Reinsurance
Reinsurance is insurance purchased by an insurer to transfer part of the risk it has assumed to another insurer, the reinsurer. It is used to increase underwriting capacity, share large risks, stabilise results, and support capital and solvency management. The International Association of Insurance Supervisors says "Reinsurance is insurance for insurers. Just as firms and individuals buy insurance for perils they do not want to bear, primary insurers purchase reinsurance for risks they do not want to fully retain. Reinsurers absorb losses that are not retained by primary insurers, and in so doing they limit the earnings volatility of primary insurers. Reinsurers pursue the same business model as primary insurers. They contract with the primary insurer to reimburse any future claim the primary insurer may have against the payment of a premium today. In order to meet future claims, reinsurers apply the same insurance techniques and models for risk selection as primary insurers, and they follow the same insurance accounting principles. Just like primary insurers, reinsurers are prefunded through premium payments, and they pursue similar general approaches to asset liability management ".
Reinsurance arrangements are commonly classified as facultative, which applies to individual risks, or treaty, which covers a class of business under a standing agreement between the parties.
Treaty and facultative arrangements may be structured on a pro rata basis or an excess of loss basis, depending on how premiums and losses are shared and on the retention and limits set in the contract.
Functions
Insurers commonly use reinsurance as part of their risk and capital management, transferring a portion of their underwriting risk to reinsurers in exchange for a premium. The structure and extent of a reinsurance programme can vary with an insurer's business strategy, risk appetite and cost of capital, and some insurers may choose to retain all risk.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 re-insurer. See.Income smoothing
Reinsurance can make an insurance company's results more predictable by absorbing large losses. This is likely to reduce the amount of capital needed to provide coverage. The risks are spread, with the reinsurer or reinsurers bearing some of the loss incurred by the insurance company. The income smoothing arises because the losses of the cedent are limited. This fosters stability in claim payouts and caps indemnification costs.Surplus relief
Proportional Treaties provide the cedent with "surplus relief"; surplus relief being the capacity to write more business and/or at larger limits.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 conservative 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 cedent if it thinks the premiums charged by the cedent are excessively conservative.
- The reinsurer may have a more diverse portfolio of assets and especially liabilities than the cedent. This may create opportunities for hedging that the cedent 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
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 make its results more predictable on a net basis. This is usually one of the objectives of reinsurance arrangements for the insurance companies.Types of reinsurance
Proportional
Under proportional reinsurance, one or more reinsurers take a stated percentage share of each policy that an insurer issues. The reinsurer will then receive that stated percentage of the premiums and will pay the stated percentage of claims. In addition, the reinsurer will allow a "ceding commission" to the insurer to cover the costs incurred by the ceding 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, up to a maximum of $100,000 per policy or per risk, and the excess over this retention limit is reinsured.
The ceding company may seek a quota share arrangement for several reasons. First, it 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, and retain some of the profits on the additional business via the ceding commission.
The ceding company may seek surplus reinsurance 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 cedent would be $1,000,000 in this example. Any policy larger than this would require facultative reinsurance.
Non-proportional
Under non-proportional reinsurance the reinsurer only pays out if the total claim suffered by the insurer 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 insurer also retains any 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 cedent'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 cedent'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 cedent'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 reinsurancerelates. The insurer knows there is coverage during the whole policy period even if claims are only discovered or made later on.
All claims from cedent 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 cedent underlying policies incepting outside the period of the reinsurance contract are not covered even if they occur during the period of the reinsurance contract.