Reinsurance

Reinsurance

The intention of all insurance companies should be to create the most effective reinsurance program. However, to achieve this objective, the company must first establish a reinsurance strategy. Some companies may wish to retain as much as possible the original premium income while others would be prepared to pay more in reinsurance premiums to secure as stable a result as possible and minimize the exposure to risk.

An effective reinsurance program could achieve the following objectives:

  • The primary objective of reinsurance is that it should reduce the company's probability of a loss at a price acceptable to the company. In this sense, the basic role of reinsurance is to safeguard the solvency of an insurer against random fluctuations in the overall claims' experience and an accumulation of losses arising out of one event.
  • It stabilizes any fluctuation in the company's annual aggregate claims'experience, so that wide fluctuations in results from one year to the next are avoided.
  • Reinsurance can be used to allow a company to accept risks beyond its normal retention,ensuring that it is not placed at a serious disadvantage compared to its competitors.
  • Particularly for a newly formed company, reinsurance can be used to finance growth. In countries where minimum solvency margins based on net premiums are applied, reinsurance can reduce net premiums so that a company can accept more business without requiring a corresponding increase in capital.

Reinsurance can beunderstood with the analogy of the shock absorbers in a car. They do not make the road smoother, but passengers feel the bumps less because these are absorbed by the device fitted in the car. Similarly, reinsurance does not reduce losses but merely smoothens out the effect on the insurer.

Methods of Reinsurance

The major methods of reinsurance are proportional and non-proportional. In proportional reinsurance, liability and premiums are split on apro-rata basis between cedant and reinsurer. In non-proportional reinsurance, the insurer undertakes to pay for all losses up to a pre-agreed figure. The reinsurer is usually subject to an agreed maximum that they will meet the balance of any loss exceeding this limit. The price for this type of cover is determined by negotiation between the parties, and one reinsurer may differ from another in their opinion of what is an appropriate premium. A reinsurer will base their rate on the exposure to risk, and other factors,such as exposure to storm, earthquake and other natural disasters, are also taken into account for property portfolios, whereas the statistical record plays an important role in the rating of a motor cover.

Both proportional and non-proportional reinsurance can be placed on a facultative or a treaty basis. Facultative reinsurance means that each risk is offered individually, whereas treaty reinsurance refers to a prior agreement between insurer and reinsurer, providing for the automatic reinsurance of all businesses of a certain type or class. The ceding company is obliged to cede, and the reinsurer is obliged to accept all businesses within the terms and conditions of the treaty.


The most common types of reinsurance are listed below.

Facultative Reinsurance
Facultative reinsurance implies that a riskis reinsured individually. The ceding company is free to choose retentions and reinsurers, among other things, and reinsurers can accept or decline the individual risk on its own merits. Traditionally, facultative reinsurance has been arranged on a proportional basis, but it has become increasingly common to place facultative risks on a non-proportional basis.

Facultative reinsurance is used under the following circumstances:

  • When extra capacity above the automatic treaty capacity is required;
  • When a risk falls outside the scope of the existing treaties; and
  • When, for some reason, a Cedant does not want to use the existing treaties (fully or partially).

The advantages are as follows:

  • It provides extra capacity for insurance companies to accept risks into their portfolio; and
  • The reinsurer is given a chance to make their own assessment of the risk.

The disadvantages are as follows:

  • No automatic capacity. The Cedant cannot commit themselves to accepting the direct insurance risk until they know that reinsurance capacity is available;
  • Time factor -a placement can take considerable time as it is not accepted automatically;
  • Administration is burdensome, as detailed information must be provided for every risk; and
  • Consequently, cost of reinsurance (reinsurance premium)is considerably higher than it is for treaties.

Quota Share Treaties

A quota share treaty is a proportional contract whereby the reinsurer receives a fixed proportion of all risks in a portfolio, pays the same proportion of all losses and receives the same proportion of all premiums. Put differently, with a quota share arrangement, all risks of a specified type are reinsured in the same proportion. The ceding company receives a commission, the rate of which is subject to negotiation, but it is normally based on the acquisition and administration costs of the reinsured and the profitability of the account.

Quota share treaties tend to be used as follows:

  • By small and/or newly formed companies requiring protections that are easy to administer and that can reduce the constraint on capital;
  • For new classes of insurance where little experience is available; and
  • For classes with uniform policies or policies that are similar.

Advantages

  • Simple administration; and
  • Consequently,lowering cost.

Disadvantages

  • Since the same proportion of all policies, large and small, is ceded, those risks that could be retained for own account will be reinsured; and
  • It does not increase capacity as efficiently as other types of reinsurance.

Surplus Treaties

A surplus treaty is an automatic reinsurance contract whereby the ceding company agrees to cede, and the reinsurers agree to accept the part of a risk that exceeds the cedants retention. The ceding company decides in advance the level of its retention that may vary according to the type of exposure unit. Small risks may be fully retained while risks exceeding the fixed retention would be ceded to the surplus treaty up to a predetermined level. The retention can vary from 100% on smaller risks (i.e., fully retained) to 1-2% on the largest. The cession to reinsurers is normally fixed as a multiple of the retention, for example, ten times the retention (which would be described as a ten-line treaty, where one line equals one retention). With a ten-line treaty and a retention of GBP 10,000, the company can cede automatically up to GBP 100,000. The ceding company receives a commission to cover its costs.

Advantages

  • There is no cession of smaller risks that could be retained for a net account as in quota share reinsurance; and
  • A surplus treaty option increases the retained premium income without undue increase of retained liability.

Disadvantages

  • Complicated administration as the allocation of every risk to retention and treaty has to be calculated separately; and
  • Relatively more expensive method to use.

However, these disadvantages have significantly reduced with the development of computerized systems.

Excess of loss

Excess of loss is the most common of the non-proportional reinsurance forms. An excess of loss cover can be either of the following:

  • On a per-risk basis; or
  • On a per-event basis.

A per-risk cover gives protection for each risk involved in a loss when it exceeds a pre-agreed level (the priority) and up to the pre-agreed limit. Thus, if the number of risks is involved in the same loss event, the reinsured pays the priority on each, and the reinsurer pays the amount exceeding the priority on each and every risk affected.

Per-risk covers are used to protect accounts against large individual losses, for example, motor third-party liability or public liability insurances. A per-event limitation is often included to ensure that the cover only provides protection against large single losses and not an accumulation of losses from one event.

Per-event covers protect the reinsured against an accumulation of losses. When the sum of the losses exceeds the pre-agreed amount (known as the priority), the reinsurer will be liable to pay the excess up to a pre-agreed upper limit. Typically,per-event covers are used to protect a company against catastrophe events, such as windstorms or the accumulation of losses in a personal accident account from a major accident affecting many individuals. A per-event cover often contains a two-risk warranty to ensure that it will not be affected by a single claim.

More than loss reinsurance, it is particularly important to ensure that the definitions of the terms "risk" and "event" are unambiguous.

The premium for an excess of loss cover is subject to negotiation between the parties and is based on the claims' experience and/orthe potential exposure to a claim. Consequently, it can vary considerably from reinsurer to reinsurer and from one year to another.

The premium on a per-event cover would normally only pay for the use of the cover once. However, the reinsured may require protection for more than one total loss. Therefore, a per-event excess of loss cover could contain a reinstatement condition implying that the cover can be reinstated an agreed number of times, subject to the payment of an additional (reinstatement) premium.

Advantages of an excess of loss reinsurance are as follows:

  • Simple and inexpensive administration; and
  • Efficient and clear protection.

Disadvantages of an excess of loss reinsurance are as follows:

  • Premium cost might vary considerably;
  • The sum of retentions for a per-risk cover can be relatively high if the frequency of losses is large; and
  • Risk of running out of cover if an unexpected frequency exhausts the automatic reinstatements. Further reinstatements might be available,but the price of these could prove to be expensive.