Term
| 1. Risk Based Capital (RBC) |
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Definition
| 2. A measurment developed by the National Assn of Insurance Commissioners (NAIC) that establishes a min amt of capital that an insurer needs to support its overall onging business operations based on the risk-based capital formula. |
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Term
| 2. Total Adjusted Capital |
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Definition
2. An insurer's statutory capital and surplus adjusted for any items provided in the insuers domiciliary state
risk-based capital requirements |
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Term
| 3. Authorized control level risk-based capital (ACL) |
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Definition
| 3. The amount of capital determined using the risk-based capital formula. |
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Term
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Definition
| 4. The transfer of insurance risk from one insurer to another through a contractual agreement under which one insurer (the reinsurer)agrees, in return for a reinsurance premium, to indemnify another insurer (the primary insurer) for some or all of the financial consequences of certain loss exposures covered by the primary insurer's policies. |
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Term
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Definition
| 5. An insurer's ability to provide a greater limit of insurance on a single risk than it is otherwise willing to provide |
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Term
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Definition
| 6. An amount paid by th ereinsurer to the primary insurer to cover part or all of the primary insurer's policy acquisition expenses. |
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Term
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Definition
| 7. A replenishment of policyholders surplus provided by the ceding commission paid to the primary insurer by the reinsurer |
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Definition
| 7. A replenishment of policyholders surplus provided by the ceding commission paid to the primary insurer by the reinsurer |
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Term
| 8. Finite Risk Reinsurance |
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Definition
| 8. A nontraditional type of reinsurance in which the reinsurer's liability is limited and anticipated investment income is expressly acknowledge as an underwriting component |
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Term
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Definition
| 9. A transaction in which the owner of an asset sells the asset to another party and then leases the asset back from the new owner. |
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Term
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Definition
| 10. A type of unsecured debt instrument inssued only by insurers that has characteristics of both conventional equity and debt securitys and is classified as policyholder's surplus on the insurer's statutory balance sheet |
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Term
| 1. Explain why an insurer needs additional capital beyond its initial capital. |
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Definition
| 1. Additional capital is needed to pay for expanded sales and operational capabilities such as marketing and advertising expenses, new employees and related expenses, and additional information technology resources. Also, as the amt of insurance written increases, the insurer will need more capital to provide a larger reserve to cover unexpected losses. Additional capital is also needed to replenish policyholders' surplus for the reduction in net income caused by statutory accounting rules that require insurers to recognize all policy acquisition costs at the time the policy is written (as opposed to ratably over the policy period in the way that premium revenue is recognized) |
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Term
| 2. Describe the regulatory requirements regarding the capital needed by insurers. |
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Definition
| 2. An insurer must meet certain regulatory requirements regarding the amt of its capital and policyholders' surplus. Themin amt of initial capital required for an insurer is set by the state in which it is domiciled. This amt depends on the type of business organization the insurer uses, generally either stock or mutual and the lines of biz the insurer writes. The amts vary by state statute, from $150,000 to $5 million. However, the ongoing amt of capital required depends on the amt of the insurer's risk-based capital. |
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Term
| 3. Describe four major categories of risk that must be measured to determine the amt of an insurer's overall risk-based capital. |
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Definition
3. The four major categories of risk that must be measured to determine the amt of an insurer's overall risk-based capital (RBC) amount are as follows:
1. Asset Risk - A measure of an asset's default risk on principal or decline in mkt value as a result of changes in the market.
2. Credit Risk - A measure of the default risk on amts that are due from policyholders, resinsurers or creditors.
3. Underwriting Risk - A measure of the risk that arises from underestimating the liabilities from business already written or inadequately pricing current or prospective business.
4. Business Risk - A measure of the risk caused by excessive rates of growth, contingent liabilities, or other items not reflected on the balance sheet. |
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Term
| 4. Describe the implications if an insurer fails to meet the RBC requirements. |
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Definition
4. An insurer's faulure to meet the RBC requirements can lead to the following four levels of regulatory action, depending on the amt of the shortfall:
1. At the company-action level which is when the insurer's total adjusted capital is less than 200 percent of the authorized control level risk-based capital (ACL), the insurer is required to submit a business plan to regulators indicating how RBC requirements will be met in the future.
2. At the regulatory-control level, which is when the insurer's total adjusted capital is less than 150 percent of the ACL, additional regulatory involvement may be initiated.
3. At the authorized-control level, which is when when the insurer's total adjusted capital is less than 100 percent of the ACL, regulators may take control of the insurer.
4. If the insurer's total adjusted capital is less than 70 percent of the ACL, regulators are required to take control of the insurer. |
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Term
| 5. Explain how insurers use risk reduction as a method to meet their internal capital needs. |
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Definition
| 5. As an alternative to raising additional capital, an insurer may seek to reduce the amt of capital required by reducing its overall exposure to risks. For example, if the cost of obtaining additional capital for writing more insurance exceeds the profits projected from that business, then reducing capital requirements may ultimately generate a higher rate of return to the owners. |
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Term
| 6. Describe why insurers use reinsurance in risk reduction. |
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Definition
| 6. The main purpose of reinsurance is to stabilize a primary insurer's loss experience. Smoothing the peaks and troughs of loss experience is important because an insuer must have a reasonably steady flow of profits to attract and retain capital to support growth. |
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Term
| 7. Explain how insurers can use reinsurance, in addition to risk reduction, to limit their need for additional capital. |
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Definition
7.Insurers can use reinsurance to limit their need for additional capital in the following ways:
A. To increase lg line capacity: reinsurers can provide primary insurers with large line capacity by accepting liability for those high value loss exposures that the primary insurer would otherwise be unwilling or unable to accept. Purchasing reinsurance enables the primary insurer to increase its market share without having to increase its capital.
B. To provide catastrophe protection: Insurers can also use reinsurance to protect themselves from the financial consequences of a single catastrophic event causing multiple losses. Both natural and man made catastrophes can result in significant property and liability losses. The use of reinsurance would provide stability to th einsurers financial position in case of an unexpected catastrophe, allowing the insurer to reduce the amt of capital it must have available.
C. To facilitate withdrawal from a mkt segment: A primary insurer may determine that a particular mkt segment no longer fits into its biz strategy or will not be profitable in the future; therefore, it may want to withdraw from that mkt segment. Portfolio reinsurance might be an attractive option to facilitate such a withdrawal. Portfolio reinsurance can allow a primary insurer to ID and limit the amt of capital it will need to allocate to the mkt fro which it is withdrawing. |
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Term
| 8. Explain how insurers use operations as a method to meet their internal capital needs. |
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Definition
| 8.The most valuable source of internal capital is the generation of net income from the insurers business operations. An insurer's business operations raise capital from the premiums received when insurance policies are sold. In some cases, internal capital can also come from surplus relief provided by reinsruance transactions. |
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Term
| 9. Describe how long-tail liability claims generate investment income for insurers. |
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Definition
| 9. It can be many years before long-tail libaility claims become known to the insured, are officially reported as claims, and are finalized and paid. In effect, long-tail claims create long-term debt, the proceeds of which become part of the insurer's investment portfolio and are used to generate investment income and increase policyholders' surplus. However, long-term debt is not considered capital for regulatory purposes. |
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Term
| 10. Describe when insurers must recognize expenses and revenues for accounting purposes, according to state regulations. |
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Definition
| 10. State insurance regulation mandates that for accounting purposes, all expenses related to the acquisition (sale) of an insurance policy be recognized at the time the policy is sold. However, insurance accounting rules also require the insurer to recognize premiums as revenue only as they are earned over the policy's life. |
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Term
| 11. Explain how the accounting rules for the recognition of insurer expenses and revenues affect policyholders' surplus. |
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Definition
| 11. Immediately recognizing expenses combined with gradually recognizing revenue causes an insurer's policyholders' surplus to decrease. |
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Term
| 12. Explain how reinsurance ceding commissions provide surplus relief. |
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Definition
| 12. Ceding commissions are usually a percentage of the ceded written premiums and are recognized as revenue by the primary insurer at the time the reinsurance is put into effect. Therefore, both revenue and policyholders' surplus increase. Consequently, the reinsurance transaction provides surplus relief. |
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Term
| 13. Id the two FAS 113 requirements necessary for a short-duration reinsurance transaction to qualify for reinsurance accounting treatment. |
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Definition
13. According to FAS 113, a short-duration reinsurance transaction qualifies for reinsurance accounting treatment only if the following two requirements are met:
(1) the reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance contracts.
(2) It is reasonabley possible that the reinsurer may realize a significant loss from the transaction. |
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Term
| 14. Describe how FAS 113 defines "insurance risk" |
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Definition
| 14. FAS 113 defines "insurance risk" as including both underwriting risk and timing risk. Underwriting risk is described as the uncertainty about the ultimate amt of any premiums, commissions, claims, and claim settlement expenses. Timing risk is described as the uncertainty about the timing of premiums, commissions, claims and claim settlement expenses. |
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Term
| 15. Explain how insurers use balance sheet values as a method of meeting their internal capital needs. |
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Definition
15. The following two types of activities are commonly used to provide capital on a balance sheet:
(1) Actions to change loss and loss adjustment expense reserve valuations
(2) Transactions that recognize existing asset market values. |
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Term
| 16. Describe how changes to loss adjustment and loss adjustment expense reserves affect policyholders' surplus |
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Definition
| 16. Any adjustments reducing loss reserves will reduce loss expenses in the year the adjustment is made, thereby increasing both net income an dpolicyholders' surplus. Any adjustments made to increase reserves will decrease net income and policyholders' surplus. |
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Term
| 17. Describe how insurers use existing assets to increase asset values. |
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Definition
| 17. Insurers can use existing assets to increase asset value by sale and leaseback transactions, through which the owner of an asset sells the asset to another party and then leases the asset back from the new owner. Because the sold asset was previously carried on the insurer's balance sheet at historical cost, the difference between fair market value and historical cost was not included in the insurer's capital. However, when the asset was sold, the entire proceeds of the sale became an admitted asset. Therefore, the difference between historical cost and higher fair market value (minus taxes due on the gain from the sale) is now included in the insurer's capital, thereby increasing the capital. |
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Term
| 18. Explain how insurers use equity as a method to meet their external capital needs. |
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Definition
| 18. Insurers organized as stock companies have the option of using the capital mkts to raise equity capital, based on their particular capital needs and financial circumstances. However, mutual insurers do not have the option to access the capital mkts to raise equity capital because they are owned by their policyholders. |
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Term
| 19. Explain why a mutual insurer might consider reorganization. |
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Definition
| 19. The inability of a mutual insurer to use the financial mkts to raise capital can limit its strategic options, such as those related to mergers and acquisitions. Therefore, a mutual insurer may determine that the stock form of owenrship will provide it with more flexibility and alternatives for raising capital |
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Term
| 20. Id two ways in which a mutual insurer can demutualize. |
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Definition
| 20. A mutual insurer can demutualize in two ways. It can go through a complete demutualization process into a stock company, or it can go through a mutual holding company conversion. |
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Term
| 21. Describe what happens to a mutual insurer's surplus when the insurer demutualizes and becomes a stock insurer. |
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Definition
| 21. When the insurer demutualizes and becomes a stock insurer, the insurer's surplus is usually distributed to policyholders as stock, cash, and policy enhancements. Most policyholders will recive stock, but some will recieve cash or policy enhancements that have an equivilant value. |
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Term
| 22. Explain who demutualization provides financial flexibility for an insurer. |
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Definition
| 22. Demutualization provides financial flexibility because the reorganized co can issue stock and debt and can obtain bank credit facilities. It provides maximum access to capital to finance future growth, and it creates a source of pmt that the co can use for mergers and acquisitions. |
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Term
| 23. Describe how demutualization provides organizational flexibility for an insurer. |
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Definition
| 23. Demutualization provides organizational flexibility because business entities can become subsidiaries of a holding co rather than the insurer, thereby simplifying insurer regulation. Also, offering stock options can help to attract and retain employees. |
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Term
| 24. ID the disadvantages of demutualization |
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Definition
| 24. One disadvantage of demutualization is that the demutualization process is very expensive. Ongoing administration is also expensive because of the increased fianncial reporting requirements of publicly co's and because the co is likely to have many small shareholders. This process is also time consuming; it can take from eighteen to twenty-four months to complete. During this time, mgmt's attention is distracted from other duties. |
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Term
| 25. Describe how insurers use long-term debt as a method to meet their external capital needs. |
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Definition
| 25. Insurers can use long-term debt to meet their external capital needs by selling bonds to raise long-term debt capital. |
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Term
| 26. Id the main method that mutual insurers use to raise surplus of equity |
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Definition
| 26. Surplus notes are the main method mutual insurers use to raise surplus or equity |
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Term
| 27. Id the tow main categories of alternative sources of capital that insurers can use as a method to meet their external capital. |
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Definition
| 27. The tow main categories of alternative sources of capital that insurers can use to meet their external capital needs are insurance-linked securities, which in effect are direct risk transfer instruments, and contingent capital securities, which reduce an insurer's need for traditional sources of capital. |
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Term
| 28. Explain how insurance-linked securities such as catastrophe bonds, provide funds to help insurers offset catastrophe losses. |
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Definition
| 28. Insurance-linked securities provide funds to help offset the catastrophe losses suffered by an insurer. They do this by transferring the risk of loss from a catastrophe directly to the investor. Catastrophe bonds are the most commonly used insurance-linked securityh. Insurers issue catastrophe bonds to the providers of capital with the provision that the pmt of interest, repayment of principal, or botth are reduced or even eliminated |
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Term
| 29. Describe how insurers can use contingent capital arrangements as a method to meed their external capital needs. |
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Definition
| 29. Contingent capital arrangements are agreements entered intobefore any lossess occur, and they enable an insurer to raise cash by selling stock or issuing debt at prearranged terms. The insurer pays a capital commitment fee to theparty that agrees in advance to buy the equity or debt securities following a loss. Usinga contingent capital arrangement does not transfer the insurer's risk of loss to the investors. However, after a loss occurs, the insurer receives an inflow of capital to replenish its policyholders' surplus after it pays for the loss. |
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Term
| 30. Describe how contingent capital can be provided. |
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Definition
| 30. Contingent capital can be provided through a contingent surplus note arrangement or through the purchase of a catastrophe equity put option. Contingent surplus notes are prearranged to allow an insurer, at its option, to immediately obtain funds by issuing surplus notes at a pre-agreed rate and maturity. Contingent surplus notes are mde available to an insurer through a contingent surplus note (CSN) trust, which receives funds from investors and places them in liquid investments such as US treasury securities. In exchange, the investors receive trust notes from the CSN trust. For a specified time, the insurer can, at its option, receive the cash value of the trust investments in exchange for surplus notes that it issues to the trust. Therefore, the insurer has a standby source of cash that it can use to help it recover from large losses. |
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Term
| 31. Explain how the envestors of contingent surplus notes (CSN) are compensated for providing standby funds to the insurer and for taking on the notes credit risk. |
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Definition
| 31. As compensation for providing standby funds to the insurer and taking the credit risk involved with any surplus notes that are issued, the investors in the CSN trust receive a return higher than that available from other liquid investments of comparable maturity. |
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Term
| 32. Explain how insurers can use catastrophe equity put options to raise funds in the event of catastrophe losses. |
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Definition
| 32. Insurers use catastrophe equity put options (also called catastrophe equity puts) to raise funds in the event of catastrophic losses. A catastrophe equity put option is the right to sell equity (stock) at a predetermined price in the event of a catastrophic loss. The purchaser of a catastrophe equity at a pre-agreed price in the event of a catastrophic loss, as defined in the put agreement. |
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Term
| 33. Id a major benefit of catastrophe equity put options |
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Definition
| 33. A major benefit of catastrophe equity put options is that they make equity capital available at a pre-agreed price immediately after a catastrophe, when the insurer most needs that capital. If an insurer suffers a loss of capital as a result of a catastrophe its stock price is likely to decrease, lowering the amount it would receive from newly issued stock. Catastrophe put options provide instant equity at a predermined price to help an insurer replenish its capital following such a loss. |
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