Risk Management and Reinsurance
Domain 6 links two themes the exam treats together: how risk is identified and treated before insurance is bought, and how an insurer lays off the risk it has accepted.
Risk and its treatment
Pure risks (loss or no loss) are insurable; speculative risks (gain or loss, as in trading or investment) are not. Hazards modify a risk without being the peril: physical hazards (combustible stock, faulty wiring), moral hazard (dishonest intent, exaggerated claims) and morale hazard (carelessness because insurance exists). The management cycle is identification, evaluation, control, then financing. Treatments are avoid, reduce or prevent, retain, and transfer - insurance being one transfer mechanism alongside captives and contractual indemnities.
A risk is insurable when losses are fortuitous, definite and measurable, exposures are numerous and homogeneous, probability is calculable, the maximum loss is tolerable to the insurer, and insurable interest exists at law.
Why insurers reinsure
To increase capacity on large risks, protect against catastrophe and accumulation, stabilise results, release capital, and obtain technical assistance. Reinsurance is a separate contract between insurer and reinsurer; the original insured has no rights under it and cannot claim directly.
Structure
- Proportional: quota share (fixed percentage of premium and losses) and surplus (retain a line, cede the excess up to a stated number of lines).
- Non-proportional: excess of loss per risk, excess of loss per event or catastrophe, and aggregate stop loss.
- Facultative is a single-risk cession negotiated separately; treaty is automatic for a defined class.
Worked example
A property treaty carries a per-risk excess of loss layer of HK$4m in excess of HK$1m. A single fire loss is HK$2.5m: the insurer retains HK$1m and the reinsurer pays the HK$1.5m above it, still inside the HK$4m limit. On a HK$6m loss the reinsurer pays its full HK$4m and the insurer keeps HK$2m - the layer, not the loss, caps recovery.
Traps that cost marks
Thinking quota share removes the whole risk (the insurer keeps its retention percentage of every loss); confusing treaty retention with the policy deductible; assuming the insured can claim against the reinsurer; classifying speculative risk as insurable; forgetting catastrophe excess of loss attaches to an event, not to each risk.