Reinsurance
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Reinsurance

Introduction

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

reinsurance arrangements.

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.

Financing

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

underwriting.

Capacity

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.

Catastrophe Protection

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.

Underwriting Assistance

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

region.

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).

Quota-Share Contracts

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

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

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