Reinsurance

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Reinsurance is insurance that is purchased by an insurance company (insurer also sometimes called a "cedant" or "cedent") from another insurance company (reinsurer) as a means of risk management. The reinsurer and the insurer enter into a reinsurance agreement which details the conditions upon which the reinsurer would pay the insurer's losses (in terms of excess of loss or proportional to loss). The reinsurer is paid a reinsurance premium by the insurer, and the insurer issues insurance policies to its own policyholders. The main reason for insurers to buy reinsurance is to transfer risk from the insurer to the reinsurer, but reinsurance has various other functions as explained below.

For example, assume an insurer sells one thousand 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 reinsurance company (reinsurer) as this will reduce the insurer's exposure to risk.

There are two basic methods of reinsurance:

1. Facultative Reinsurance In facultative reinsurance, the ceding company cedes and the reinsurer assumes all or part of the risk assumed by a particular specified insurance policy. Facultative reinsurance is negotiated separately for each insurance contract that is reinsured. Facultative reinsurance normally is purchased by ceding companies for individual risks not 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 relative to premiums written on facultative business because each risk is individually underwritten and administered. The ability to separately evaluate each risk reinsured, however, increases the probability that the underwriter can price the contract to more accurately reflect the risks involved.
2. Treaty Reinsurance is a method of reinsurance in which the insurer and the reinsurer formulate and execute a reinsurance contract. The reinsurer then covers all the insurance policies coming within the scope of that contract. The reinsurance contract may oblige the reinsurer to accept reinsurance of all contracts within the scope (known as "obligatory" reinsurance), or it may require the insurer to give the reinsurer the option to reinsure each such contract (known as "facultative-obligatory" or "fac oblig" reinsurance).

There are two basic methods of treaty reinsurance:

• Quota Share Treaty Reinsurance, and
• Excess of Loss Treaty Reinsurance.

In the past 30 years there has been a major shift from Quota Share to Excess of Loss 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 the exposure to loss to a reinsurer or a group of reinsurers. Therefore, they are 'transferring some of the risk to the reinsurer or a group of reinsurers'. In the USA, insurance, which is regulated at the state level, permits an insurer only to issue policies with a maximum limit of 10% of their surplus (net worth), unless those policies are reinsured.

Risk transfer

With reinsurance, the insurer can issue policies with higher limits than it would otherwise be allowed, therefore being permitted to take on more risk because some of that risk is now transferred to the reinsurer. Reinsurance has gone from a relatively unsophisticated business to a highly sophisticated endeavor. The reason for this is the number of reinsurers that have suffered significant losses and become financially impaired. From 2000 onward, reinsurers have become much more reliant on actuarial models and 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. Almost all reinsurers now visit the insurance company and review underwriting and claim files and more.

Income smoothing

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. The risk factor is diversified with the reinsurer bearing some of the loss incurred.

Surplus relief

An insurance company's writings are limited by its balance sheet (this test is known as the solvency margin). 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, which can be in the area of risk associated with any form of the asset that is being issued or loaned against. It can be a car, a mortgage, an insurance (personal, fire, business, etc.) and the like.

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.
• 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 (specialised) risk.

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 homogenous portfolio of insured risks. This would lend greater predictability to the portfolio results on net basis (after reinsurance) 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.

Managing cost of capital for an insurance company

By getting a suitable reinsurance, the insurance company may be able to substitute "capital needed" as per the requirements of the regulator for premium written. It could happen that the writing of insurance business requires x amount of capital with y% of cost of capital and reinsurance cost is less than x*y%. Thus more unpredictable or less frequent the likelihood of an insured loss, the more profitable it can be for an insurance company to seek reinsurance.

Types

Proportional

Proportional reinsurance (the types of which are quota share and surplus reinsurance) involves one or more reinsurers taking a stated percent share of each policy that an insurer produces ("writes"). This means that the reinsurer will receive that stated percentage of each dollar of premiums and will pay that percentage of each dollar of losses. In addition, the reinsurer will allow a "ceding commission" to the insurer to cover the initial costs incurred by the insurer (marketing, underwriting, claims etc.).

The insurer may seek such coverage for several reasons. First, the insurer may not have sufficient capital to prudently retain all of the exposure that it is capable of producing. For example, it may only be able to offer $1 million in coverage, 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) 3/4 of all premiums and losses.

The other form of proportional reinsurance is surplus share or surplus of line treaty. In this case, a retained “line” is defined as the ceding company's retention - say $100,000. In a 9 line surplus treaty the reinsurer would 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). The maximum underwriting capacity of the cedant would be $ 1,000,000 in this example.

Non-proportional

Non-proportional reinsurance only responds if the loss suffered by the insurer exceeds a certain amount, which is called the "retention" or "priority." An example of this form of reinsurance is where the insurer is prepared to accept a 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 "retain" $1 million of the loss and would recover $2 million from its reinsurer. In this example, the reinsured also retains any loss exceeding $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" (Working XL), "Per Occurrence or Per Event XL" (Catastrophe or Cat 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.

In catastrophe excess of loss, the cedant’s per risk retention is usually less than the cat reinsurance retention (this is not important as these contracts usually contain a 2 risk warranty i.e. they are designed to protect the reinsured against catastrophic events that involve more than 1 policy). For example, an insurance company issues homeowner's 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 (i.e., hurricane, earthquake, flood, etc.).

Aggregate XL affords a frequency protection to the reinsured. For instance if the company retains $1 million net any one vessel in the cover of $10 million in the aggregate, the excess of $5 million in the aggregate would equate to 5 total losses (or more partial 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" or annual aggregate XL.

Risk-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 for the whole policy period when written.

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.

Loss-occurring basis

A Reinsurance treaty from under which all claims occurring during the period of the contract, irrespective of when the underlying policies incepted, are covered. Any claims occurring after the contract expiration date are not covered.

As opposed to claims-made policy. Insurance coverage is provided for losses occurring in the defined period. This is the usual basis of cover for most policies.

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 (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. 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 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 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 multi-national company, to cover property and liability risks in every country in 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" (or a "front") usually receives a fronting fee for this service. 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

Most 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 (premium and contract conditions) for the reinsurance contract is called the lead reinsurer; the other companies subscribing to the contract are called following reinsurers.

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. In Europe reinsurers write both direct and brokered accounts.

Using game-theoretic modeling, Professors Michael R. Powers (Temple University) and Martin Shubik (Yale University) 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.^[1] Econometric analysis has provided empirical support for the Powers-Shubik rule.^[2]

Insurers (that is to say, reinsureds) tend to choose their reinsurers with great care as they are exchanging insurance risk for credit risk. Risk managers monitor reinsurers' financial ratings (S&P, A.M. Best, etc.) and aggregated exposures regularly.

Reinsurers

(Based on company figures; in US$)

In addition, syndicates at Lloyd's of London wrote £6.3 billion of reinsurance premium in 2008.

Major reinsurance brokers include:

Retrocession

Reinsurance companies themselves also purchase reinsurance, a practice known as a retrocession. They purchase this reinsurance from other reinsurance companies. A reinsurance company that sells reinsurance (receives a premium and offers cover) is a "retrocessionaire". A reinsurance company that buys reinsurance is a "retrocedent".

The flow of business and premium is as follows: client --> insurer --> reinsurer --> retrocessionaire. Other terms used for each of these entities in this flow of business would be: client --> cedent --> retrocedent --> retrocessionaire.

It is not unusual for a reinsurer to buy reinsurance protection from other reinsurers. For example, a reinsurer that provides proportional, or pro rata, reinsurance capacity to insurance companies may wish to protect its own exposure to catastrophes by buying excess of loss protection. Another situation would be that a reinsurer which provides excess of loss reinsurance protection may wish to protect itself against an accumulation of losses in different branches of business which may all become affected by the same catastrophe. This may happen when a windstorm causes damage to property, automobiles, boats, aircraft and loss of life, for example.

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 creation of reinsurance spirals. This resulted in the same loss going around the market thereby artificially inflating market loss figures of big claims (such as the Piper Alpha oil rig). The LMX spiral (as it was called) has been stopped by excluding retrocessional business from reinsurance covers protecting direct insurance accounts.

It is important to note that the insurance company is obliged to indemnify its policyholder for the loss under the insurance policy whether or not the reinsurer reimburses the insurer. Many insurance companies have experienced difficulties by purchasing reinsurance from companies that did not or could not pay their share of the loss. (These unpaid claims are known as uncollectibles.) This is particularly important on long-tail lines of business where the claims may arise many years after the premium is paid.

See also

References

External links

Look up reinsurance in Wiktionary, the free dictionary.

• 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 news and information from Artemis.bm