Insurance was created in response to a pervasive need for
protection against the risk of losses. It is feasible because it allows
many similar individual loss risks to be pooled into classes of risk.
Sometimes, however, the underwriting risk is too large to be assumed by any
one entity, even if the probability that an event will occur can be
accurately predicted. For example, a single insurance company might be
unable to cover catastrophe risks such as an epidemic or war damage because
catastrophe can strike a huge number of insured parties at the same time.
Reinsurance, simply defined, is the transfer of liability from the
primary insurer, the company that issued the insurance contract, to another
insurer, the reinsurance company. Business placed with a reinsurer is
called a cession, the insurance of an insurance company. The reinsurer
itself may cede part of the assumed liability to another reinsurance
company. This second transaction is called a retrocession, and the assuming
reinsurer is the retrocessionnaire.
Reinsurance contracts are entered into between insurance (or
reinsurance) companies, whereas insurance contracts are created between
insurance companies and individuals or noninsurance firms. A reinsurance
contract therefore deals only with the original insured event or loss
exposure, and the reinsurer is liable only to the ceding insurance company.
An insurance company’s policyholders have no right of action against the
reinsurer, even though the policyholder is probably the main beneficiary of
What does reinsurance do?
No single insurance company has the financial capacity to extend an
unlimited amount of insurance coverage in any line of business. Similarly,
an insurance company is always restricted in a size of any single risk it
can safely accept. If a risk is too large for a single insurance company,
it can be spread over several companies. Insurance companies often use this
process, known as coinsurance.
Reciprocity is the practice or cession of two primary insurers. It
is the exchange of one share of business for another insurer’s business of
the same type.
Reciprocity is an attempt to maintain the same premium volume while
widening the risk spread.
Reinsurance is more efficient and less costly than having several
insurers underwrite separate portions of a loss exposure. It is also a more
efficient way to spread the risk among several companies. But an insurer
might decide to buy reinsurance for other reasons. Reinsurance offers
advantages in financing, capacity, stabilization of loss experience,
protection against catastrophe, and underwriting assistance.
An insurer’s limit on the value of premiums it can write is related
to the size of its surplus. When premiums are collected in advance, the
company must establish an unearned premium reserve. Reinsurance enables a
company to increase its surplus by reducing its unearned premium reserve.
This mechanism is particularly useful lo a new or growing insurance company
or to an established insurance company entering a new field of
Capacity, in insurance terminology, means a company’s ability to
underwrite a large amount of insurance coverage on a single loss exposure
(large line capacity) or on many contracts in one line of business (premium
capacity). Reinsurance also allows insurers to cover larger individual
risks than the company’s capital and surplus position would allow or risks
that the company’s management would consider too hazardous.
Stabilization of Loss Experience
An insurance company, like any other business firm, likes to smooth
out its year-to-year financial results as much as possible. However,
underwriting losses can fluctuate widely in some lines of business as a
result of economic, climatic, and other extraneous reasons, or as a result
of inadequate business diversification. Reinsurance enables an insurance
company to limit year-to-year fluctuations. It is sometimes compared to a
banking operation where the insurer borrows from the reinsurer in bad years
and pays back when its loss experience is good.
The potential impact of a catastrophe loss from a natural disaster,
an industrial accident, or similar disasters on a company’s normal (or
expected) loss experience is the main reason for buying reinsurance. A
catastrophe loss may endanger a company’s very existence. In that case, a
reinsurance contract insures the insurer.
Reinsurance companies accumulate a great of information and
statistical experience regarding different types of insurance coverage and
methods of rating, underwriting, and adjusting claims. This experience is
quite useful, especially for ceding company that may want to enter a new
line of business or territory or underwrite an uncommon type of risk.
Reinsurance facilities can provide extremely valuable services for the
company entering a new market, but they are also
when an insurance company
decides to stop underwriting in a particular line of business or geographic
What are the traditional reinsurance methods?
The two major categories of reinsurance contracts arc facultative
reinsurance contracts and treaty reinsurance contracts.
In facultative reinsurance (single risk), the ceding company
negotiates a contract for each insurance policy it wishes to reinsure. This
type of insurance is especially useful for reinsuring large risks, that is,
those that the insurance company is either unwilling or unable to retain
for its own account.
Facultative reinsurance, by nature, involves some degree of adverse
selection for the reinsurer. It is expensive for the insurance company and
practical only when the risks arc few. It is useful when the primary
insurer has no experience with a particular risk and turns to the reinsurer
for underwriting assistance.
In treaty reinsurance, the ceding company agrees in advance to the
type, terms, and conditions of reinsurance. Treaty reinsurance affords a
more stable contractual relationship between primary insurer and reinsurer
than does facultative reinsurance. Most insurers depend heavily on treaty
reinsurance because facultative reinsurance is not practical when dealing
with a single business class or line. The reinsurer does not examine each
risk individually and cannot refuse to cover a risk within the treaty. The
treaty method is also less expensive and easier to operate and administer
than facultative reinsurance.
Although me reinsurer must accept all business cessions under the
treaty, adverse selection is less likely to occur if the insurer wants to
establish a long-term business relationship with the reinsurer. In this
case, the reinsurer follows the ceding company’s good or bad operating
results (somewhat as a banker does) over a longer period of time.
The type of reinsurance contract chosen depends on the distribution
of risks between insurer and reinsurer. There are two types of reinsurance
contract: proportional (pro-rate) or nonproportional (excess). Proportional
reinsurance can be extended through a quota-share or a surplus-share
contract. Nonproportional reinsurance can be issued for risk excess
(working XL per risk), for occurrence excess (per catastrophic event: cat-
XL), or for aggregate excess (stop loss).
Under a quota-share contract, the primary insurer cedes a fixed
percentage of every exposure it insures within the class of business
covered by the contract. The reinsurer receives a share of the premiums
(less a ceding commission) and pays the same percentage of each loss.
Quota-share contracts are common in property and liability
insurance. They are simple to administer, and there is no adverse selection
for the reinsurer. Quota-share contracts are usually profitable for the
reinsurer because both commissions and terms are better.
A quota-share contract is a most effective means for small
companies to reduce their unearned premium reserve when taking on a new
line or class of business. A quota share is also ideal for reciprocal
treaties between insurance companies. For example, two insurance companies
with similar business volumes and profitability could each reinsure a 50
percent quota share of the other’s business. This could have substantial
diversification effects on each, particularly if they are involved in
different geographical areas.
Surplus-share contracts, like quota-share contracts, are defined as
proportional reinsurance, but the difference between them is in the way the
retention is stated. In a surplus-share contract, the retention is defined
as a monetary amount instead of as a fixed percentage.
As a result, in a surplus treaty, the percentage varies with the
extent of loss exposure and the limit imposed by the reinsurer on the size
of the potential loss. This reinsurance limit is usually defined as an „n-
line surplus treaty,“ which means that the reinsurer will accept
reinsurance coverage up to n times the retention amount. The surplus can be
divided among several companies.
The reinsurer would pay its share of losses in the same proportion
as its share of the premium. The surplus treaty is particularly useful for
large commercial and industrial risks. It provides a larger line capacity
than the quota-share treaty and does not require the primary insurer to
share small exposures that it can carry itself. However, it does not confer