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c. Risk Transfer and Risk Charges
Reinsurance agreements are structured to transfer risks that
are inherent in the underlying policies. Risks commonly found in
policies sold by life insurers include mortality, lapse, and
investment.
Mortality is: (1) The risk that policyholders will die and
death benefits will be paid sooner than expected, in the case of
life insurance, or (2) the risk that policyholders will continue
to live and collect benefits longer than expected, in the case of
annuity insurance. When a life policy is reinsured, the
reinsurer usually agrees with the ceding company to reimburse it
for the full death benefits. In the case of annuity contracts,
the reinsurance agreement may transfer two types of mortality
risk. First, reinsurers usually realize a loss when a
policyholder dies in the early years of his or her policy,
because the death benefit tends to be higher than the cash value.
Second, reinsurers usually suffer a loss when the annuitization
benefits which are payable according to the settlement terms of a
policy are greater than anticipated due to better than expected
annuitant longevity (i.e., the policyholder lives longer than
predicted by standard mortality tables).
Surrender, which is also known as lapse, is the risk that a
policy holder will voluntarily terminate his or her policy prior
to the time that the insurer recoups its costs of selling and
issuing the policy. A reinsurer will realize a loss on the
reinsurance agreement when: (1) It receives an initial
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