Reinsurance

Reinsurance is the means by which an insurance company (called the reinsured, ceding company or cedant) shares the risk of loss with another insurance company (called the reinsurer).

Functions of Reinsurance

There are many reasons an insurance company will choose to buy reinsurance as part of its responsibility to manage a portfolio of risks. Main uses of reinsurance are to allow the ceding company to assume individual risks greater than its size would allow, and to protect the cedant against catastrophic losses.

Reinsurance allows an insurance company to offer larger limits of protection to a policyholder than its own capital would allow. If an insurance company can safely write only $5 million in limits on any one policy, it can reinsure (or cede) the amount of the limits in excess of $5 million to reinsurers. Reinsurance also allows the ceding insurer to write more business than its size would allow.

Reinsurance can help to make an insurance company’s results more predictable by absorbing larger losses and reducing the amount of capital needed to provide coverage.

Surplus relief

Reinsurance can improve an insurance company's balance sheet by reducing the amount of retained liabilities and thereby increasing the amount of Surplus. Surplus is roughly the same as shareholder equity on a balance sheet (assets less liabilites) of a non-insurance company.

Arbitrage

The insurance company may be motivated by arbitrage in purchasing reinsurance coverage at a lower rate than what they charge for the original coverage.

Types of Reinsurance

Proportional

Proportional reinsurance (mostly known as quota share reinsurance) is where the reinsurer takes a stated percent share of each policy the insurer writes and then shares in the premiums and losses in that same proportion. The size of the insurer might only allow it to write a risk with a policy limit of up to $1 million, but by purchasing proportional reinsurance it might double or triple that limit. Premiums and losses are then shared on a pro-rata basis. For example an insurance company might purchase a 50% quota share treaty; in this case they would share half of all premium and losses with the reinsurer. In a 75% quota share, they would share (cede) 3/4th's of all premiums and losses. The reinsurance company usually pays a commission on the premiums back to the insurer in order to compensate them for costs incurred in sourcing and administering (e.g. retail brokerage, taxes, fees, home office expenses) the business (usually 20-30%) This is known as the ceding commission.

The other (lesser known) form of proportional reinsurance is surplus share. In this case, a "line" is defined as a certain policy limit - say $100,000. In a 9 line surplus share treaty the reinsurer could then accept up to $900,000 (9 lines). 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 (cede) half of the premiums and losses to the reinsurer (1 line each). If they issue a $500,000 policy, they would cede 80% of the premiums and losses on that policy to the reinsurer (1 line to the company, 4 lines to the reinsurer 4/5 = 80%) If they issue the maximum policy limit of $1,000,000 the Reinsurer would then get 90% of all of the premiums and losses from that policy.

Non-proportional (excess of loss)

Non-Proportional Reinsurance (or Excess of Loss) only responds if the loss suffered by the insurer exceeds a certain amount (retention). An example of this form of reinsurance is where the insurer is prepared to accept a loss of $1 million for any loss which may occur and purchases a layer of reinsurance of $4m in excess of $1 million - if a loss of $3 million occurs the insurer pays the $3 million to the insured(s), and then recovers $2 million from their reinsurer(s). In this example, the insurer will retain any loss exceeding $5 million unless they have purchased a further excess layer (second layer) of say $10 million excess of $5 million.

Excess of Loss Reinsurance can have two forms - Per Risk or Per Occurrence (Catastrophe or "Cat"). In Per Risk, the insurance policy limits are exposed within the reinsurance limits. 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.

In Catastrophe Excess of Loss. the insurance policy limits must be less than the reinsurance retention. For example, an insurance company issues homeowner's policy 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 losses in one event (i.e hurricane, earthquake, etc.).

Should the insurer make claims against their Excess of Loss reinsurance they may be able to pay an additional premium in order to reinstate the Treaty Occurrence limit to its original value. Otherwise the Treaty Occurrence limit will be progressivly exhausted by the claims.

This additional amount restore complete coverage is called a reinstatement premium and is often calculated on a pro rata basis to the original premium and the amount of the limit used. In the example above this would mean that the insurer pays to the reinsurer 20% (1/5) of the original premium in order to reinstate the Treaty Occurrence limit to the original $5m of XS coverage. Not every Excess of Loss contract has reinstatements and those that do are often limited in number, (also known as the Aggregate Limit). This protects the reinsurer from having to cover repeated excess losses.

(This same principle applies to casualty reinsurance except that in the case of Catastrophe excess the word "Clash" is used.)

Contracts

Most of the above examples concern reinsurance contracts that cover more than one policy (treaty). 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.

Reinsurance treaties can either be written on a "Continuous" or "Term" basis. A Continuous contract continues indefinitely, but generally has a "notice" period whereby either party can give its intent to cancel or amend the treaty within 90 days. A Term agreement has a built-in cancellation date of usually one year after inception coninciding with the expiration of the policy(ies) covering the underlying risk. It is common for insurers and reinsurers to have long term relationships that span many years.

Market

Many reinsurance placements are not placed with a single reinsurer but are shared between a number of reinsurers. (for example a $30,000,000 xs of $20,000,000 layer may be shared by 30 reinsurers with a $1,000,000 participation each) The reinsurer who sets the terms (premium and contract conditions) for the reinsurance contract is called the lead reinsurer; the other companies subscribing to the contract are called following reinsurers (they follow the lead).

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 production staff and thus reinsure insurance companies directly.

Retrocession

Reinsurance companies themselves also purchase reinsurance and this is known as retrocession. They purchase this reinsurance from other reinsurance companies, who are then known as "retrocessionaires." The reinsurance company that purchases the reinsurance is know as the "retrocedent."

This process can sometimes continue until the original reinsurance company unknowingly gets some of its own business (and therefore its own liabilities) back. This is known as a "spiral" and was common in some specialty lines of business such as marine and aviation. Sophisticated reinsurance companies are aware of this danger and through careful underwriting attempt to avoid it.

In the 1980s the London market was badly affected by the intentional creation of reinsurance spirals, which concentrated risks into the hands of a few reinsurance syndicates. A series of catastrophic losses in the late 1980s, bankrupted these syndicates causing many ceding insurance companies to lose their effective coverage.

It is important to note that the insurance company is obliged to indemnify their policyholder for the loss under the insurance policy whether or not the Reinsurer actually reimburses the Insurer. Many insurance companies have got into trouble by purchasing reinsurance from reinsurance companies that did not or could not pay their share of the loss.

In a 50% quota share the insurance company could then be left with half the premium and the entire loss! This is a genuine concern when purchasing reinsurance from a reinsurer that is not domiciled in the same country as the insurer. Remember that losses come after the premium, and for certain lines of casualty business (e.g. asbestos or pollution) the losses can come many, many years later.

See also

• Retrocession (Insurance)
• General Re
• Lloyd's of London
• Munich Reinsurance
• Swiss Reinsurance