The Institute of Finance

Management (IFM)
Department of Insurance
Subject Code:IRU-08610
:
Subject Name

REINSURANCE
PREPARED BY;
MR. MLAPONI, S
 Contents
❑ Definition & Concept of retention
❑ Factors influencing cedant retention level
❑ Fixing Cedant retention
❑ Types of retention
❑ Single and Graded retention
❑ Probable Maximum Loss (PML)
❑ Advantage of PML
❑ Disadvantage of PML
❑ Cession of the risk using PML-Quota Share Treaty
❑ Cession of the risk using PML-Surplus Treaty
❑ PML Error
❑ How to correct PML error
❑ Question Session.
 RETENTION
 Any proportional treaty reinsurance is essentially
designed to support the cedant for that portion of risk
that they would ordinarily not be in position to handle.
 The arrangement is based on the idea that the cedant
bears a portion of the risk and the balance is handled
by the Reinsurer.
 The Reinsurer would however like to know how much of
the said risk, the cedant would be in position to pay out
of its own account.
 Thisportion of that risk is what is known as the cedants
retention.
 RETENTION
 Retention
in normal English literature means to keep or
to withhold. The insurance definition of retention is
synonymous with this.
 Retention as applied to Reinsurance;
“Is the amount of risk that the Cedant is willing to pay out
of its own account for any policy, risk or group of risks. The
Portion of risk that is written and not ceded away to the
reinsurer”
➢ The basis of all reinsurance is the decision taken by the
insurer as to how much it wishes to retain on any one risk
(good or bad, large or small).
 RETENTION

 The difference between the amount of retention and the

amount of the original acceptance on the risk will need to be
ceded to reinsurer.
 However the process of coming up with an ideal Retention for
the cedant, is a rather complex one.
 There is no particular mathematical formula that can be used to
determine the best retention.
 The whole idea of retention is somewhat subjective i.e. it varies
from company to company.
 An ideal retention for company X would not be the same as
that for company Y.
 RETENTION

 The Responsibility of determining the retention ultimately falls on

the shoulders of the cedant albeit with advice and guidance
from the reinsurer.
 However, a higher retention for the cedant than would
ordinarily apply in any given case would mean the reinsurance
program is not efficiently being used since most of the risk is
born by the cedant.
 A lower retention on the other hand than would ordinarily apply
would also mean that the cedant is passing the risks over to the
reinsurer and acting more as an agent which defeats the
purpose of the reinsurance in the first place.
 RETENTION

 Theremust be a balance between maximizing the

premium income retained by the cedant while at the
same time minimizing the exposure to losses.
 The sole purpose of determining an appropriate
retention is to ensure that the reinsurance program is
used efficiently.
 Thusto say, a combination of factors is usually taken into
consideration in coming up with an ideal retention for
the cedant.
 FACTORS INFLUENCING RETENTION LEVEL

 For purposes of understanding, we can categorized these

factors into two i.e. “The A Factors” and “The B Factors”.
 The A Factors- These are the items that are critical to
determining the actual value of the retention of the Reinsured
(Cedant). They include 1. The cedant’s Capital, 2. The Free
Reserves, 3. the Liquid assets such as cash balances in the bank,
shares e.t.c, 4. The Gross Premium Income of the cedant.
 There must be relationship between the maximum retention and
the paid up capital and free reserves of the company.
 The amount of liquid assets (cash in bank, easily realizable
bonds, and shares) at the company’s disposal to immediately
settle losses for own account.
 FACTORS INFLUENCING RETENTION LEVEL

 The premium volumes written and needed to absorb

fluctuations.
 Size of the Company: Small firms, whose portfolios are
still unbalanced have to fix retentions related to their
financial capacity. They (small firms) may be forced to
retain a more significant portion of their capital than
the large companies, whilst remaining within the legal
requirements, and norms of natural prudence and
market practice.
 FACTORS INFLUENCING RETENTION LEVEL
 The B Factors. We can refer to these as the sidekicks to the A Factors. They
are what the cedant encompasses together with the A factors to make a
reasonable Judgment on the retention amount to consider. Among these
factors taken into consideration include but are not limited to;
1. Reinsurance Market conditions
2. The Nature and quality of Business Written by the cedant also plays big
role in determining the retention.
3. Regulations imposed by the regulatory body.
4. Attitude of the senior management.
5. Geographical location of the risk.
6. Business strategy
7. Reinsurer’s requirement.
 FIXING A RETENTION

➢ In the determining the retention, a number of complex

mathematical models have been developed such as the
Straub’s Method, Heckman and Meyers Method that attempt to
establish the ideal retention level.
➢ These methods are often theoretical and are not sufficiently
accurate enough given the data requirements and assumptions
made.
➢ As a result, a more practical approach and general industry
practice is to use the general guidelines known as the “Rules of
thumb”.
➢ There are various rules of thumb but the most common one
used is the Rule based on Maximum Percentages.
 FIXING A RETENTION
 Under this rule, the retentions are set such a level that they do not exceed a
certain percentage of the capital, free reserves, liquid assets or even other
items such as the gross premium income of a given class of business
 Maximum retention per risk & per loss:
✓ 1%-5% of Capital and free reserves- For a large company - up to 1% of the
capital & free reserves, while for small company, 5% of its capital and free
reserves or 1% of premiums retained for own account (GNPI).
➢ Reasoning behind retentions:-
✓ 2% of Estimated Retained Premium Income- No loss should increase the loss
ratio by more than 1%-3%.
✓ 5% of liquid funds- No one loss should bring the company into payment
difficulties.
✓ 1% of Capital & Free Reserves- Not risking too much capital, depending on
size.
 FIXING A RETENTION
➢ For example;
If XYZ Insurance company has the following data from 2022 and would like to
fix its retention amount for its fire class of business using the average method:

Capital and Free Reserves TZS 4bn

Estimated Gross Premium Income TZS 2bn
(EGPI)
Liquid Funds/Assets TZS 500m

Capital and Free Reserves :- TZS 4bn × 1% = TZS 40m

EGPI:- TZS 2bn × 2% = TZS 40m
Liquid Funds/Assets:- TZS 500m × 5% = TZS 25m
Taking the average of the three, the proposed retention amount for the class
will be;
Retention = (TZS 40m + TZS 40m + TZS 25m)/3 = TZS 35m
 TYPE OF RETENTION
➢ The ceding company may suffer a loss from individual risk or from a
collection of risks as a results of the catastrophic event.
➢ Therefore, it’s a duty of ceding company to ensure that the retention
amount is at balance for both scenario.
➢ As such, there are two kinds of retentions
1. “The per risk/per policy retention”. - cedant ascertains how much of each
individual risk it can pay out of its own account.
2. The “per event retention” where if a number risks were affected by an
event such as a catastrophe (accumulation of risk)-for example if the
cedant covers six buildings and all these were affected by an
earthquake, how much would it be in position to pay out of its own
account for all the affected risks. In other words, this kind of retention is
usually associated with risk accumulations arising as result of the
occurrence of catastrophe events.
 SINGLE AND GRADED RETENTION
➢ Per risk retention and Per event retentions can further be subdivided into
two;
1. Single Retention
2. Graded Retention

SINGLE RETENTION
➢ With the Single Retention level, the cedant uses one uniform retention level
for all the Risks its written in its portfolio.
➢ Single retention is simple to administer, Less temptation for the Underwriter
➢ Less flexibility for the underwriter
➢ Less balance for the treaty reinsurer- get more of the bad risk
➢ Less overall spread for the reinsured.
 GRADED RETENTION
➢ With the graded retentions, the cedant has different retention levels for
different categories of risk.
➢ Many insurers particularly smaller and those with less diversified portfolio,
having decided on their retention for best risk and assuming their reinsurers
are agreeable will set up a Table of Retention grading risks by type and
location etc, thus higher retention for best risks, and lower for less good.
➢ Graded retentions can be also used by large companies that have a well-
diversified portfolio of risk.
➢ The Basic idea behind the graded retentions is that the cedant retains
more of the good quality risks and less of the bad quality risks.
➢ This is only going to be effective if reinsurers support the proposal and are
agreeable to accept the difference between the retention and the risk
itself as obviously what is left will need to be reinsured.
 GRADED RETENTION

100% - 80% 80% - 60% 60% - 40% 40% - 0%

Grade I Grade II Grade III Grade IV

- Hotels / Restaurants /
- Tea Processing, Sugar - Petroleum, Oil refineries
Kitchens / Hostel where
Processing / storage, Fuel pumps
- Services such as cooking is done
schools and hospitals

- Dry cleaners, Supermarket - Explosives, Matches

- Shops / Supermarkets
- Residential and and Department store factories
Office buildings

- Laundries, Stone
- Grain silos, mills and fodder - Paper industries, printing
Quarrying, Aircraft
factories, flour mills works
- Water processing assembly
plants
 GRADED RETENTION
 There is no mathematical background to these figures, and they do change from time to
time depending on the state of the Reinsurance market.
 The cedant can adjust the retention levels on a given risk in a given category between
the Minimum Retention level and the Max Retention Level of course using his judgment
and experience.
 Let’s take for example that a cedant has a 15lines Surplus Treaty with gross retention of
TZS 1bn.
 The treaty capacity will be TZS 1bn + (TZS 1bn × 15) = TZS 16bn.
 Therefore:
 For a risk fall under Grade 1 the retention can be adjusted between the minimum of;
TZS 1bn × 80% = TZS 800m and the maximum of TZS 1bn.
 Subsequently, the surplus treaty will also be adjusted according to the retention.
 If minimum retention is considered the surplus capacity will be;
TZS 800m × 15lines = TZS 12bn
 GRADED RETENTION

 In addition to the table of limits, instead of having a range

between which the retention amount should for a given
category of risk.
 The cedant may instead adopt defined percentages for
example in Category 1, the cedant may adopt a retention of
100%, category 2, a retention of 75%.
 This makes it administratively easier for the underwriter to
handle.
 It’s ideal that the retention levels for a table of limits in a surplus
treaty be set basing on the assessment of the quality of risk.
 PROBABLE MAXIMUM LOSS (PML)

 When ceding in proportional property treaty such as fire

and allied perils, industrial/assets all risks and
contractors all risks, we can cede the risk using the Sum
Insured or by using Probable Maximum Loss (PML), or
Estimated Maximum Loss (EML).
 Hence,when using PML or EML we indirect incorporate
the element of probability with reference to the
frequency of the loss.
 We infer that the chance that the monetary value of
the loss will be X instead of full value Y.
 PROBABLE MAXIMUM LOSS (PML)
 For example:
 ABC Insurance provide fire insurance cover for Building with the Sum
Insured TZS 10bn.
 On Surveying the risk, the surveyor determines the building is a modern
structure fully installed with extinguishers, water hoses, fully automated
sprinklers.
 The location of the building is such that it’s not very far from the fire
brigade services.
 With such information the underwriters and surveyors could decide that in
the event of a fire, the damage to the building would most likely not
exceed 60% of its total value.
 The probable maximum loss would therefore be 65%.
 PROBABLE MAXIMUM LOSS (PML)

 The estimates are made by the Risk Surveyors on the basis of

their observation of the actual risk.
 The surveyor inspects the given risk, examines the loss control
measures in place such as fire extinguishers, automatic water
sprinklers, smoke detectors, the structure/nature of the building
e.t.c.
 The determination of PML will among other factors take into
consideration to extent of damage in the likely scenario that
these loss control measures fail.
 PROBABLE MAXIMUM LOSS (PML)

 A generally used definition of PML is that it is;

“An estimate of the maximum Monetary Loss which could be
sustained by an insurer on a single risk as a result of a single fire or
explosion, considered to be within the realms of probability”
 The underwriter therefore needs to asses three sizes of losses:-
1. The size of the routine loss.
2. The biggest loss that might occur when all preventative and
protective measures achieve their objectives
3. The biggest loss that would occur if all such preventative and
protective measures were to fail.
 ADVANTAGE OF PROBABLE MAXIMUM LOSS (PML)

Higher premium retention

Larger shares of the risk
Maximum utilization of auto capacity
Ease of placing large risks
Balanced portfolio
 DISADVANTAGE OF PROBABLE MAXIMUM LOSS (PML)

 No standard definition
 No mathematical formula
 No guidelines
 Subjective estimates
 Only experts can do
 Continuous review not possible
 Estimate of cedant.
 PML Error
CESSION OF RISK USING PROBABLE MAXIMUM LOSS (PML)

 As insurers grow, they write bigger risks. From individual

buildings to Industries and plants, bigger complexes like
malls e.t.c.
 As such they find themselves compelled to cede much of
these large risks to reinsurers while retaining less for their
account and yet, presumably the likelihood of claims
occurring in totality for such risks close to zero
 Through the use of PML, the cedant can increase their net
retention and retain more premium.
 PML also allows the cedant to write more of the risk and
also fully utilize their treaty capacity.
CESSION OF RISK USING PROBABLE MAXIMUM LOSS (PML)
(QUOTA SHARE TREATY)
 Example;
XYZ Insurance company has 60% Quota share treaty with
100% cession limit of TZS 3bn for its Engineering class of
business.
It has insured a CAR project with a contract price of TZS 5bn
and premium of TZS 2m was charged, and per surveyor’s
recommendation is considering PML of 60%.
Required:
Show how risk and premium will be ceded to the treaty using
full Sum Insured and how it will differ when using PML value.
CESSION OF RISK USING PROBABLE MAXIMUM LOSS (PML)
(SURPLUS TREATY)
 Example;
XYZ Insurance company has issued a fire policy to a complex
mall value at TZS 19bn and premium paid by insured is TZS
1m. The surveyor’s recommendation on the PML is 60%.
On its fire portfolio XYZ Insurance sit a 5lines Surplus treaty with
a gross retention of TZS 2bn.
Required:
Show how risk and premium will be ceded to the treaty using
full Sum Insured and how it will differ when using PML value.
 PML ERROR

 PML error arises as a results of wrongly estimation of the PML

value.
 PMLerror is only identified at the point of when loss event
occurs.
 It
appears when the loss amount is greater than the PML
value i.e. a fire might spread to all parts of the property or
damage in one part is greater than expected.
 When PML is miscalculated will affect the net account
share of loss, treaty share of the loss, treaties renewals and
cedant underwriting credibility.
 PML ERROR

 Example;
XYZ Insurance company has issued a fire policy to a complex
mall value at TZS 19bn and premium paid by insured is TZS
1m. The surveyor’s recommendation on the PML is 60%.
On its fire portfolio XYZ Insurance sit a 5lines Surplus treaty with
a gross retention of TZS 2bn.
During the insurance period a fire occurred destroying the
mall completely.
Required:
Show how a loss will be ceded to the treaty and how PML
error value will be allocated.
 HOW TO CORRECT PML ERROR

 Theoreticallyspeaking, the cedant can protect its net

retained line from un-reinsured losses resulting from PML
error by purchasing PML error excess of loss cover such
as a facultative excess of loss to cover for the
difference between the PML value and the sum
insured.
Review Questions
1. What is retention?
2. What is difference between retention under proportional treaty and
deductible under non-proportional treaty.
3. How fixing correct retention enable efficient in utilizing insurer’s capital?
4. Define what is PML?
5. What is PML error
6. An original insured has a risk valued at TZS 10bn which is written 100% by
XYZ Insurance Company. The EML is determined at 60% by XYZ, which
then decides to buy a non-proportional facultative reinsurance of TZS
3bn Xs TZS 3bn. The insured has a loss giving rise to a valid claim of TZS
8bn. XYZ Insurance has no other reinsurance on the risk. Show how much
XYZ Insurance would recover from the reinsurer.
Any Question?
MBONA MAHESABU TENA…. NTATOBOA KWELI..??