Reinsurance Business Practices - a good read for those starting in this business.

                                                                                               

     Reinsurance Protection  

a must have necessity for the Insurance business

Questions

Who benefits from reinsurance?

Is Reinsurance about the consumer/original insured and the insurance company or both?

Everyone benefits from reinsurance in a big way.

Reinsurance for the insurance company

Reinsurance is the only mechanism that allows insurance companies to take/insure big risks. It is this reinsurance mechanism that allows them to insure as much as they often do? Without reinsurance they will not be able to.

An insurance company never knows when they will have to pay out a loss and to how many people in any given year and how much. They are actually insuring more than they would be able to afford to pay out all at once, that is when reinsurance comes into their rescue. By reinsuring the amounts they will be able to pass some of the risk on to other insurance and reinsurance companies thus giving the original insured a larger benefit package. For the original insured this means higher insurance policy limits and larger pay-outs.

The transferring of risk

By transferring the risk the insurance company will be less likely to go bankrupt and close down. They will be able to continue to do business and they will not have to worry about the losses that they incur in any given year, or as a matter of fact, they will not worry about the losses each year because everything will flow smoothly with the help of reinsurance. The Insurance Company will not have to have so much capital at all times, giving them much more leeway in their business.

Most insurance companies are able to get this reinsurance at much lower rates than we could get insurance for. The benefits of reinsurance do not just end with the Insurance Company being able to write bigger policy limits for the original insured but it also lowers their liability, which is something that all insurance companies would like to do.

How reinsurance is written

Reinsurance contracts can be written as cover for single insurance policies/single risks, or they can cover many more risks than just one. Most insurance companies have reinsurance policies that cover much of the business that they write.

Reinsuring the reinsurer

Even Reinsurance Company buys reinsurance protection. It is a continuous cycle of insuring the insured. It is all about protecting everyone’s interests.

Functions of Reinsurance

Protecting against catastrophic events is only one kind of reinsurance. There are many reasons an insurance company will choose to reinsure as part of its responsibility to manage a portfolio of risks for the benefit of its policyholders and investors.

Some of the reinsurance terminology used

Risk transfer

The main uses of reinsurance are to allow the ceding company to assume individual risks greater than its size would otherwise 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 USD5 million in limits on any one policy, it can reinsure (or cede) the amount of the limits in excess of USD 5 million to reinsurers.

Reinsurance highly refined uses in recent years include applications where reinsurance was used as part of a carefully planned hedge strategy.

Income smoothing

Reinsurance can help to make insurance companies 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 net liability, and thereby increasing surplus. Surplus, assets less liabilities, is roughly the same as shareholder equity on a balance sheet of a non-insurance company.

Types of Reinsurance

Proportional

Proportional reinsurance (mostly known as quota share reinsurance) is where the reinsurer takes a stated percentage share of each policy that 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. This is 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 USD100,000. In a 9 line surplus share treaty the reinsurer could then accept up to USD 900,000 (9 lines). So if the Insurance Company issues a policy for USD 100,000, they would keep all of the premiums and losses from that policy. If they issue a USD 200,000 policy, they would give (cede) half of the premiums and losses to the reinsurer (1 line each). If they issue a USD 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 USD 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, also known as excess of loss reinsurance, only responds if the loss suffered by the insurer exceeds a certain amount, called the retention. An example of this form of reinsurance is where the insurer is prepared to accept a loss of USD1 million for any loss which may occur and purchases a layer of reinsurance of USD4m in excess of USD1 million - if a loss of USD3 million occurs the insurer pays the USD3 million to the insured(s), and then recovers USD2 million from their reinsurer(s). In this example, the insurer will retain any loss exceeding USD 5 million unless they have purchased a further excess layer (second layer) of say USD10 million excess of USD 5 million.

Excess of loss reinsurance can have two forms - Per Risk or Per Occurrence/Event (Catastrophe or Cat).

 In per risk cover, the cedants insurance policy limits are greater than the reinsurance retention. For example, an insurance company might insure commercial property risks with policy limits up to USD10 million and then buy per risk reinsurance of USD5 million in excess of USD 5 million. In this case a loss of USD6 million on that policy will result in the recovery of USD1 million from the reinsurer.

In catastrophe excess of loss, the cedants insurance policy limits must be less than the reinsurance retention. For example, insurance company issues homeowner's policy limits of up to USD500,000 and then buys catastrophe reinsurance of USD22,000,000 in excess of USD3,000,000. 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.

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 always carry reinsurance contracts (documents) 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 fixed 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 fixed term agreement has a built-in expiration date. It is common for insurers and reinsurers to have long term relationships that span many years.

Markets

Many reinsurance placements are not placed with a single reinsurer but are shared between a numbers of reinsurers. (For example a USD30,000,000 xs of USD20,000,000 layer may be shared by 30 reinsurers with a USD1,000,000 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).

It is common practice that about half of all reinsurance is handled by Reinsurance Brokers who then place the 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 a retrocession. They purchase this reinsurance from other reinsurance companies, who are then known as retrocessionaires. The Reinsurance Company that purchases the reinsurance is known as the retrocedent.

It is not unusual for a reinsurer to buy reinsurance protection from other reinsurers. For example, a reinsurer which 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, loss of life etc.

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 gotten 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.

Financial reinsurance

Financial reinsurance, is a form of reinsurance which is focused more on capital management than on risk transfer. One of the particular difficulties of running an insurance company is that its financial results - and hence its profitability - tend to be uneven from one year to the next. Since insurance companies want, above all else, to produce consistent results, they are always attracted to ways of hoarding this year's profit to pay for next year's possible losses. Financial reinsurance is one means by which insurance companies can smooth their results.

A pure financial reinsurance contract tends to cover a multi-year period, during which the premium is held and invested by the reinsurer. It is returned to the ceding company - minus a pre-determined profit-margin for the reinsurer - either when the period has elapsed, or when the ceding company suffers a loss.

Financial reinsurance therefore differs from conventional reinsurance because most of the premium is returned whether there is a loss or not: little or no risk-transfer has taken place. This reinsurance business practice has been around since at least the 1960s, when Lloyd’s syndicates started sending money overseas as reinsurance premium for what were then called roll-overs - multi-year contracts with specially-established vehicles in tax-light jurisdictions such as the Cayman Islands. These deals were legal and approved by the UK tax-authorities.

Source:

various independent reading insurance materials accessed by 
ART Ins. Services Limited