Reinsurance is insurance that is purchased by an insurance company from one or more other
insurance companies directly or through a broker as a means of risk management, sometimes
in practice including tax mitigation and other reasons described below.
The ceding company and the reinsurer enter into a reinsurance agreement which details
the conditions upon which the reinsurer would pay a share of the claims incurred by the
ceding company.
The reinsurer is paid a "reinsurance premium" by the ceding company, which issues insurance
policies to its own policyholders.
The reinsurer may be either a specialist reinsurance company, which only undertakes reinsurance
business, or another insurance company.
Insurance Companies that sell reinsurance refer to the business as 'assumed reinsurance'.
Assumed reinsurance is reported separately on their books from their non-reinsurance
business.
For an example of a reason for purchasing reinsurance, assume an insurer sells 1,000
policies, each with a $1 million policy limit.
Theoretically, the insurer could lose $1 million on each policy – totaling up to $1 billion.
It may be better to pass some risk to a reinsurer as this will reduce the ceding company's exposure
to risk.
A healthy reinsurance marketplace helps to ensure that insurance companies can remain
solvent because the risks and costs are spread, particularly after a major disaster such as
a major hurricane.
There are two basic methods of reinsurance: Facultative Reinsurance, which is negotiated
separately for each insurance policy that is reinsured.
Facultative reinsurance is normally purchased by ceding companies for individual risks not
covered, or insufficiently covered, by their reinsurance treaties, for amounts in excess
of the monetary limits of their reinsurance treaties and for unusual risks.
Underwriting expenses, and in particular personnel costs, are higher for such business because
each risk is individually underwritten and administered.
However as they can separately evaluate each risk reinsured, the reinsurer's underwriter
can price the contract to more accurately reflect the risks involved.
Ultimately, a facultative certificate is issued by the reinsurance company to the ceding company
reinsuring that one policy.
Treaty Reinsurance means that the ceding company and the reinsurer negotiate and execute a
reinsurance contract.
The reinsurer then covers the specified share of more than one insurance policy issued by
the ceding company which come within the scope of that contract.
The reinsurance contract may oblige the reinsurer to accept reinsurance of all contracts within
the scope, or it may allow the insurer to choose which risks it wants to cede, with
the reinsurer obliged to accept such risks.
Ultimately, a treaty is issued by the reinsurance company to the ceding company reinsuring more
than one policy.
There are two main types of treaty reinsurance, proportional and non-proportional, which are
detailed below.
Under proportional reinsurance, the reinsurer's share of the risk is defined for each separate
policy, while under non-proportional reinsurance the reinsurer's liability is based on the
aggregate claims incurred by the ceding office.
In the past 30 years there has been a major shift from proportional to non-proportional
reinsurance in the property and casualty fields.
Functions Almost all insurance companies have a reinsurance
program.
The ultimate goal of that program is to reduce their exposure to loss by passing part of
the risk of loss to a reinsurer or a group of reinsurers.
In the United States, insurance is regulated at the state level, which only allows insurers
to issue policies with a maximum limit of 10% of their surplus, unless those policies
are reinsured.
In other jurisdictions allowance is typically made for reinsurance when determining statutory
required solvency margins.
Risk transfer With reinsurance, the insurer can issue policies
with higher limits than would otherwise be allowed, thus being able to take on more risk
because some of that risk is now transferred to the reinsurer.
The reason for this is the number of insurers that have suffered significant losses and
become financially impaired.
Over the years there has been a tendency for reinsurance to become a science rather than
an art: thus reinsurers have become much more reliant on actuarial models and on tight review
of the companies they are willing to reinsure.
They review their financials closely, examine the experience of the proposed business to
be reinsured, review the underwriters that will write that business, review their rates,
and much more.
Income smoothing Reinsurance can make an insurance company's
results more predictable by absorbing larger losses and reducing the amount of capital
needed to provide coverage.
The risks are diversified, with the reinsurer bearing some of the loss incurred by the insurance
company.
The income smoothing comes forward as the losses of the cedant are essentially limited.
This fosters stability in claim payouts and caps indemnification costs.
Surplus relief An insurance company's random writings are
limited by its balance sheet.
When that limit is reached, an insurer can do one of the following: stop writing new
business, increase its capital, or buy "surplus relief".
Arbitrage The insurance company may be motivated by
arbitrage in purchasing reinsurance coverage at a lower rate than they charge the insured
for the underlying risk, whatever the class of insurance.
In general, the reinsurer may be able to cover the risk at a lower premium than the insurer
because: The reinsurer may have some intrinsic cost
advantage due to economies of scale or some other efficiency.
Reinsurers may operate under weaker regulation than their clients.
This enables them to use less capital to cover any risk, and to make less prudent assumptions
when valuing the risk.
Reinsurers may operate under a more favourable tax regime than their clients.
Reinsurers will often have better access to underwriting expertise and to claims experience
data, enabling them to assess the risk more accurately and reduce the need for contingency
margins in pricing the risk Even if the regulatory standards are the same,
the reinsurer may be able to hold smaller actuarial reserves than the cedant if it thinks
the premiums charged by the cedant are excessively prudent.
The reinsurer may have a more diverse portfolio of assets and especially liabilities than
the cedant.
This may create opportunities for hedging that the cedant could not exploit alone.
Depending on the regulations imposed on the reinsurer, this may mean they can hold fewer
assets to cover the risk.
The reinsurer may have a greater risk appetite than the insurer.
Reinsurer's expertise The insurance company may want to avail itself
of the expertise of a reinsurer, or the reinsurer's ability to set an appropriate premium, in
regard to a specific risk.
The reinsurer will also wish to apply this expertise to the underwriting in order to
protect their own interests.
Creating a manageable and profitable portfolio of insured risks
By choosing a particular type of reinsurance method, the insurance company may be able
to create a more balanced and homogeneous portfolio of insured risks.
This would lend greater predictability to the portfolio results on net basis and would
be reflected in income smoothing.
While income smoothing is one of the objectives of reinsurance arrangements, the mechanism
is by way of balancing the portfolio.
Types Proportional
Under proportional reinsurance, one or more reinsurers take a stated percentage share
of each policy that an insurer produces.
This means that the reinsurer will receive that stated percentage of the premiums and
will pay the same percentage of claims.
In addition, the reinsurer will allow a "ceding commission" to the insurer to cover the costs
incurred by the insurer.
The arrangement may be "quota share" or "surplus reinsurance" or a combination of the two.
Under a quota share arrangement, a fixed percentage of each insurance policy is reinsured.
Under a surplus share arrangement, the ceding company decides on a "retention limit" - say
$100,000.
The ceding company retains the full amount of each risk, with a maximum of $100,000 per
policy or per risk, and the balance of the risk is reinsured.
The ceding company may seek a quota share arrangement for several reasons.
First, they may not have sufficient capital to prudently retain all of the business that
it can sell.
For example, it may only be able to offer a total of $100 million in coverage, but by
reinsuring 75% of it, it can sell four times as much.
The ceding company may seek surplus reinsurance simply to limit the losses it might incur
from a small number of large claims as a result of random fluctuations in experience.
In a 9 line surplus treaty the reinsurer would then accept up to $900,000.
So if the insurance company issues a policy for $100,000, they would keep all of the premiums
and losses from that policy.
If they issue a $200,000 policy, they would give half of the premiums and losses to the
reinsurer.
The maximum automatic underwriting capacity of the cedant would be $1,000,000 in this
example.
Non-proportional Under non-proportional reinsurance the reinsurer
only pays out if the total claims suffered by the insurer in a given period exceed a
stated amount, which is called the "retention" or "priority".
For instance the insurer may be prepared to accept a total loss up to $1 million, and
purchases a layer of reinsurance of $4 million in excess of this $1 million.
If a loss of $3 million were then to occur, the insurer would bear $1 million of the loss
and would recover $2 million from its reinsurer.
In this example, the insured also retains any excess of loss over $5 million unless
it has purchased a further excess layer of reinsurance.
The main forms of non-proportional reinsurance are excess of loss and stop loss.
Excess of loss reinsurance can have three forms - "Per Risk XL", "Per Occurrence or
Per Event XL", and "Aggregate XL".
In per risk, the cedant's insurance policy limits are greater than the reinsurance retention.
For example, an insurance company might insure commercial property risks with policy limits
up to $10 million, and then buy per risk reinsurance of $5 million in excess of $5 million.
In this case a loss of $6 million on that policy will result in the recovery of $1 million
from the reinsurer.
These contracts usually contain event limits to prevent their misuse as a substitute for
Catastrophe XLs.
In catastrophe excess of loss, the cedant's retention is usually a multiple of the underlying
policy limits, and the reinsurance contract usually contains a two risk warranty.
For example, an insurance company issues homeowners' policies with limits of up to $500,000 and
then buys catastrophe reinsurance of $22,000,000 in excess of $3,000,000.
In that case, the insurance company would only recover from reinsurers in the event
of multiple policy losses in one event.
Aggregate XL affords a frequency protection to the reinsured.
For instance if the company retains $1 million net any one vessel, $5 million annual aggregate
limit in excess of $5m annual aggregate deductible, the cover would equate to 5 total losses in
excess of 5 total losses.
Aggregate covers can also be linked to the cedant's gross premium income during a 12-month
period, with limit and deductible expressed as percentages and amounts.
Such covers are then known as "Stop Loss" contracts.
Risks attaching basis A basis under which reinsurance is provided
for claims arising from policies commencing during the period to which the reinsurance
relates.
The insurer knows there is coverage during the whole policy period even if claims are
only discovered or made later on.
All claims from cedant underlying policies incepting during the period of the reinsurance
contract are covered even if they occur after the expiration date of the reinsurance contract.
Any claims from cedant underlying policies incepting outside the period of the reinsurance
contract are not covered even if they occur during the period of the reinsurance contract.
Losses occurring basis A Reinsurance treaty under which all claims
occurring during the period of the contract, irrespective of when the underlying policies
incepted, are covered.
Any losses occurring after the contract expiration date are not covered.
As opposed to claims-made or risks attaching contracts.
Insurance coverage is provided for losses occurring in the defined period.
This is the usual basis of cover for short tail business.
Claims-made basis A policy which covers all claims reported
to an insurer within the policy period irrespective of when they occurred.
Contracts Most of the above examples concern reinsurance
contracts that cover more than one policy.
Reinsurance can also be purchased on a per policy basis, in which case it is known as
facultative reinsurance.
Facultative reinsurance can be written on either a quota share or excess of loss basis.
Facultative reinsurance is commonly used for large or unusual risks that do not fit within
standard reinsurance treaties due to their exclusions.
The term of a facultative agreement coincides with the term of the policy.
Facultative reinsurance is usually purchased by the insurance underwriter who underwrote
the original insurance policy, whereas treaty reinsurance is typically purchased by a senior
executive at the insurance company.
Reinsurance treaties can either be written on a "continuous" or "term" basis.
A continuous contract has no predetermined end date, but generally either party can give
90 days notice to cancel or amend the treaty.
A term agreement has a built-in expiration date.
It is common for insurers and reinsurers to have long term relationships that span many
years.
Fronting Sometimes insurance companies wish to offer
insurance in jurisdictions where they are not licensed: for example, an insurer may
wish to offer an insurance programme to a multinational company, to cover property and
liability risks in many countries around the world.
In such situations, the insurance company may find a local insurance company which is
authorised in the relevant country, arrange for the local insurer to issue an insurance
policy covering the risks in that country, and enter into a reinsurance contract with
the local insurer to transfer the risks.
In the event of a loss, the policyholder would claim against the local insurer under the
local insurance policy, the local insurer would pay the claim and would claim reimbursement
under the reinsurance contract.
Such an arrangement is called "fronting".
Fronting is also sometimes used where an insurance buyer requires its insurers to have a certain
financial strength rating and the prospective insurer does not satisfy that requirement:
the prospective insurer may be able to persuade another insurer, with the requisite credit
rating, to provide the coverage to the insurance buyer, and to take out reinsurance in respect
of the risk.
An insurer which acts as a "fronting insurer" receives a fronting fee for this service to
cover administration and the potential default of the reinsurer.
The fronting insurer is taking a risk in such transactions, because it has an obligation
to pay its insurance claims even if the reinsurer becomes insolvent and fails to reimburse the
claims.
Markets Many reinsurance placements are not placed
with a single reinsurer but are shared between a number of reinsurers.
For example a $30,000,000 excess of $20,000,000 layer may be shared by 30 or more reinsurers.
The reinsurer who sets the terms for the reinsurance contract is called the lead reinsurer; the
other companies subscribing to the contract are called following reinsurers.
Alternatively, one reinsurer can accept the whole of the reinsurance and then retrocede
it to other companies About half of all reinsurance is handled by
reinsurance brokers who then place business with reinsurance companies.
The other half is with "direct writing" reinsurers who have their own sales staff and deal with
the ceding companies directly.
In Europe reinsurers write both direct and brokered accounts.
Using game-theoretic modeling, Professors Michael R. Powers and Martin Shubik have argued
that the number of active reinsurers in a given national market should be approximately
equal to the square-root of the number of primary insurers active in the same market.
Econometric analysis has provided empirical support for the Powers-Shubik rule.
Ceding companies often choose their reinsurers with great care as they are exchanging insurance
risk for credit risk.
Risk managers monitor reinsurers' financial ratings and aggregated exposures regularly.
Reinsurers Major reinsurance brokers include:
Willis Re Guy Carpenter
Cooper Gay Swett & Crawford Aon Corporation
See also
References
External links The US Reinsurance Under 40s Group
(French) APREF Association des Professionnels de la Réassurance en France
(French) ENASS - Ecole Nationale d'Assurances website,(French National School of Insurance)
Captive Review Captive Review Reinsurance, by Gary Patrick [1]
Reinsurance Association of America Risk transfer, ILS, weather risk and reinsurance
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