The Nature of Reinsurance - (article published by ART Ins. Services Limited)
The Nature of Reinsurance
Reinsurance, at its essence, is a risk transfer and
risk spreading mechanism that is consistent with and further supports the basic
theory of insurance. Insurance is about spreading of risk. Insurance works only
because many policyholders pool their risks of loss and transfer portions of
those risks to an insurance company. The insurance company, having accepted
potential losses from many policyholders, is able to charge an affordable
premium to each policyholder based on the probability that only a few of the
potential losses will actually occur and have to be paid. Thus, by pooling
risks together through an insurance company, insureds are able to insure their
risks at a reasonable price, which would otherwise not be possible if the risks
of all insureds had not been pooled together through an insurance company.
Spreading Risk through Reinsurance
Just as policyholders spread their risks of loss by
purchasing insurance from a company that collects premiums from many policyholders,
an insurance company spreads its risk of loss—the risks it assumed from its
policyholders—to other insurance companies—reinsurers—in exchange for a share
of the premium received by the insurance company from its policyholders. In
other words, the same risks that were pooled together through the insurance
company get spread further through the distribution of those risks to many
other insurance companies, called reinsurers. The reinsurers aggregate the
pooled risks assumed by many insurance companies just like the insurance
companies aggregate the pooled risks of the policyholders.
Let's consider an example. You own a factory. There
is a risk that your factory might burn down from a fire. You purchase property
insurance to protect against that risk of a fire loss and, in essence, transfer
the risk that your factory might burn down to your insurance company in
exchange for a premium. Your insurance company writes hundreds of property
insurance policies like yours and has determined the probability that only a
few of its insureds will suffer property damage losses in any given year and at
varying degrees of severity. But to protect against the insurance company's
accumulation of so much property damage and fire risk, it purchases
reinsurance, further spreading your fire damage risk to other insurance
companies. If your factory burns down and you file a claim, your insurance
company will be able to recover a portion of its payment of your claim back
from its reinsurers after it has paid your claim.
In the traditional reinsurance setting, the
obligation to pay a loss suffered by a policyholder rests and remains with the
insurance company that issued the insurance policy to the policyholder. A
policyholder that suffers a loss must notify its insurance company, not the
reinsurer (which it is unlikely to know about), and the insurance company is
generally obligated to address the claim. The reinsurance company has no direct
contractual or other relationship with the original insured and, generally,
only pays the insurance company after the insurance company has paid the
underlying policyholder and has submitted a reinsurance claim for
indemnification. If, in the example, your insurance company, for whatever
reason, fails to pay your fire loss claim, generally you would have no direct
right of action against the reinsurance company because there is no contractual
privity between you as the original policyholder and the reinsurer. The
contractual relationship in the reinsurance context is only between the insurance
company and the reinsurer, and that is a separate contract of indemnity.
Reinsurance as a Financial Tool
Reinsurance is also used for other purposes, often
for financial or regulatory reasons, none of which are mutually exclusive. On
the financial side, reinsurance is often described as a transaction where the
reinsurer lends its capital to the reinsured. Insurance laws and rules
generally regulate how much insurance risk an insurance company can underwrite
based on its financial condition. These rules are in place to prevent an
insurance company from becoming insolvent because of an over extension of its
business. Reinsurance can be used to mitigate this risk by transferring
(ceding) some of the liabilities on the books of the insurance company (risks
assumed under policies it wrote for its policyholders) to the reinsurer. The
obligation of the reinsurer to assume those ceded risks becomes an asset on the
financial statement of the insurance company assuming it meets all the
statutory and regulatory requirements.
For life and health insurance, reinsurance is often
used much more as a financial tool than as a device to spread risk, although it
often has both features. Because of the nature of life and health insurance and
related products, a great deal of capital must be allocated to required
reserves. Reinsurance provides a mechanism for infusing capital into an insurer
by ceding blocks of life and health insurance policies to the reinsurer in
exchange for that capital.
Using Reinsurance To Protect against Catastrophic Loss
Reinsurance is also used by many insurance
companies to protect against catastrophic loss. An insurance company may have
plenty of capital to pay the losses it anticipates from the insurance policies
it writes, but may be concerned about losses it does not anticipate. Using the
property insurance example again, the insurance company that writes your
factory's fire insurance policy may wish to protect itself from a massive fire
that burns down many of its insureds' properties in a concentrated factory
district. In the homeowners' situation, insurance companies that write property
insurance on the coast are always concerned about the losses they will sustain
in the event of a serious hurricane that destroys hundreds or thousands of homes.
Various types of reinsurance are available to
protect an insurance company for these catastrophic losses. Insurance companies
may buy excess-of-loss reinsurance, which is reinsurance that responds when a
specific loss exceeds a certain dollar figure. Insurance companies also may
purchase aggregate excess-of-loss reinsurance, which is reinsurance that
responds based on the aggregate losses paid by an insurance company within a
period of time. Property catastrophe reinsurance is what companies purchase to
protect themselves against large losses arising out of a large event like a
hurricane. This type of reinsurance may respond based on the aggregated loss
payments made by the specific insurer arising from one storm or based on the
total value of all losses suffered industry wide for that storm.
Reinsurance and Premiums
Insurance companies that use reinsurance to spread
their risk of loss or to protect themselves from catastrophic risk will factor
the cost of reinsurance into the premiums charged to their policyholders. If
the cost of reinsurance goes up, the premiums charged to policyholders likely
will go up also. But the cost of reinsurance is only one of many factors that
affect the cost of insurance, which also includes interest rates, taxes and
fees, the cost of running the insurance operation, and the cost of acquiring
the policyholders' business.
Determining the price a reinsurer will charge is a
complicated exercise often based on actuarial models. Typically, insurance and reinsurance
companies look to past experience to predict the cost of future losses so that
a proper premium can be determined. Those predictions are never perfect, but
over the long term, should follow the ultimate loss costs reasonably well.
Predicting future losses in property catastrophe
reinsurance for coastal homeowners insurance is very difficult. We have now
seen a few years with very few hurricanes. This followed a few years with some
of the most catastrophic storms in history. The probabilities are that
hurricanes will strike again, and insurance and reinsurance companies are
trying to match premiums to reflect this probability.
Life without Reinsurance
So what happens if we cut out the reinsurers and
save on that cost? Certainly, extremely well-capitalized direct writers of
insurance may not need to purchase traditional reinsurance. These companies may
only purchase catastrophe reinsurance or go into the capital markets and obtain
other catastrophe loss protection like cat bonds or loss warranties. But the
reality is that most insurers have reinsurance programs because reinsurance is
a significant tool used by insurers to manage their business and their overall
risk exposure.
Without reinsurance, an insurance company will have
to shoulder all the risks of loss it has assumed from all of its policyholders.
Unlike its policyholders, it will not have the advantage of spreading its risk
of loss to other companies and policyholders. Should it accumulate too much
business in a particular geographic location or in a particular line of
insurance, it may find that its capital will be severely strained. By using
reinsurance, accumulation risk, catastrophic risk, and overall risk are
lessened.
Moreover, most insurance companies are not large
mega-companies. There are literally thousands of small, regional insurers that
are crucial to the existence and well-being of local businesses and coastal
communities. These smaller companies necessarily rely more on reinsurance to
spread their risk of loss and to avoid accumulation and catastrophic exposures.
These companies also often rely on the underwriting and claims expertise of
their reinsurers to improve their products and better serve their insureds.
Without strong reinsurance relationships, these smaller and regional insurers
likely would not exist.
Conclusion
While reinsurance bashing has seemingly taken over
for insurance bashing, it is important to put in perspective the reasons why
reinsurance exists and the importance of reinsurance to the economy.
Reinsurance is the backbone of insurance because it enables risks of loss to be
spread more widely across companies and borders. Without the spreading of risks
of loss through reinsurance, policyholders would find it even more difficult to
obtain affordable insurance.
January 2010
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