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  • Reinsurance is insurance that is purchased by an insurance company from one or more other

  • insurance companies directly or through a broker as a means of risk management, sometimes

  • in practice including tax mitigation and other reasons described below. The ceding company

  • and the reinsurer enter into a reinsurance agreement which details the conditions upon

  • which the reinsurer would pay a share of the claims incurred by the ceding company. The

  • reinsurer is paid a "reinsurance premium" by the ceding company, which issues insurance

  • policies to its own policyholders. The reinsurer may be either a specialist reinsurance

  • company, which only undertakes reinsurance business, or another insurance company. Insurance

  • Companies that sell reinsurance refer to the business as 'assumed reinsurance'. Assumed

  • reinsurance is reported separately on their books from their non-reinsurance business.

  • For an example of a reason for purchasing reinsurance, assume an insurer sells 1,000

  • policies, each with a $1 million policy limit. Theoretically, the insurer could lose $1 million

  • on each policytotaling up to $1 billion. It may be better to pass some risk to a reinsurer

  • as this will reduce the ceding company's exposure to risk.

  • A healthy reinsurance marketplace helps to ensure that insurance companies can remain

  • solvent because the risks and costs are spread, particularly after a major disaster such as

  • a major hurricane. There are two basic methods of reinsurance:

  • Facultative Reinsurance, which is negotiated separately for each insurance policy that

  • is reinsured. Facultative reinsurance is normally purchased by ceding companies for individual

  • risks not covered, or insufficiently covered, by their reinsurance treaties, for amounts

  • in excess of the monetary limits of their reinsurance treaties and for unusual risks.

  • Underwriting expenses, and in particular personnel costs, are higher for such business because

  • each risk is individually underwritten and administered. However as they can separately

  • evaluate each risk reinsured, the reinsurer's underwriter can price the contract to more

  • accurately reflect the risks involved. Ultimately, a facultative certificate is issued by the

  • reinsurance company to the ceding company reinsuring that one policy.

  • Treaty Reinsurance means that the ceding company and the reinsurer negotiate and execute a

  • reinsurance contract. The reinsurer then covers the specified share of more than one insurance

  • policy issued by the ceding company which come within the scope of that contract. The

  • reinsurance contract may oblige the reinsurer to accept reinsurance of all contracts within

  • the scope, or it may allow the insurer to choose which risks it wants to cede, with

  • the reinsurer obliged to accept such risks. Ultimately, a treaty is issued by the reinsurance

  • company to the ceding company reinsuring more than one policy.

  • There are two main types of treaty reinsurance, proportional and non-proportional, which are

  • detailed below. Under proportional reinsurance, the reinsurer's share of the risk is defined

  • for each separate policy, while under non-proportional reinsurance the reinsurer's liability is based

  • on the aggregate claims incurred by the ceding office. In the past 30 years there has been

  • a major shift from proportional to non-proportional reinsurance in the property and casualty fields.

  • Functions Almost all insurance companies have a reinsurance

  • program. The ultimate goal of that program is to reduce their exposure to loss by passing

  • part of the risk of loss to a reinsurer or a group of reinsurers. In the United States,

  • insurance is regulated at the state level, which only allows insurers to issue policies

  • with a maximum limit of 10% of their surplus, unless those policies are reinsured. In other

  • jurisdictions allowance is typically made for reinsurance when determining statutory

  • required solvency margins. 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 reinsurer. The reason for this is the number of insurers that have suffered significant

  • losses and become financially impaired. Over the years there has been a tendency for reinsurance

  • to become a science rather than an art: thus reinsurers have become much more reliant on

  • actuarial models and on tight review of the companies they are willing to reinsure. They

  • review their financials closely, examine the experience of the proposed business to be

  • reinsured, review the underwriters that will write that business, review their rates, and

  • much more. Income smoothing

  • Reinsurance can make an insurance company's results more predictable by absorbing larger

  • losses and reducing the amount of capital needed to provide coverage. The risks are

  • diversified, with the reinsurer bearing some of the loss incurred by the insurance company.

  • The income smoothing comes forward as the losses of the cedant are essentially limited.

  • This fosters stability in claim payouts and caps indemnification costs.

  • Surplus relief An insurance company's random writings are

  • limited by its balance sheet. When that limit is reached, an insurer can do one of the following:

  • stop writing new business, increase its capital, or buy "surplus relief".

  • 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 prudent 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 cedant if it thinks the premiums charged by the cedant are excessively

  • prudent. The reinsurer may have a more diverse portfolio

  • of assets and especially liabilities than the cedant. This may create opportunities

  • for hedging that the cedant 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 The insurance company may want to avail itself

  • of the expertise of a reinsurer, or the reinsurer's ability to set an appropriate premium, in

  • regard to a specific risk. The reinsurer will also wish to apply this expertise to the underwriting

  • in order to protect their own interests. 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 lend greater predictability to the portfolio results

  • on net basis and would be reflected in income smoothing. While income smoothing is one of

  • the objectives of reinsurance arrangements, the mechanism is by way of balancing the portfolio.

  • Types Proportional

  • Under proportional reinsurance, one or more reinsurers take a stated percentage share

  • of each policy that an insurer produces. This means that the reinsurer will receive that

  • stated percentage of the premiums and will pay the same percentage of claims. In addition,

  • the reinsurer will allow a "ceding commission" to the insurer to cover the costs incurred

  • by the 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, with a maximum of $100,000 per policy or per risk, and the balance of the

  • risk is reinsured. The ceding company may seek a quota share

  • arrangement for several reasons. First, they 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. The ceding company may seek surplus reinsurance

  • simply 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 cedant would be $1,000,000 in this example.

  • Non-proportional Under non-proportional reinsurance the reinsurer

  • only pays out if the total claims suffered by the insurer in a given period 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 insured also retains any excess of 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 cedant'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 cedant'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 cedant'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 reinsurance

  • relates. The insurer knows there is coverage during the whole policy period even if claims

  • are only discovered or made later on. All claims from cedant 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 cedant underlying policies

  • incepting outside the period of the reinsurance contract are not covered even if they occur

  • during the period of the reinsurance contract. Losses occurring basis

  • A Reinsurance treaty under which all claims occurring during the period of the contract,

  • irrespective of when the underlying policies incepted, are covered. Any losses occurring

  • after the contract expiration date are not covered.

  • As opposed to claims-made or risks attaching contracts. Insurance coverage is provided

  • for losses occurring in the defined period. This is the usual basis of cover for short

  • tail business. Claims-made basis

  • A policy which covers all claims reported to an insurer within the policy period irrespective

  • of when they occurred. Contracts

  • Most of the above examples concern reinsurance contracts that cover more than one policy.

  • 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