Catastrophe reinsurance structure: net versus gross attachment
You are the chief actuary of an Indian insurer with a commercial property portfolio. Gross written premium is ₹9bn. The company cedes 60% of the whole account under a quota share, so it retains 40% of losses, and it also buys a catastrophe cover of ₹2.5bn excess of ₹500m on its net retained account, with one reinstatement. In the 2024 floods the portfolio suffered a gross loss of ₹1.9bn; reinstatement premium was ₹180m and the cat cover was exhausted. The vendor model puts the 1-in-100 gross loss at ₹5.2bn and the 1-in-200 at ₹7.8bn. The CEO proposes a second cat layer of ₹3bn excess of ₹3bn, also on the net account, at a rate-on-line of 14%, funded by raising the quota share cession from 60% to 70%; the ceding commission is 32%. The CFO says the layer is poor value because it attaches above the 1-in-50 return period. The board wants a net combined ratio below 108% and a solvency ratio above 1.8; the current ratio is 1.78.
1. Quantify the net retained catastrophe loss at the 1-in-100 and 1-in-200 return periods under the current programme, with the second layer, and with the 70% quota share. State your assumptions.
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Assume the quota share applies first and the cat layers sit on the retained net account. Retained share = 40%. At the 1-in-100, gross loss = ₹5.2bn, net before cat = 0.40 × 5.2 = ₹2.08bn. The cat cover is ₹2.5bn xs ₹0.5bn, so it pays 2.08 − 0.50 = ₹1.58bn and the net retained loss is the ₹0.50bn retention. The second layer of ₹3bn xs ₹3bn does not attach, so the net loss is unchanged at ₹0.50bn.
At the 1-in-200, net before cat = 0.40 × 7.8 = ₹3.12bn. The first cat cover pays its full ₹2.5bn, leaving ₹0.62bn. The second layer attaches at ₹3.0bn, so it pays 3.12 − 3.0 = ₹0.12bn, leaving ₹0.50bn. The marginal benefit of the second layer is therefore only ₹0.12bn at the 1-in-200, and zero at the 1-in-100. The annual premium is 14% × ₹3bn = ₹420m, so the layer is extremely poor value on a net basis.
With a 70% quota share, retained share = 30%. At 1-in-200, net before cat = 0.30 × 7.8 = ₹2.34bn; the first cat cover pays 2.34 − 0.50 = ₹1.84bn and the net loss is ₹0.50bn. The second layer does not attach. The quota share increase lowers the amount recovered from the cat cover but does not reduce the net retained loss at these return periods because the first cover already caps it at ₹0.50bn.
2. Advise the board on whether to buy the second layer and how to fund any additional protection.
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The second layer is mispriced for the cedent because it is written on the net account after a 60% quota share. At the 1-in-200 the net loss before the layer is only ₹3.12bn, so a layer attaching at ₹3.0bn is almost out of the money. The CFO is right on value, though the reason is the attachment basis, not simply the return period. Buying it would spend ₹420m for a expected recovery close to zero.
If the board wants more cat protection, the correct response is to restructure, not to add an overlying layer. Options include: (i) buy a gross-basis layer or a layer that attaches to the net account at a much lower point, for example ₹1.5bn xs ₹1.0bn; (ii) increase the first cat limit if the modelled net loss can exceed ₹0.5bn after a reinstatement; (iii) buy an aggregate stop-loss or a second-event cover; (iv) retain the risk and hold capital if the cost of cover exceeds the cost of capital.
Raising the quota share from 60% to 70% is a separate decision. It cedes a further 10% of premium (₹900m), receives 32% commission (₹288m), and cedes 10% of losses. At a 65% loss ratio the expected cost is modest, and it reduces volatility and capital. But it also gives away 10% of future profit and may not reduce net cat loss at the 1-in-200 because the first cat cover already caps it. Fund additional protection from capital or from the quota share only if the board accepts the profit give-up. Present the gross and net maths explicitly, and do not let the broker's rate-on-line be compared with a gross loss curve.
3. What risk-transfer and governance issues would you raise with the board before it decides?
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First, confirm the basis of every layer: gross versus net of quota share, and whether reinstatements are paid by the cedent or the reinsurer. A layer that looks cheap on a gross curve can be worthless on a net curve. Second, check counterparty credit risk and collateral; the 2024 flood shows the cover can be exhausted, and a reinsurer downgrade would hit both capital and recoverables.
Third, test the structure against multiple return periods and against a second event. The model gives 1-in-100 and 1-in-200 points, but the board should see the full exceedance curve, including aggregate and clash scenarios. Fourth, consider basis risk, exposure drift and the quality of the vendor model; the 2024 loss may be outside the calibration.
Fifth, assess the accounting and regulatory capital treatment. Quota share ceding commission affects the net combined ratio and profit, while cat premiums affect the expense ratio. Under the proposed risk-based capital framework, the capital credit for reinsurance depends on the structure and counterparty quality. Sixth, document the decision and the alternatives considered. The board should approve a risk appetite for net cat loss, not a single layer.