Optimization of Excess of Loss Reinsurance Structure

Abstract

In the current practice in the region, before purchasing a reinsurance contract, small to medium insurance companies rarely conduct internal analysis of their data and experiences in order to evaluate and achieve optimal reinsurance arrangements and contracts. Most companies settle their reinsurance agreements through reinsurance intermediary, broker, who acts as the link of communication, negotiation and settlement between both the reinsurers and the ceding insurer. Alternatively, the reinsurance companies or intermediaries evaluate and analyze the insurer's historical losses and offer reinsurance agreement and proposal accordingly. Therefore, the proposed reinsurance structure is not necessarily the insurer's optimal arrangement. In this thesis, excess of loss reinsurance optimization models are developed in order to enable insurers to utilize user-friendly and efficient tools to evaluate the optimal reinsurance arrangement depending on financial requirements, and to gain better value of their reinsurance contracts. The models are developed to define the insurer's optimal reinsurance retention and ceding limits for two objectives; minimizing insurer's retention variance and maximizing insurer's return on capital. The model maximizing the return on capital resulted in more realistic optimization solutions of retention limits. A sensitivity analysis to evaluate the impact of the model's parameters on the return on capital was also conducted, and it was concluded that the impact of the insurer's retention limit on the return on capital was significantly small. Moreover, the defined capital and gross premium safety loading had a major impact on the behavior of the return on capital.