Example: 1919 Spanish flu with 50 to 100 mio deaths);
• Aircraft, Bus, or ship accident (Example: 2014 Sewol ferry sinking in South Korea, 2012 Wallis Bus accident
with 28 deaths);
• Terrorism, Mass murder (Example: 2015 Paris Bataclan attack with 130 deaths, 2001 Leibacher attack in Zug
with 15 deaths);
• Natural catastrophe (Example: 2010 Indean Ocean tsunami with 220’000 deaths).
Currently, more than 95% of the ILS market is covering non-life risks, but it is important to recognize that ILS
represents a generic risk transfer technique not limited to non-life.
There can be quite some concentration risk for pension funds which insure personnel working at the same com-
pany, potentially all affected by the same event.
For large life insurance companies, the concentration risk diversifies very well in the scope of the entire balance
sheet, and the mortality pattern of the insured portfolio is strongly correlated with the mortality pattern of the
population, or age segments thereof.
Example 6.7 (Excess Mortality Bond). Consider the case where the risk bearing entity is exposed to mortality risk,
and the payouts are almost one-to-one correlated to the mortality rate of population segments. I.e., the policy
specific terms and conditions drive only the overall exposure, but not the uncertainty.
In this case an index based protection against (excess) mortality can be considered through a so called "Excess
Mortality Bond".
• Let q ag e,g end er be observed mortality in population groups (age, gender);
• Let ωag e,g end er be weights for each group depending on the insured portfolio;
• Define an the Index I = ∑ag e,g end er ωag e,g end er ⋅ q ag e,g end er , which represents a weighted mortality rate.
Then we can construct an index based excess mortality bond by applying a layer structure on the index instead of
the corresponding monetary loss amounts:
L D,C ( I )
R = P r i nci pal ⋅ ,
C
Where the principal is the amount invested by the investors. It serves as the capital used for doing the investment
at construction time, and is potentially paid to the sponsor if the Index exceeds D.
64
Recovery as a function of the index
Principal
0 D D+C
Figure 49: Parametric mortality bond payout as a function of the index.
Consider now the following expected and realized mortality, separated by age and gender group.
Overall population Insured population

Male Female Male Female
Population Age 21-40 1’100’000 1’100’000 100’000 200’000
Age 41-60 1’100’000 1’100’000 100’000 50’000
Expected Mortality Age 21-40 0.002% 0.038% 0.002% 0.038%
Age 41-60 0.609% 0.353% 0.609% 0.353%
Overall (weighted average) 0.260% 0.192%
Realized Mortality Age 21-40 0.050% 0.010%
Age 41-60 0.600% 0.400%
Overall (weighted average) 0.275%
Table 28: Mortality bond example.
In case the deductible is D = 0.25%, limit C = 0.1%, and the principal 100 mio CHF, then the bond payout is equal
to
min{(0.275% − 0.25%) , 0.1%}

+
100 mio CHF ⋅ = 100 mio CHF ⋅ 25% = 25 mio CHF.
0.1%
65
7 Swiss Solvency Test

7.1 Capital & Solvency
We would now like to deal in greater detail with the capital required by a reinsurance company and the associated
mathematical concepts. This essentially involves the following tasks:
1. Determining the required capital
2. Dividing the total capital to individual business units with regard to a uniform risk-adjusted performance
measurement
3. Translating the global target return into margins for individual treaties.
7.2 Determining the Required Risk Capital

7.2.1 Quantile and Shortfall as Risk Measures
In order to determine the risk adjusted capital, we first need to define risk. In our context risk is related to the
potential negative deviation from the expected outcome of some future events which deplete the economic net
worth of the company. Let X thus be the change in economic value of the (re-) insurance company in a given
period. We consider the following two risk measures associated with X :
1. The p-quantile of X is defined by

−1
Q p ( X ) = F X (p )
−1
where F X (p ) = inf{x ∶ F (x ) ≥ p } is the generalized inverse of the distribution function.
2. The p-Shortfall of X is defined by
1
1 −1
SF p ( X ) = ∫ Fx (y ) d y
1−p
p
Note that in the case where F X is continuous, the shortfall is equal to the conditional expected value
−1
E [ X ∣ X > F X (p )]
Both risk measures are widely used in practice, but the shortfall has the advantage that it is a coherent risk measure
whereas the quantile is not.
1
Definition 7.1. A risk measure ρ ∶ L → R is called coherent, if the following holds:
1. Translation Invariance: For α ∈ R, ρ ( X + α) = ρ ( X ) + α
2. Homogeneity: For λ ∈ R , ρ (λX ) = λ ⋅ ρ ( X )

+
3. Subadditivity: ρ ( X + Y ) ≤ ρ ( X ) + ρ (Y )
+ +
4. Additivity for comonotonic risks: For f , g :R → R , increasing,
ρ ( f ( X ) + g ( X )) = ρ ( f ( X )) + ρ (g ( X ))
We would like to have translation invariance in order to distinguish between the contribution to the expected value
and the contribution to the volatility. Homogeneity is desired to make the risk measure independent of the unit
chosen for risk quantification (especially the currency). Finally, subadditivity enables to quantify the diversifica-
tion benefit. The reason while the quantile is not coherent lies in the fact that 3. is violated, i.e. subadditivity does
not hold.
66
7.2.2 Some properties of Quantiles
Here we ant to discuss some properties of quantiles. We will especially prove that quantiles are not subadditive,
but they are additive for comonotonic risks.
Definition 7.2. Two random variables X and Y on a probability space (Ω, F , P ) are comonotonic, if there exists a
probability space (Ω̃, F̃ , P̃ ) and ( X̃ , Ỹ ) random variables on Ω̃ such that
d
1. ( X̃ , Ỹ ) = ( X , Y )
2. X̃ (ω1 ) ≤ X̃ (ω2 ) implies Ỹ (ω1 ) ≤ Ỹ (ω2 ) ∀ω1 , ω2 ∈ Ω̃.
Proposition 7.3. If X and Y have continuous marginals, it holds that

−1
X and Y comonotonic ⟺ Y = g ( X ) a.s., with g = F Y ◦ F X increasing
Lemma 7.4. Let X and Y denote two random variables such that there exists an increasing function g, such that
Y=g(X). In addition suppose that g is continuous.
−1 −1
Let x p ∶= F X (p ) and y p ∶= F Y (p ) denote the quantile functions of X and Y . Then
y p = g ( x p ), (7.1)
that means, that the quantiles transform the same way like the random variables.
Proof.
(i) g increasing ⟹ {ω ∈ Ω ∶ X (ω) ≤ x p } ⊆ {ω ∈ Ω ∶ g ( X (ω)) ≤ g (x p )},
⟹ P [g ( X ) ≤ g (x p )] ≥ P [ X ≤ x p ] ≥ p. (7.2)
(ii) Since g is continuous we know that

∀ε > 0 ∃δ > 0 such that g (z ) > g (x p ) − ε, whenever z > x p − δ
thus g (z ) ≤ g (x p ) − ε ⟹ z ≤ x p − δ,
therefore {ω ∈ Ω ∶ g ( X (ω)) ≤ g (x p ) − ε} ⊆ {ω ∈ Ω ∶ X (ω) ≤ x p − δ},
hence
∀ε > 0 ∃δ > 0 ∶ P [ g ( X ) ≤ g ( x p ) − ε] ≤ P [ X ≤ x p − δ] < p (7.3)
⟹ y p = inf {z ∶ P [g ( X ) ≤ z ] ≥ p } = g (x p ).
In the following theorem we will show that in a case of two comonotonic random variables the sum of their quan-
tiles is equal to the quantile of their sum.
Theorem 7.5. Let X and Y denote two comonotonic random variables. Then we have
−1 −1 −1
F X +Y ( p ) = F X ( p ) + F Y ( p ) )
Proof.
Because of comonotonicity there exist continuous increasing functions
u, v ∶ R → R and a random variable Z such that
d
( X , Y ) = (u ( Z ), v ( Z ))
and thus
d
X + Y = (u + v )( Z )
Using the previous Lemma and the fact that u + v is a continuous increasing function we obtain
−1 −1 −1 −1 −1 −1
F X +Y (p ) = (u + v )(F Z (p )) = u (F z (p )) + v (F z (p )) = F X (p ) + F Y (p ) )
We now show that quantiles are not subadditive by giving a counterexample:
67
Lemma 7.6. If X and Y are independent random variables, X , Y ∼ P ar et o (1, 21 ), then
P ( X + Y ≤ 2z ) < P ( X ≤ z ) ∀z > 1. (7.4)
Proof. √ √
z >1 ⇒ 2z > z + 1 ⇒ 2z − 1 > z ⇒ 2z − 1 > z
√ √
√ z 2z − 1 1 2 2z − 1 1
⇒ 2z − 1 > √ ⇒ z <√ ⇒ >√
z z 2z z
Hence √
2 2z − 1 1
P ( X + Y ≤ 2z ) = 1 − < 1 − √ = P (X ≤ z )
2z z
Let X , Y be independent P ar et o (1, 12 ) distributed random variables and 0 < p < 1.Then:
−1 −1 −1
F X +Y (p ) > F X (p ) + F Y (p )
Proof.
−1
Let p ∈ (0, 1).Then z = F X (p ) > 1.Form the previous Lemma we then have
P [ X + Y ≤ 2z ] < P [ X ≤ z ] = p
Thus,
−1 −1 −1
F X +Y (p ) > 2z = F X (p ) + F Y (p )
7.3 The Swiss Solvency Test

In economic capital frameworks, capital requirements are usually expressed by a risk measure applied to the
change of the company’s economic value over a certain time period, usually one year. We describe here the frame-
work used under the Swiss Solvency Test (SST) for which the following principles have been established.
• All assets and liabilities are valued market consistently
• Risks considered are market, credit and insurance risks
• Risk-bearing capital is defined as the difference of the market consistent value of assets less the market
consistent value of liabilities, plus the market value margin
• The market value margin is approximated by the cost of the present value of future required regulatory cap-
ital for the run-off of the portfolio of assets and liabilities
• Target capital is defined as the sum of the Expected Shortfall of change of risk-bearing capital within one
year at the 99% confidence level.
• Under the SST, an insurer’s capital adequacy is defined if its target capital is less than its risk bearing capital
• The scope of the SST is legal entity and group / conglomerate level domiciled in Switzerland
• Scenarios defined by the regulator as well as company specific scenarios have to be evaluated and, if relevant,
aggregated within the target capital calculation
• All relevant probabilistic states have to be modeled probabilistically
• Partial and full internal models can and should be used. If the SST standard model is not applicable, then a
partial or full internal model has to be used
• The internal model has to be integrated into the core processes within the company SST Report to supervisor
such that a knowledgeable 3rd party can understand the results
68
• Public disclosure of methodology of internal model such that a knowledgeable 3rd party can get a reasonably
good impression on methodology and design decisions
• Senior Management is responsible for the adherence to principles
The starting point for the Swiss Solvency Test (SST) is thus the economic balance sheet of the company. The
available capital is defined as
C A (t ) = Asset s (t ) − Li abi l i t i es (t ) (7.5)
whereby both assets and liabilities are valued market consistently. The market consistent valuation of liabilities
means that one takes the market value -if exists - or the value of the replicating portfolio of traded financial in-
struments plus the cost of capital for the remaining basis risk. The replicating portfolio is a portfolio of financial
instruments which are traded in a deep, liquid market, with cash flow characteristics matching either the expected
cash flows of the policy obligations or, more generally, matching the cash flows of the policy obligations under a
number of financial market scenarios. The replicating portfolio has to match the company specific cash flows, de-
pending on the company specific expenses, claims experience etc. The cost of capital margin is defined as the cost
for future regulatory capital which has to be set up for the liabilities. With the introduction of the Swiss Solvency
Test the cost of capital was set as 6% over risk-free and has remained unchanged since then.
The Solvency Capital Requirement (SCR) captures the risk that the economic balance sheet of the company at t = 1
differs from the economic balance sheet at t = 0.
SC R = ρ (C A (1)/(1 + r ) − C A (0)) (7.6)

where ρ stands for the 99% shortfall risk measure and r is the one year risk free rate.
The market value margin is the cost of future regulatory capital which has to be set up for the liabilities, i.e
t
MV M = C oC × ∑ SC R (t )/(1 + r ) (7.7)
t ≥1
The capital SCR(t) , t ≥ 1 has to cover the the run-off risk (i.e. the risk that the actual claims will be higher than
reserved ultimates at t=0) and the credit and market risk for the replicating portfolio.
7.4 Internal Models

Internal models (sometimes also called economic capital models) are models used to derive the probability distri-
bution of the change in the company’s economic value over a one year time horizon. Some companies have been
using such models since the early ninetees but their popularity has massively increased with the introduction of
the modern solvency frameworks as the SST or Solvency II. These regulations allow companies to use their internal
capital models to compute the relevant solvency requirements. The precondition is, however, that the supervisory
authorities examine the internal model in detail and approve it for the solvency capital calculation. For this, the
company has to demonstrate that its model covers all material risks which impact the balance sheet and that the
modeling approach fulfills strong quality standards. The most important risks which have to be quantified by an
internal model are
• Property and Casualty Risk
– Natural Catastrophe Risks

– Reserve Risk
– Man-made catastrophe risk (e.g. terrorism, liabilty threats)
– Unexpected Claims Inflation
• Life and Health Risks
– Pandemic Influenza
– Mortality Trend Risk
• Financial Market Risk
– Equity Risk
69
– Credit Spread Risk

– Interest Rate Risk
• Operational Risk
7.5 Division of capital and performance measurement

Now that we have determined a company’s total risk capital we wish to allocate it to the individual sub-units
commensurate to their risk. Sub-units can be of an organisational nature (such as profit centers) or products
(eg all non-proportional business). This division aims at judging and comparing the results of the individual sub-
units. The riskier the business of a sub-unit is, the more capital should be allocated to it. We will then be in a
position to make a direct comparison of the results of the individual areas by measuring the return against the
capital allocated. This is referred to as return on risk-adjusted capital or in short RORAC.
It is important to recognise that the risk-adjusted capital defined in this way is an imaginary concept and not
something which can be physically attributed to the various business segments. This RAC is (as we have seen in
the last chapter) generally much lower than the risk capital which the unit would require if it were an independent
company having the same risk tendencies.
It is now a question of defining a key for the risk-commensurate allocation of capital. For this we use the following
simplified model:
• The entire company U is divided into n separate sub-units U1 , . . . ,Un
• The results of the sub-units are R 1 , . . . , R n , and those of the whole company R = ∑ R i
• R i = Vi ⋅ Yi , where Vi is a measure of volume for the unit i.
For a given risk model (distribution of (Y1 , . . . , Yn )), the risk of the total portfolio depends only on the volume
vector V = (V1 , . . .Vn ), i.e. ρ = ρ (V ). The risk of the unit i on a standalone basis is ρ i = ρ (0, . . . , 0,Vi , 0, . . . , 0) and
the diversification benefit is defined as
∆ρ d i v (V ) = ∑ ρ i − ρ (V ) (7.8)
For quantifying the contribution of a unit to the total risk, we can use different principles:
1. The marginal principle
ρ (V + ∆Vi ) − ρ (V )
∆i ρ = ∗ Vi (7.9)
∆Vi
Since in general ∑ ∆i ρ ≠ ρ (V ), it is better to replace ∆i ρ with the normalized contribution
∆i ρ
∆˜i ρ = ρ (V ) ∗ (7.10)
∑j ∆j ρ
2. The ’with and without’ principle
∆i ρ = ρ (V ) − ρ (V1 ,V2 , . . . ,Vi −1 , 0,Vi +1 , . . . ,Vn ) (7.11)
This is a special case of the marginal principle with ∆Vi = −Vi .
3. The Euler principle
∂ρ (V )
∆i ρ = ∗ Vi (7.12)
∂Vi
Note that according to the Euler Theorem for homogeneous functions we have for all λ > 0 ∶
70
∂ρ (λV )
∑ ∗ Vi = ρ (V ) (7.13)
∂(λVi )
Especially, for λ = 1 we obtain
∑ ∆i ρ = ρ (V )
Theorem 7.7. The Euler principle is the only allocation principle which satisfies the axioms of a coherent allocation
defined by Denault.
• Full allocation: ∑ K i = K , whereby K i is the capital allocated to unit i and K is the total capital.
• No undercut: the capital allocated to any subportfolio is smaller or equal to the capital determined for the
subportfolio on a standalone basis, using the same risk measure.
• Symmetry: two units contributing the same risk get the same capital.
• Additivity over risk measures: ρ = ρ 1 + ρ 2 , ⇒ K i (ρ ) = K i (ρ 1 ) + K i (ρ 2 ), ∀i
• Riskless allocation: ρ i = 0 ⇒ K i = 0
Remark: The covariance principle is an Euler allocation with ρ = σ(standard deviation).

In this case we namely have
∂σ
∆i ρ = ∗ Vi (7.14)
∂Vi
Furthermore,
2
∂σ Vi ∂σ 1
∗ Vi = (7.15)
∂Vi 2 ∂Vi σ
Using
2
σ = ∑ C ov [R k , R j ]
k, j
we get
2
Vi ∂σ
= C ov [R i , R ]
2 ∂Vi
and using (7.15) we get
C ov [R, R i ]
∆i ρ = (7.16)
σ(R )
ie. the capital must be allocated in proportion to the covariances of each sub-unit with the total business.
7.6 The Loading for Profit and Capital Costs

Let us imagine a company calculating a premium only accounting for expected losses and the costs incurred (ad-
ministrative costs, brokerage, etc), in the hope that the available capital reserves would be sufficient to balance
out the fluctuations between the expected and the actual results. Such a non-profit-making company would thus
require for a treaty with a loss burden S, the premium
P = E [S ] + K
where K is defined so that the sum of all K s from all treaties would provide the exact total costs of the reinsurance.
(It is very difficult to attribute the exact costs to each treaty). Unfortunately any such reinsurer would with proba-
bility 1 be ruined after a finite period of time, regardless of how large his capital reserve might be. In order to show
this we introduce the following quantities:
• S i = the annual loss burden in the year i (i = 1, 2, . . .)
71
• P i = the premiums paid in year i
• K i = the cost in year i
• R i = P i − S i − K i = the result in year i

i
• B i = ∑k =1 R k = the total balance following i years
Since we have already used P to represent the premiums, we will use P to indicate the probability measure. We
now make the following assumptions:
1. supi E [S i +1 ∣ σ(S 1 , . . . , S i )] < ∞
2. infi V ar [S i +1 ∣ σ(S 1 , . . . , S i )] > 0
3. P i +1 = E [S i +1 ∣ σ(S 1 , . . . , S i )] + K i +1
It should be noted that we have not assumed independence, nor do the S i all have the same distribution. The
latter assumption would be completely unrealistic in practice as a company’s portfolio structure and thus also the
aggregate loss distribution generally varies from year to year.
Theorem 7.8. If the annual losses S 1 , S 2 , . . . fulfill the above conditions, then the following applies for each a > 0 ∶
P[T a < ∞] = 1
where T a = min{k ≥ 1, B k ≤ −a }.
Proof.
First of all we note that (B i )i ∈N is a Martingale since on the basis of assumption 3:
E [B i +1 − B i ∣ σ(B 1 , . . . , B i )] = 0
A Martingale with bounded increments (assumption 1) can, however, only behave in 2 ways, depending on whether
the variance process
n
2
Vn = ∑ E [R i ∣ σ(R 1 , . . . , R i −1 )]
i =1
for n → ∞ remains finite or not. It converges towards a finite limit on the set {V∞ < ∞}, whilst unlimited os-
cillation is to be observed on {V∞ = ∞}, ie lim supi →∞ B i = ∞ and lim infi →∞ B i = −∞. In our case, due to
assumption 2, V∞ = ∞ P-a.s. applies and the balance B i P-a.s. thus achieves every negative level.
Economic considerations: Private insurers need a certain amount of equity capital to compensate for business
fluctuations. However, they only obtain this capital in the long-term if they aim at an additional return to the
return on risk-free investments, which flows back to the investors in the form of dividends and increased equity. It
is the task of management to set an appropriate target for returns. Once this is done is must be defined how much
an individual treaty should contribute towards the aggregate capital costs of the company.
72
7.7 Slide Version of this Section
Reinsurance Analytics HS 2021

Capital & Solvency
Capital Requirements for a Reinsurance

Company
Capital Requirements for (Re-)Insurance Companies are driven by multiple
considerations:
• Internal view – driven by the Board’s risk tolerance
• Rating Agencies
• Regulators
73
Common building blocks for capital

requirements based on quantitative models
(1) Valuation Standard (2) Available Capital
• For assets: Market Values Roughly assets minus liabilities

• For insurance liabilities: best estimate plus risk margin
Required
Available (3) Required Capital
Capital
Capital
Assets Based on the selected valuation standard

and a selected risk measure at a specific
Liabilities
confidence level over a specific time period
Risk Measures
Value at Risk:
Expected Shortfall*:
For continuous X, the expected shortfall is also equal to the conditional

expectation : -‫ܺ[ܧ‬/ܺ < ܸܴܽఈ (ܺ)]
* sometimes also called Tail Value at Risk, TVaR

4
74
Acceptance Sets
The notion of “required capital > available capital” can also be expressed in
terms of an acceptance set.
An acceptance set represents the set of future capital positions that the
regulator deems to provide a reasonable level of security. Testing whether a
financial institution is adequately capitalized or not with respect to the chosen
acceptance set A amounts to establishing whether its capital position belongs to
A or not.
VaR based:
Expected Shortfall based:
Coherence Criterion
It can be shown that the Expected Shortfall is coherent, but the Value at Risk is
not (subadditivity is violated, see lemma 7.6 in the Lecture Notes).
75
The Swiss Solvency Test (SST)
The Swiss Solvency Test: building blocks
76
10
77
11
12
78
Internal Models
• Reinsurance companies started developing capital models in the

90’s with the aim to better understand their risk landscape
• Since then, capital models have been used for
• determining the total required capital given the firm’s risk
tolerance
• allocating capital to portfolios for risk adjusted performance
measurement
• supporting risk decisions (portfolio steering, M&A’s etc.)
• calculating Solvency Capital (SII, SST)
Ideal Approach to Capital Modeling

1. Identify all relevant risk factors which impact the balance sheet
2. Quantify the impact of each risk factor on the balance sheet
3. Develop stochastic models for the risk factors and their dependencies
4. Simulate many realizations of the risk factors and implied changes to the balance sheet value
5. Apply appropriate risk measures to determine the required capital
Risk
factors
Liabilities
Assets Liabilities
Capital
79
March 16, 2017
Internal Models March 6, 2017
Input Output
• Probability distributions by risk class/portfolio for insurance risks • The model generates (joint
• Distribution of reserve movements over one year outcomes of results for the defined
• Joint realizations (simulations) of financial market variables (equity indices, risk classes/portfolios
credit spreads, real estate prices etc.) from an economic scenario generator. • Sign convention: positive numbers
• Dependency structures between risks and/or portfolios described by represent financial losses
functional relationships or “copulas”.
C. Simulations by risk class
A. Loss Distribution B. Correlation Matrix:

by LoB Used for combining LoBs
Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - Global - U.S. - E&U.S. - E&U.S. - M U.S. - M U.S. - St U.S. - St U.S. - Pr U.S. - Pr U.S. - Pr U.S. - Pr U.S. - SpU.S. - SpU.S. - Pr U.S. - Pr U.S. - SpReserve
Global 100% 55% 10% 10% 10% 10% 10% 15% 15% 10% 10% 10% 5% 10% 10% 10% 15% 10% 15% 15% 10% 10% 25% 35% 10% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 23%
Global 55% 100% 10% 10% 10% 10% 10% 10% 10% 5% 5% 15% 5% 10% 10% 10% 15% 10% 15% 15% 10% 10% 25% 35% 10% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 23%
Global 10% 10% 100% 25% 25% 25% 25% 40% 40% 5% 5% 5% 5% 10% 5% 20% 5% 5% 5% 5% 5% 5% 5% 5% 20% 5% 5% 11% 10% 22% 20% 5% 5% 10% 10% 24% 23% 5% 5% 5% 23%
Global 10% 10% 25% 100% 80% 25% 35% 40% 70% 5% 5% 5% 5% 10% 5% 25% 5% 5% 5% 5% 5% 5% 5% 5% 25% 5% 5% 11% 10% 22% 20% 5% 5% 10% 10% 24% 23% 5% 5% 5% 23%
Aviation Global
Global
10%
10%
10%
10%
25%
25%
80%
25%
100%
25%
25%
100%
35%
50%
40%
50%
70%
50%
5%
5%
5%
5%
5%
5%
5%
5%
10%
10%
5%
5%
25%
10%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
25%
10%
5%
5%
5%
5%
11%
11%
10%
10%
22%
22%
20%
20%
5%
5%
5%
5%
10%
10%
10%
10%
24%
24%
23%
23%
5%
5%
5%
5%
5%
5%
23%
23%
Global 10% 10% 25% 35% 35% 50% 100% 50% 60% 5% 5% 5% 5% 10% 5% 10% 5% 5% 5% 5% 5% 5% 5% 5% 10% 5% 5% 11% 10% 22% 20% 5% 5% 10% 10% 24% 23% 5% 5% 5% 23%
Global 15% 10% 40% 40% 40% 50% 50% 100% 50% 5% 5% 5% 5% 10% 10% 35% 5% 5% 5% 5% 5% 5% 5% 5% 35% 5% 5% 11% 10% 22% 20% 5% 5% 10% 10% 24% 23% 5% 5% 5% 23%
Global 15% 10% 40% 70% 70% 50% 60% 50% 100% 5% 5% 5% 5% 10% 10% 35% 5% 5% 5% 5% 5% 5% 5% 5% 35% 5% 5% 11% 10% 22% 20% 5% 5% 10% 10% 24% 23% 5% 5% 5% 23%
Global 10% 5% 5% 5% 5% 5% 5% 5% 5% 100% 70% 10% 5% 10% 60% 10% 5% 5% 5% 5% 5% 5% 5% 5% 10% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 23%
Global 10% 5% 5% 5% 5% 5% 5% 5% 5% 70% 100% 10% 5% 10% 50% 10% 5% 5% 5% 5% 5% 5% 5% 5% 10% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 23%
Global 10% 15% 5% 5% 5% 5% 5% 5% 5% 10% 10% 100% 5% 10% 10% 10% 70% 60% 30% 30% 5% 5% 5% 5% 10% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 23%
Global 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 100% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 10% 10% 5% 23%
Marine
Global 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 5% 100% 10% 10% 15% 15% 10% 10% 10% 10% 15% 15% 10% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 30% 23%
Global 10% 10% 5% 5% 5% 5% 5% 10% 10% 60% 50% 10% 5% 10% 100% 10% 10% 10% 10% 10% 50% 50% 15% 15% 10% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 23%
Global 10% 10% 20% 25% 25% 10% 10% 35% 35% 10% 10% 10% 5% 10% 10% 100% 20% 20% 5% 5% 15% 15% 5% 5% 80% 5% 5% 15% 10% 22% 20% 5% 5% 5% 5% 29% 25% 5% 5% 5% 23%
D. Aggregate Loss Distribution

Global 15% 15% 5% 5% 5% 5% 5% 5% 5% 5% 5% 70% 5% 15% 10% 20% 100% 70% 30% 30% 10% 10% 30% 30% 20% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 23%
Global 10% 10% 5% 5% 5% 5% 5% 5% 5% 5% 5% 60% 5% 15% 10% 20% 70% 100% 30% 30% 10% 10% 30% 30% 20% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 23%
Global 15% 15% 5% 5% 5% 5% 5% 5% 5% 5% 5% 30% 5% 10% 10% 5% 30% 30% 100% 70% 15% 15% 25% 25% 5% 15% 15% 6% 5% 11% 10% 8% 8% 8% 8% 13% 10% 8% 8% 8% 23%
Global 15% 15% 5% 5% 5% 5% 5% 5% 5% 5% 5% 30% 5% 10% 10% 5% 30% 30% 70% 100% 15% 15% 25% 25% 5% 15% 15% 6% 5% 11% 10% 8% 8% 8% 8% 13% 10% 8% 8% 8% 23%
Global 10% 10% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 10% 50% 15% 10% 10% 15% 15% 100% 80% 15% 15% 15% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 23%
Global 10% 10% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 10% 50% 15% 10% 10% 15% 15% 80% 100% 15% 15% 15% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 23%
Global 25% 25% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 15% 15% 5% 30% 30% 25% 25% 15% 15% 100% 50% 5% 30% 30% 5% 5% 5% 5% 8% 8% 5% 5% 5% 5% 5% 5% 5% 23%
Global 35% 35% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 15% 15% 5% 30% 30% 25% 25% 15% 15% 50% 100% 5% 30% 30% 8% 8% 8% 8% 15% 15% 8% 8% 8% 8% 8% 8% 8% 23%
Global 10% 10% 20% 25% 25% 10% 10% 35% 35% 10% 10% 10% 5% 10% 10% 80% 20% 20% 5% 5% 15% 15% 5% 5% 100% 5% 5% 15% 10% 22% 20% 5% 5% 5% 5% 29% 25% 5% 5% 5% 23%
U.S. - E 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 8% 8% 5% 8% 8% 15% 15% 8% 8% 30% 30% 5% 100% 75% 35% 30% 15% 15% 75% 75% 20% 15% 5% 5% 20% 20% -% 23%
U.S. - E 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 8% 8% 5% 8% 8% 15% 15% 8% 8% 30% 30% 5% 75% 100% 35% 30% 15% 15% 75% 75% 20% 15% 5% 5% 20% 20% -% 23%
Agriculture
U.S. - M 5% 5% 11% 11% 11% 11% 11% 11% 11% 5% 5% 5% 5% 8% 8% 15% 8% 8% 6% 6% 8% 8% 5% 8% 15% 35% 35% 100% 70% 60% 60% 35% 35% 35% 25% 60% 60% 15% 5% -% 23%
U.S. - M 5% 5% 10% 10% 10% 10% 10% 10% 10% 5% 5% 5% 5% 8% 8% 10% 8% 8% 5% 5% 8% 8% 5% 8% 10% 30% 30% 70% 100% 50% 50% 30% 30% 20% 15% 55% 50% 15% 5% -% 23%
U.S. - S 5% 5% 22% 22% 22% 22% 22% 22% 22% 5% 5% 5% 5% 8% 8% 22% 8% 8% 11% 11% 8% 8% 5% 8% 22% 15% 15% 60% 50% 100% 85% 15% 15% 20% 15% 65% 60% 15% 5% -% 23%
U.S. - S 5% 5% 20% 20% 20% 20% 20% 20% 20% 5% 5% 5% 5% 8% 8% 20% 8% 8% 10% 10% 8% 8% 5% 8% 20% 15% 15% 60% 50% 85% 100% 15% 15% 20% 15% 60% 60% 15% 5% -% 23%
U.S. - P 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 8% 8% 5% 8% 8% 8% 8% 8% 8% 8% 15% 5% 75% 75% 35% 30% 15% 15% 100% 75% 20% 15% 5% 5% 20% 20% -% 23%
U.S. - P 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 8% 8% 5% 8% 8% 8% 8% 8% 8% 8% 15% 5% 75% 75% 35% 30% 15% 15% 75% 100% 20% 15% 5% 5% 20% 20% -% 23%
U.S. - P
U.S. - P
5%
5%
5%
5%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
5%
5%
5%
5%
5%
5%
5%
5%
8%
8%
8%
8%
5%
5%
8%
8%
8%
8%
8%
8%
8%
8%
8%
8%
8%
8%
5%
5%
8%
8%
5%
5%
20%
15%
20%
15%
35%
25%
20%
15%
20%
15%
20%
15%
20%
15%
20%
15%
100%
50%
50%
100%
5%
5%
5%
5%
5%
5%
5%
5%
-%
-%
23%
23%
U.S. - S
U.S. - S
5%
5%
5%
5%
24%
23%
24%
23%
24%
23%
24%
23%
24%
23%
24%
23%
24%
23%
5%
5%
5%
5%
5%
5%
5%
5%
8%
8%
8%
8%
29%
25%
8%
8%
8%
8%
13%
10%
13%
10%
8%
8%
8%
8%
5%
5%
8%
8%
29%
25%
5%
5%
5%
5%
60%
60%
55%
50%
65%
60%
60%
60%
5%
5%
5%
5%
5%
5%
5%
5%
100%
90%
90%
100%
15%
15%
5%
5%
-%
-%
23%
23%

U.S. - P 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 10% 8% 8% 5% 8% 8% 8% 8% 8% 8% 5% 8% 5% 20% 20% 15% 15% 15% 15% 20% 20% 5% 5% 15% 15% 100% 70% -% 23%
U.S. - P 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 10% 8% 8% 5% 8% 8% 8% 8% 8% 8% 5% 8% 5% 20% 20% 5% 5% 5% 5% 20% 20% 5% 5% 5% 5% 70% 100% -% 23%
U.S. - S 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 30% 8% 5% 8% 8% 8% 8% 8% 8% 5% 8% 5% -% -% -% -% -% -% -% -% -% -% -% -% -% -% 100% 23%
15 Capital Modelling Framework

Reserv 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 23% 100%
Example: Modeling Pandemic Risk

Typical Pandemic Modeling prior to the COVID Crisis
1 Stochastic Epidemic Model

- Lethality of Virus random variables
- Reproduction Number
- Interventions (antivirals, vaccines, Excess mortality for the

contact modification) insured portfolio
- Portfolio characteristics (geography,
age profile, etc)
2 Dependencies with other risks

Dependence of Pandemic with Financial Market Risk:
- It seemed reasonable to assume a causal dependency as function of the excess mortality: the more people
die, the higher is the shock on the markets ->declining equity prices, spread widening, declining real estate
prices, declining interest rates
- For capital modeling only a prolonged market impact is relevant, i.e. effects which are observable on a one -
year time horizon
Dependence of Pandemic and P&C Insurance Risks:

- Prior to COVID such dependencies have typically been modeled w.r.t. financial lines (Credit & Surety, D&O).
80
What have we learned so far from

COVID-19 ?
• The difference in lethality between the general population and the insured
population can be very material.
• The regional differences in dealing with the pandemic are striking and they
are not as most people would have anticipated.
• The COVID crisis did impact GDP
Advanced Emerging World
Economies Markets
-5.8% -3.3% -4.4% IMF forecast for 2020 real GDP Growth as of October 2020
• but: financial markets witnessed only a temporary shock and have recovered
after a short time.
• Several insurance companies have reported significant COVID losses from
Event Cancellation covers. Also, several companies have set up reserves for
potential Business Interruption losses.
Internal Models in a Multi Currency Setup
Relevant currencies in an Internal Model :
• underlying currency :
currency in which a balance sheet position is denominated
• calculation currency:
for aggregation purposes, the exposures denominated in the various currencies need to
be converted into a common currency
• reporting currency
currency chosen to report risk figures
18
81
Converting to the Calculation Currency
For simplicity we consider a balance sheet with only two currencies:

domestic currency : d
foreign currency : f
which are converted into an aggregation currency a.
To calculate the capital position at time T, we need the corresponding (random)
exchange rates at time T :
The capital position at time T, expressed in currency a, is given by
where A and L stand for the Assets and Liabilities in the respective currency
19
Observations
¾ Required Solvency Capital - calculated as TailVar or Var - depends on the

calculation currency
¾ As a consequence, the Solvency Ratio (required capital / available capital)

also depends on the calculation currency
What about Capital Adequacy Tests ?
20
82
Currency Invariance of Capital Adequacy

Tests
Var based capital adequacy tests are currency invariant, i.e
But the analogous result does not hold for Expected Shortfall based capital
adequacy test !
This was first observed by Artzner, Delbaen & Koch-Medina in 2009 (ASTIN
Bulletin 39), but the result got largely unnoticed in the risk management
community.
21
Example:
• Discrete Setup (e.g. "simulation approach"): 1000 possible states of the world,
each with the same probability
• The worst 1% states (in term of economic value), expressed in the domestic
currency are given by
22
83
Example (cont)
Exchange rate model:
i.e. the exchange rate is 1 except in the two worst outcomes where we observe a
strong devaluation of the foreign currency vs. the domestic currency.
23
Is this relevant ?
• For our example we needed a model where a currency depreciates at the

time where the worst economic losses happen.
• We have evidence from history that such events are not implausible:
- in the 2008 financial crisis, the US Dollar appreciated against almost all currencies
- after the Tohuku Earthquake the Japanese Yen depreciated for a short period and
started appreciating a month later at a very rapid rate
24
84
Reinsurance Analytics HS 2021

Capital & Solvency (Part 2)
Economic
valuation
85
Economic Valuation
Illustrative Example
We look at a generic economic valuation framework with extremely simplified

assumptions:
• Capital requirements are described as required economic capital
• No debt funding
• No corporate tax
• No expenses
• Insurance cash flows are not subject to financial market risk and are default-
free
• All assets are invested in risk-free government bonds
• No excess capital is held, i.e. the economic value of the company is always
equal to the economic capital requirements
3 December 25, 2021
Economic Valuation
Since there is no debt, tax, or expenses, the economic value EV(t) of the
company is equal to the difference of the economic value of assets and the
economic value of insurance liabilities:
Note that ‫ܮܸܧ‬௧ can be positive (liability) or negative (asset).

We assume that ࡱࢂ࡭࢚ is observable from the market but ࡱࢂࡸ࢚ is unknown
and we want to derive an expression for ࡱࢂࡸ࢚ .
The economic value of a company can also be expressed as the present value
of the future dividend payments, discounted at the company’s cost of equity rate:
where
x ‫ ݐܸܫܦ‬is the expected dividend payment at time ‫ݐ‬
߳
x ݀‫ݐ‬,݇ is the discount factor from time ݇ to time ‫ ݐ‬based on the cost of equity rate ‫߳ ݎ‬
4 December 25, 2021
86
Economic Valuation
This can be rearranged so that we get:
Since we assume that no excess capital is held, the dividend payment at time t
will be equal to the sum of the net cash flows from insurance operations and the
investment return of the assets, minus the change in the economic reserve
requirements (economic liability) and the change in the capital requirements
(economic capital):
5 December 25, 2021
Economic Valuation
Combining the two formulas on the previous Slide we get:
6 December 25, 2021
87
Economic Valuation
7 December 25, 2021
Capital
Allocation
88
Capital Allocation
9 December 25, 2021
Principles
10 December 25, 2021
89
Coherent Allocation
Example 1 : Covariance Principle
90
Example 2: Contribution to Expected

Shortfall
If the risk measure is equal to the expected shortfall , i.e.
ߩ ܴ ൌ െ‫ܧ‬ሾܴ |ܴ ൑ ܸܴܽఈ ܴ ]
then the Euler allocation is given by the contribution of the respective

portfolio to the expected shortfall :
ο௜ ߩ ൌ െ‫ܧ‬ሾܴ௜ |ܴ ൑ ܸܴܽఈ ܴ ሿ
Allocation of Capital at Contract Level

“Profit Loading”
First we show here that an insurance company which does not charge capital
costs at contract level (i.e. it only covers its expected claims and expenses) will
go bankrupt with probability 1.
We define first the following quantities:
ܵ௜ = the annual loss burden in the year i (i = 1,2, … )

ܲ௜ = the premiums paid in year i
‫ = ܭ‬the cost in year i
ܴ௜ = ܲ௜ െ ܵ௜ െ ‫ܭ‬௜ the result in year i
‫ܤ‬௜ =σ௜௞ୀଵ ܴ௞ the cumulative balance after year i
91
We now assume the following:
No profit loading
92
Loading Principles
93
94
95

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Reinsurance Analytics

Philipp Arbenz, Peter Antal

December 25, 2021

Version December 2021

6 Insurance Linked Securities 57

7 Swiss Solvency Test 66

8 Natural Catastrophe Modelling 96

• Reinsurance Contracts: Different forms of reinsurance and their mathematical representation.

Event Bicycle theft House burning down Hurricane damage

Loss order of Magnitude ∼ 1’000 EUR ∼ 1’000’000 EUR ∼ 1’000’000’000 EUR

1.2 Organizational aspects (Autumn Semester 2020)

• Questions: During lecture (oral or EduApp feedback channel), by email

• Documents: All materials will be on polybox (link will be shared by email)

• Content to be known for exam: Lecture notes, Presentations, Exercise series.

Table 2: Possible additional Literature.

1.3 Primary insurance vs Reinsurance

Primary Insurance vs Reinsurance

Table 3: Overview table Primary insurance vs Reinsurance

Figure 2: Illustration frequency and severity of losses primary vs reinsurance.

Table 4: Overview on proportional and non-proportional reinsurance contract types

Proportional: Overall loss Non-proportional: Only losses

Figure 3: Illustration proportional vs non-proportional reinsurance

2.2 Proportional Reinsurance

Figure 4: Illustration quota share with share α.

Figure 5: Illustration surplus with cession shares αk .

Depending on perspective, the commission has the following role:

Fixed Commission Profit Commission Sliding Scale Commission

Table 5: Overview commission clauses

E[C (P RE , X RE )] ≠ C (E[P RE ], E[ X RE ])].

Quota Share Surplus

Table 6: QS vs SP on sum insured and losses.

Before Reinsurance Quota Share 60% Surplus R=10m, NL=2

Figure 6: Illustration quotqa share and surplus contracts

Above surplus 120

Figure 7: Illustration surplus

2.3 Non-Proportional Contracts

L D,C ( X ) = min {max { X − D, 0} ,C } = min { X − D, 0} − min { X − (D + C ) , 0} .

• "priority" or "retention" for D,

• "exit point" for D + C.

Reinsured loss Primary Insurance loss before/after reinsurance

Figure 8: Illustration loss before/after reinsurance layer.

Per Risk Excess-of-Loss Per Event Excess-of-Loss Stop Loss

Table 7: Comparison of non-proportional reinsurance contract types

2.4 Reinsurance Structuring and Wordings

For instance, a program can be:

• A Tower of XL’s, e.g. a 5xs5, 10xs10, and 10xs20;

• XL reinsuring retention net of QS

• QS reinsuring retention net of XL

Figure 9: IGP&I reinsurance structure. [Source: https://www.igpandi.org/reinsurance]

2.5 Advanced Non-Proportional Contract Features

• Fixed premium, where e.g. P RE = 123EU R.

• Fixed premium rate, where P RE in-/decreases linearly with P P I . E.g., P RE = 2% ⋅ P P I .

The most common form is the fixed premium rate.

Figure 11: Illustration reinstatements

E[L D,∞ (g X )] = E[(g X − D ) ] = g E[( X − D /g ) ] ≥ g E[( X − D ) ] = g E[L D,∞ ( X )].

Before loss inflation After loss inflation

"uninflated" loss amount and Ultimate "inflated" loss amount:

Figure 12: Illustration of stabilization clause

E [L A AD,A AL (∑ L D,C ( X i ))] ≤ E [∑ L D,C ( X i )]

Ships and Marine transport always represented signif-

Figure 13: Port of Genoa, 1597.

3.1.2 Great Fire of London 1666

The Great Fire of London was a massive conflagration