reinsurance practice

REINSURANCE PRACTICE An Introduction to Reinsurance

by Dr Nicholas G. Berketis

ATHENS UNIVERSITY OF ECONOMICS AND BUSINESS, MSC in International Shipping, Finance and Management

What is it?

Reinsurance is a financial market that trades in the risk of unpredictable and devastating disasters – such as Hurricane Katrina, the Tohoku earthquake and tsunami, and the terrorist attacks on the World Trade Center. Such disasters are increasing in both frequency and severity, with the cost of their losses mounting rapidly. Reinsurance insures insurance companies, enabling them to pay claims arising from these losses. It is thus a market mechanism that is a critical part of the social and economic safety net, helping to pick up the pieces after disasters.


Summary

n  Why does reinsurance exist and what function does it fulfill?

n  Alternatives to Reinsurance n  Other Benefits to Reinsurance n  Need for Reinsurance n  How does the Reinsurer assist? n  How does Reinsurance do it? n  What Reinsurance CANNOT do! n  The Principle Methods of Reinsurance


Why does reinsurance exist and what function does it fulfill?

n  Three paramount principles: n  Insurable Interest; n  Indemnity; n  Utmost Good Faith;


(A) Insurable Interest

n  An Insurance Company acquires an insurable interest in the original policy of insurance that has been issued.

n  However, its insurable interest in that policy only extends as far as the actual conditions and sum insured of the original policy.

n  Provided that the insurer has an insurable interest it may effect reinsurance.


(B) Indemnity n  A policy of reinsurance is always one of indemnity, even

though the original policy of insurance may not be an indemnity policy, e.g. personal accident.

n  Reinsurance operates in order to pay to the original insurance company the reinsured proportion of an amount which the Insurance Company has paid or has proportion of an amount which the Insurance Company has paid or has become liable to pay.

n  If it is proved that under the original policy the Insurance Company itself is not liable to pay a claim then the Reinsurer is not liable to pay any claim under the reinsurance.

n  The strict principle of indemnity applies, i.e. there can be no profit from the existence of a reinsurance.


(C) Utmost Good Faith

n  The principle that one party to an insurance contract should disclose all material information to the other party applies even more strictly in reinsurance than in insurance, if only because both parties are considered to be "experts" in their business.

n  Because of the nature of reinsurance, particularly the treaty method whereby any number of risks may reinsured at any time, automatically and without individual negotiation between Insurance Company and Reinsurer, considerable trust is placed in the competence and correctness of the Insurance Company.

n  In essence, full disclosure of material facts operates until the contract of reinsurance is concluded and thereafter the Insurance Company is expected to exercise utmost good faith in its ceding of risks to Reinsurers.


Alternatives to Reinsurance

What are the alternatives to reinsurance? If an Insurer decides not to reinsure, and it still wishes to protect its equity it may: 1.  Increase its capital – to the point where all risks may be safely absorbed. 2. Reduce size of risks accepted – to a point where the Insurance Company has little or no business, or certainly no chance of growth. 3. Use co-insurance – by which several or even many Insurers may share in the same risk.


Other Benefits of Reinsurance

n  So far, we have considered reinsurance in terms of single risks only, but reinsurance has an important role to play in protecting an insurance account for other reasons.

n  For example, an Insurance Company is exposed to serious financial loss, not just from the threat / danger of a loss to a highly valued risk.

n  The prudent Company will also consider the possibility of its incurring on a large number of small risks during one event (earthquake, flood, storm) – catastrophe – or the possibility that during one period of twelve months it will suffer an unusually large number of higher than average claims – higher than average frequency of loss.

n  These eventualities may also be transferred to Reinsurers.


Need for Reinsurance

Reinsurance provides for all these eventualities and therefore the need for reinsurance can be summarized as:

n  Single Risk Loss – loss on a very highly valued risk; n  Catastrophe Event – accumulation of losses in one

event; n  Higher than Average Frequency of Loss – high

instances of losses spread throughout the year contrary to historical pattern;


Taken one by one reinsurance can:

n  Provide capacity to Insurer; n  Create Financial Stability; n  Strengthen the finances of the Insurance

Company;


Need for Reinsurance – Provide capacity to the Insurer

n  In every class of insurance there are inevitably very large or highly valued risks which one Insurance Company cannot afford to retain for its own account.

n  In dealing with these major risks it has the choice of limiting its acceptance to a level commensurate with its financial assets and co-insuring with other Insurance Companies in the same market, or even in different markets, or accepting a larger share of the risk and transferring a part of it to another Insurance or Reinsurance Company by reinsurance.

n  Exactly how the Insurance Company chooses to do this depends on the type of reinsurance selected, but its basic effect will be to reduce the Insurance Company’s exposure on the larger / more highly valued risks that it has accepted.

n  In other words, the “peak risks“ in the portfolio are levelled to a point where the Insurance Company can safely assume them.


Need for Reinsurance – Create Financial Stability (1/2)

n  The second major reason for reinsurance is that it can even-out fluctuations in an Insurance Company’s results over a number of years.

n  To return to our example of the individual buying a property insurance policy, what he or she is effectively doing is paying a fixed cost – the premium – for the comfort that in the event of loss or damage to his or her property they will not suffer any further financial loss.

n  Therefore, they are trading financial certainty – the cost of premium – for uncertainty, the possible total loss of the property.


Need for Reinsurance – Create Financial Stability (2/2)

n  In reinsurance the principle is the same; n  The results of an Insurance Company can be very adversely

affected in one year, either by a substantial loss from a number of policies affected by one event, or by very bad results over an entire portfolio during the year;

n  Reinsurance evens out such fluctuations by the Reinsurance Company sharing in the profits of the Insurance Company in a good year and contributing to the losses in a bad year;

n  For this to be effective there must be continuity of Reinsurer over a lengthy period of time;

n  This stabilizes the Company’s results from one year to the next, and this is important for shareholders, which brings us to a third function of reinsurance.


Need for Reinsurance – Strengthen the finances of the Insurance Company

n  The availability of reinsurance can protect the growth of the Insurers’ assets and enable the Company to expand at a faster rate than would otherwise be possible;

n  In most countries with a developed insurance industry Insurance Companies have to maintain certain solvency margins which are measured by the ratio of the Company’s capital and free reserves to its net retained premium and / or its liabilities;

n  The ceding away of premium by way of reinsurance can increase a Company’s solvency margin and therefore business can be expanded without the Company having to increase its paid up capital.


How does the Reinsurer assist?

n  Increases the Insurers’ Capacity n  The Reinsurer increases the Insurers’ capacity per risk through the provision

of the reinsurance facility. This is important to the Insurer who is interested in penetrating the market and promoting the capabilities of its organization. This it cannot do if it is only able to accept very small shares of large risks without threatening its balance sheet.

n  Enables the Insurer to accept greater volume n  The Reinsurer enables the Insurance Company to write a larger volume of

risks than he would be able to exercise the law of large numbers and a basic principle of insurance, that the many should contribute to the losses of the few. The larger the number of policies the Insurer is able to issue the better balanced its portfolio becomes and the less variable the claims experience.

n  Increases Classes accepted n  Reinsurance also enables the Insurance Company to spread its interest in a

number of classes of insurance. This is important in order to protect its balance sheet from unexpectedly adverse results in one particular class.


How does Reinsurance do it? (1/2)

If reinsurance is such a good thing for Insurance Companies, who are therefore able to transfer their capacity or peak risks to a Reinsurer as well as achieve greater financial stability through buying reinsurance, what is in it for the Reinsurer? The Reinsurer is in the business of providing reinsurance coverage just as the Insurer is in the business of providing direct insurance coverage. The same principles we have just been discussing, such as spread and balance and the law of large numbers, apply equally to the portfolio of the Reinsurer. So how is the Reinsurer able to provide the support to Insurers that it does and what are its own objectives?


How does Reinsurance do it? (2/2)

n  Geographical Spread n  The aim is to achieve a balanced portfolio. In the case of the Reinsurer,

this must mean a balance of all the peak risks, which it has accepted from its Ceding Companies. This necessitates an adequate spread among different Reinsureds. It also necessitates a geographical spread – this is of enormous importance from a Reinsurer’s point of view. It is easy to imagine that a catastrophe will occur in one country (flood, earthquake etc.), which will bring heavy claims to the Reinsurer from all the Insurance Companies it is protecting in that country. It must therefore seek reinsurance business from as wide a geographical area as possible and from as many companies as possible.

n  Different Classes n  The principle is the same as for the Insurance Company. Spread in the

classes of business reinsured is as important as geographical spread. n  Greater expertise of underwriting difficult or dangerous risks

n  Inevitably a Reinsurer builds up considerable knowledge in the markets in which it operates and in the major risks which, because of its ability to achieve a balance of such risks, it can safely underwrite.


What Reinsurance CANNOT do!

n  Enable the Insurer to accept bad risks. n  The Insurer must always keep in mind that its aim is to accept

business for profit. Bad risks will undermine its own stability and the confidence of its Reinsurers.

n  Protect the Insurer against the consequences of inadequate primary rates or conditions. n  Reinsurance cannot compensate for improper underwriting and

cannot turn an unprofitable account into a profitable one. The direct Insurance Companies’ account must have the potential to achieve profit before it can be reinsured.

n  Enable the Insurer to keep the good risks and divest itself of the bad. n  The Reinsurer can only contribute to the losses of the Insurance

Company if it can share in the profit of the Company in like fashion.

n  Accept a risk it would not otherwise accept ATHENS UNIVERSITY OF ECONOMICS AND BUSINESS, MSC in International Shipping, Finance and Management

Summary of what Reinsurance is

n  Reinsurance is a substitute for the deficiency of a Company’s spread of risk, and a partial substitute for additional capital.

n  In other words, a Reinsurer lends its capital and free reserves for a given amount of time (usually twelve months) in exchange for a fee – the cost of reinsurance. We should now review the principle methods of reinsurance that enable this to be done.


Cedent

An Insurance Company that buys Reinsurance. An Insurance Company gathers premium from its policyholders and has an obligation to pay their claims for loss. To protect itself against the vast payouts that would arise from either a high severity event, such as a hurricane or frequent smaller events, such as multiple motor accidents, it buys reinsurance that enables the insurance company to “cede” part of its risk to the reinsurer in return for premium.


The Principle Methods of Reinsurance

The various methods of reinsurance can be divided into two main categories of business: n  (a) PROPORTIONAL

n  CEDANT and REINSURERS jointly share the original risk(s) in fixed, pre-determined proportions.

n  If a claim occurs both parties are affected.

n  (b) NON-PROPORTIONAL n  CEDANT decides upon the amount of the risk they are

prepared to keep for themselves and seeks to pass all the risk above this amount on to REINSURERS.

n  If a claim occurs one party may be involved more than the other.


Facultative Reinsurance (1/4)

This is the oldest method of reinsurance. In today’s markets it is used mainly by CEDANTS to reinsure the whole or part of risks that cannot be covered by other existing reinsurance arrangements.


Facultative Reinsurance (2/4) n  KEY FEATURES:

n  Single risk basis – one factory / one location n  CEDANT must provide all material details of the risk n  REINSURER considers each individual risk on its merits and has the option

to accept all or part of the risk, or to decline to accept any of it. n  PURPOSES:

n  Reinsure risks outside the scope of Cedant’s normal treaty arrangements n  Reinsure amounts in excess of any existing treaty limits n  Restrict Cedant’s and treaty Reinsurer’s liability where physical hazard of

the risk is abnormally high n  Reduce exposure in areas where Cedant is already heavily committed, due

to accumulation of risk n  Enable the Insurance Company to trade its business reciprocally with that

of exactly the same quality n  Obtain reinsurance when writing new lines of business n  Enable Reinsurers to evaluate and judge the underwriting practices of the

Cedant n  Enable Cedant to seek expertise, experience and guidance of Reinsurers on

risks of a special nature ATHENS UNIVERSITY OF ECONOMICS AND BUSINESS, MSC in International Shipping, Finance and Management


INFORMATION EXPECTED 1.  Class of business – Fire, Burglary etc. 2.  Insurer 3.  Original Insured 4.  Sum Insured. Is it split between building, machinery, loss of

profits etc.? 5.  Location 6.  Period 7.  Original rates being charged 8.  Commission 9.  What is Insurer retaining? 10.  Has anything been given to existing Treaties? 11.  Amount of reinsurance needed? 12.  Special conditions?



ADVANTAGES: n  Reinsurers receive all material details of risk n  Cedant can be selective with risks offered n  Cedant can retain the maximum amount of its original premium n  The risk can be spread DISADVANTAGES: n  Potentially high administrative costs for both Cedant and

Reinsurer n  Time taken to arrange cover can be lengthy n  No guarantee reinsurance will be available. Reinsurers have the

right to accept or reject n  Commissions allowed by Reinsurers tend to be lower than with

Treaty business ATHENS UNIVERSITY OF ECONOMICS AND BUSINESS, MSC in International Shipping, Finance and Management

Proportional Treaties

A Proportional Treaty is an agreement between an INSURER (CEDANT) and REINSURER(S), whereby:

The Insurer agrees to give, (cede) and the Reinsurer(s) agree to accept, a proportional share of all risks falling within the terms and conditions of the agreement.

The two main types of proportional treaty in common use are:

QUOTA SHARE TREATY & SURPLUS TREATY


Quota Share Treaty (1/4)

These arrangements are arrangements whereby the Cedant is bound to cede, and the Reinsurer is bound to accept, a fixed proportion of every risk underwritten by the Ceding Company, in the classes of business or account to which the Treaty relates. The amount of a risk that is protected by the Cedant is called its NET RETENTION. The amount of the risk that is protected by the Cedant and its QUOTA SHARE Reinsurers is known as the Cedant’s GROSS RETENTION. The Reinsurer receives the agreed fixed proportion of all original premia and pays the same fixed proportion of all the claims.



KEY FEATURES: n  Provides automatic coverage for all risks within a particular account. n  Usually expressed as percentage arrangements, i.e.:

“80% Quota Share Treaty“: Cedant keeps 20% and gives 80% to the Reinsurer. Cedant expected not to reinsure further its retention – this prevents Cedant writing poor business and passing all the liability to Reinsurers.

n  A maximum monetary limit for any one risk will usually be defined. n  Simplified accounting / servicing methods used. PURPOSES: n  Helps Cedant to gain experience and reputation. Best way to get Reinsurers

to participate where the experience of the Reinsured is unknown and there may be limited spread of risk.

n  An efficient means of RECIPROCITY. n  Can be used to increase the solvency ratio of a Ceding Company.


Quota Share Treaty (3/4) INFORMATION EXPECTED: 1.  Ceding company 2.  Class of Business 3.  Territorial limits 4.  Type of Treaty (Quota Share) 5.  Limits, i.e. 80% 6.  Maximum liability per risk 7.  Estimated Premium Income (E.P.I.) 8.  Commission required, i.e. 10% 9.  Profit Commission 10.  Premium reserves and interest 11.  Loss reserves and interest 12.  Cash loss limit 13.  Accounting periods, i.e. quarterly 14.  Effective date 15.  Notice of cancellation, i.e. 90 days 16.  Any statistics – previous experience important



ADVANTAGES: n  Simplicity of operation n  Automatic reinsurance protection available n  Good spread and balance of business n  Cedant can get a higher rate of commission n  Reinsurers can obtain a larger share of any profitable business

from the Cedant than with any other form of Treaty DISADVANTAGES: n  Cedant not allowed to vary retention once Treaty established n  Sizes of risks retained by the Cedant not homogeneous n  Errors in ceding may occur, may still be a need for Facultative

reinsurance for some risks ATHENS UNIVERSITY OF ECONOMICS AND BUSINESS,

MSC in International Shipping, Finance and Management

Surplus Treaty (1/4)

Such arrangements are agreements whereby the Cedant will cede, and the Reinsurer be bound to accept, surplus liability over and above the Ceding Company’s retention. A Surplus treaty allows a Cedant to determine how much of a risk they wish to retain, whilst ensuring Reinsurers will accept the surplus liability, subject to a defined maximum amount.



KEY FEATURES: n  Capacity per risk of the treaty will be defined as a multiple of the Cedant’s

retention. n  Retention called a “LINE“ – Surplus Treaties are described by the number of

lines it will accept. n  Cedant needs to prepare a table of normal limits and retentions for different

types of risks it underwrites. n  Proportion of liability is fixed for each risk when it is ceded to the treaty. n  Premia and claims settled on balance of account basis, usually at the end of

each calendar quarter. PURPOSES: n  Enables Cedant to arrange retention in relation to the quality of risk it is

reinsuring. n  Increased capacity to write larger risks.


Surplus Treaty (3/4) INFORMATION EXPECTED: 1.  Ceding Company 2.  Class of business 3.  Territorial scope 4.  Type of Treaty (Surplus) 5.  Maximum limit per line 6.  Number of Lines 7.  Estimated Premium Income (E.P.I.) 8.  Commission (may be on net premium) 9.  Profit commission 10.  Premium Reserve and Interest 11.  Loss Reserve and Interest 12.  Cash Loss Limit 13.  Bordereaux 14.  Accounting detail – i.e. Quarterly Accounts 15.  Effective Date 16.  Notice of Cancellation



ADVANTAGES: n  Only the portion of risk exceeding Company’s retention must

be reinsured. n  Retained portfolio more consistent in size per risk. n  Cedant can control profitability of an account. DISADVANTAGES: n  Complicated to administer. n  Reinsurers may receive unacceptably high proportion of poor

risks. n  Treaty may create a widely fluctuating loss experience. n  Some risks may not be acceptable. Facultative protections

may be required for some of the account. ATHENS UNIVERSITY OF ECONOMICS AND BUSINESS, MSC in International Shipping, Finance and Management

Non-Proportional Treaty (1/4) Such contracts are agreements between a Reinsured and a Reinsurer(s), whereby the Reinsurer(s) agrees to pay the Reinsured all losses exceeding a certain specified limit (deductible) set by the Reinsured, arising out of a portoflio of risks being protected, up to a pre-determined fixed limit. Types of Non-Proportional Treaty are commonly described as:

EXCESS OF LOSS TREATIES (XOL or X/L) In many ways they are similar to Direct business. The relationship between Cedant and Reinsurer is not partnership (sharing in an original risk). Client has an insurance need and Excess of Loss Reinsurer is prepared to accept the liability. There are three main circumstances in which Excess of Loss can be used. 1.  Large individual losses. (Risk Excess of Loss and Working Covers) 2.  Many losses from one event. (Catastrophe Excess of Loss) 3.  An aggregation of losses on one business class (Stop Loss)


Non-Proportional Treaty (2/4)

KEY FEATURES: n  Reinsured and Reinsurer not jointly sharing risk. All loss amounts below the

deductible paid in full by the Reinsured. All loss amounts above the deductible paid in full by the Reinsurers.

n  Provides a fixed limit of protection on each treaty. n  Amount of reinsurance needed by the Reinsured may be placed in a number of

separate policies called LAYERS. n  Premium for the reinsurance is set by the Reinsurer not the Reinsured. n  Reinsured may be able to replace cover used, to maintain protection at the required

level. This process is called REINSTATEMENT. n  Commission not usually allowed by Reinsurers to the Reinsured. n  A DEPOSIT PREMIUM is usually charged at the beginning of the reinsurance contract

period. The true cost will be known at the expiry and an ADJUSTMENT made.

PURPOSE: n  Created to provide amounts of protection not available from other types of

reinsurance and to protect an Insured from unusual or unpredictable loss situations. n  Cedant decides monetary limit they are prepared to pay in event of a particular

situation and seeks to transfer ALL remaining liability to Reinsurers. ATHENS UNIVERSITY OF ECONOMICS AND BUSINESS, MSC in International Shipping, Finance and Management


INFORMATION EXPECTED: 1.  Reinsured 2.  Territorial scope 3.  Type of treaty, i.e. Catastrophe, Motor, X/L, Hull etc. 4.  Definition of cover, i.e. Net Retention 5.  Monetary limits 6.  Deductible 7.  Reinstatement provisions (not applicable to all X/L’s) 8.  Rate 9.  Period 10.  Deposit Premium 11.  Special conditions 12.  Historical information



ADVANTAGES: n  Low administration costs – simple to administer. n  Reinsured can potentially retain a larger proportion of its original gross premia, only paying

away a percentage of Premium Income, e.g. 80% Quota Share = 80% of every premium Excess of Loss will be a much smaller % of Premium Income

n  Can provide an absolute limit to the retained cost of claims for a particular event. n  May provide large amounts of reinsurance protection at relatively low cost. n  Reinsurer able to set the premium. n  Good cash flow – premia usually payable at the commencement of cover, or in instalments

at the beginning of each quarter. DISADVANTAGES: n  Does not provide much protection against an increasing incidence of small claims. n  Payment of premium at commencement may cause negative cash flow for Reinsured at

beginning of policy year. n  Little assistance in protecting solvency margins. n  Cover may be exhausted in the event of a series of losses or a major loss, particularly with

property business.


Final Summary

n  There are many different methods of reinsuring an Insurance Company’s portfolio of original business.

n  No one method can be described as being the best. n  What is required is careful analysis of the Company’s

business, so that the most suitable method is identified to meet its particular needs.

n  The solution to the problem will invariably involve a combination of methods.

n  Getting the best combination is the problem that faces the Reinsured and its Broker.


Glossary

n  Cedent: An insurance company that buys reinsurance. An insurance company gathers premium from its policyholders and has an obligation to pay their claims for loss. To protect itself against the vast payouts that may arise from either a high severity event, such as a hurricane or frequent smaller events, such as multiple motor accidents, it buys reinsurance that enables the insurance company to “cede” part of its risk to the reinsurer in return for premium.

n  Non-proportional reinsurance: A type of reinsurance cover in which payment is triggered if an insurer suffers cumulative losses (within a given period) that exceed the specific amount in the attachment point, up to a specified limit (above which losses are no longer covered).

n  Proportional reinsurance: A type of reinsurance cover where the reinsurer takes a proportional share in the cedent’s entire portfolio at a specified rate, so sharing in that cedent’s profits and losses. For instance, a reinsurer might carry 40 percent of any gains and losses on every policy underwritten by a cedent.


Sources

n  https://www.youtube.com/watch?v=frkhhF2oxS4

n  Jarzabkowski, Paula, Bednarek, Rebecca & Spee, Paul, (2015), “Making a Market for Acts of God”, Oxford University Press.


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