Reinsurance
Overview
 
Reinsurance is insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...

 that is purchased by an insurance company (insurer also sometimes called a "cedant" or "cedent") from another insurance company (reinsurer) as a means of risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...

. The reinsurer and the insurer enter into a reinsurance agreement which details the conditions upon which the reinsurer would pay the insurer's losses (in terms of excess of loss or proportional to loss). The reinsurer is paid a reinsurance premium by the insurer, and the insurer issues insurance policies to its own policyholders.
Encyclopedia
Reinsurance is insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...

 that is purchased by an insurance company (insurer also sometimes called a "cedant" or "cedent") from another insurance company (reinsurer) as a means of risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...

. The reinsurer and the insurer enter into a reinsurance agreement which details the conditions upon which the reinsurer would pay the insurer's losses (in terms of excess of loss or proportional to loss). The reinsurer is paid a reinsurance premium by the insurer, and the insurer issues insurance policies to its own policyholders. The main reason for insurers to buy reinsurance is to transfer risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...

 from the insurer to the reinsurer, but reinsurance has various other functions as explained below.

For example, assume an insurer sells one thousand policies, each with a $1 million policy limit. Theoretically, the insurer could lose $1 million on each policy totaling up to $1 billion. It may be better to pass some risk to a reinsurance company (reinsurer) as this will reduce the insurers exposure to risk.

There are two basic methods of reinsurance:
  1. Facultative Reinsurance In facultative reinsurance, the ceding company cedes and the reinsurer assumes all or part of the risk assumed by a particular specified insurance policy. Facultative reinsurance is negotiated separately for each insurance contract that is reinsured. Facultative reinsurance normally is purchased by ceding companies for individual risks not 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 relative to premiums written on facultative business because each risk is individually underwritten and administered. The ability to separately evaluate each risk reinsured, however, increases the probability that the underwriter can price the contract to more accurately reflect the risks involved.
  2. Treaty Reinsurance is a method of reinsurance in which the insurer and the reinsurer formulate and execute a reinsurance contract. The reinsurer then covers all the insurance policies coming within the scope of that contract. The reinsurance contract may oblige the reinsurer to accept reinsurance of all contracts within the scope (known as "obligatory" reinsurance), or it may require the insurer to give the reinsurer the option to reinsure each such contract (known as "facultative-obligatory" or "fac oblig" reinsurance).


There are two basic methods of treaty reinsurance:
  • Quota Share Treaty Reinsurance, and
  • Excess of Loss Treaty Reinsurance.
In the past 30 years there has been a major shift from Quota Share to Excess of Loss in the property
Property insurance
Property insurance provides protection against most risks to property, such as fire, theft and some weather damage. This includes specialized forms of insurance such as fire insurance, flood insurance, earthquake insurance, home insurance or boiler insurance. Property is insured in two main...

 and casualty
Casualty insurance
Casualty insurance, often equated to liability insurance, is used to describe an area of insurance not directly concerned with life insurance, health insurance, or property insurance. It is mainly used to describe the liability coverage of an individual or organization's for negligent acts or...

 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 the exposure to loss to a reinsurer or a group of reinsurers. Therefore, they are 'transferring some of the risk to the reinsurer or a group of reinsurers'. In the USA, insurance, which is regulated at the state level, permits an insurer only to issue policies with a maximum limit of 10% of their surplus (net worth), unless those policies are reinsured.

Risk transfer

With reinsurance, the insurer can issue policies with higher limits than it would otherwise be allowed, therefore being permitted to take on more risk because some of that risk is now transferred to the reinsurer. Reinsurance has gone from a relatively unsophisticated business to a highly sophisticated endeavor. The reason for this is the number of reinsurers that have suffered significant losses and become financially impaired. From 2000 onward, reinsurers have become much more reliant on actuarial models and 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. Almost all reinsurers now visit the insurance company and review underwriting and claim files and more.

Income smoothing

Reinsurance can help to make an insurance company’s results more predictable by absorbing larger losses and reducing the amount of capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...

 needed to provide coverage. The risk factor is diversified with the reinsurer bearing some of the loss incurred.

Surplus relief

An insurance company's writings are limited by its balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...

 (this test is known as the solvency
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...

 margin). 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
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...

 in purchasing reinsurance coverage at a lower rate than they charge the insured for the underlying risk, which can be in the area of risk associated with any form of the asset that is being issued or loaned against. It can be a car, a mortgage, an insurance (personal, fire, business, etc.) and the like.

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.
  • Even if the regulatory standards are the same, the reinsurer may be able to hold smaller actuarial reserves
    Actuarial reserves
    An actuarial reserve is a liability equal to the net present value of the future expected cash flows of a contingent event. In the insurance context an actuarial reserve is the present value of the future cash flows of an insurance policy and the total liability of the insurer is the sum of the...

     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 (specialised) risk.

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 homogenous portfolio of insured risks. This would lend greater predictability to the portfolio results on net basis (after reinsurance) 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.

Managing cost of capital for an insurance company

By getting a suitable reinsurance, the insurance company may be able to substitute "capital needed" as per the requirements of the regulator for premium written. It could happen that the writing of insurance business requires x amount of capital with y% of cost of capital and reinsurance cost is less than x*y%. Thus more unpredictable or less frequent the likelihood of an insured loss, the more profitable it can be for an insurance company to seek reinsurance.

Proportional

Proportional reinsurance (the types of which are quota share and surplus reinsurance) involves one or more reinsurers taking a stated percent share of each policy that an insurer produces ("writes"). This means that the reinsurer will receive that stated percentage of each dollar of premiums and will pay that percentage of each dollar of losses. In addition, the reinsurer will allow a "ceding commission
Commission (remuneration)
The payment of commission as remuneration for services rendered or products sold is a common way to reward sales people. Payments often will be calculated on the basis of a percentage of the goods sold...

" to the insurer to cover the initial costs incurred by the insurer (marketing, underwriting, claims etc.).

The insurer may seek such coverage for several reasons. First, the insurer may not have sufficient capital to prudently retain all of the exposure that it is capable of producing. For example, it may only be able to offer $1 million in coverage, but by purchasing proportional reinsurance it might double or triple that limit. Premiums and losses are then shared on a pro rata basis. For example, an insurance company might purchase a 50% quota share treaty; in this case they would share half of all premium and losses with the reinsurer. In a 75% quota share, they would share (cede) 3/4 of all premiums and losses.

The other form of proportional reinsurance is surplus share or surplus of line treaty. In this case, a retained “line” is defined as the ceding company's retention - say $100,000. In a 9 line surplus treaty the reinsurer would then accept up to $900,000 (9 lines). 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 (cede) half of the premiums and losses to the reinsurer (1 line each). The maximum underwriting capacity of the cedant would be $ 1,000,000 in this example.

Non-proportional

Non-proportional reinsurance only responds if the loss suffered by the insurer exceeds a certain amount, which is called the "retention" or "priority." An example of this form of reinsurance is where the insurer is prepared to accept a 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 "retain" $1 million of the loss and would recover $2 million from its reinsurer. In this example, the reinsured also retains any loss exceeding $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" (Working XL), "Per Occurrence or Per Event XL" (Catastrophe or Cat 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
Commercial property
The term commercial property refers to buildings or land intended to generate a profit, either from capital gain or rental income.-Definition:...

 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.

In catastrophe excess of loss, the cedant’s per risk retention is usually less than the cat reinsurance retention (this is not important as these contracts usually contain a 2 risk warranty i.e. they are designed to protect the reinsured against catastrophic events that involve more than 1 policy). For example, an insurance company issues homeowner's 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 (i.e., hurricane, earthquake, flood, etc.).

Aggregate XL affords a frequency protection to the reinsured. For instance if the company retains $1 million net any one vessel in the cover of $10 million in the aggregate, the excess of $5 million in the aggregate would equate to 5 total losses (or more partial losses). Aggregate covers can also be linked to the cedant's gross premium income during a 12 month period, with limit and deductible
Deductible
In an insurance policy, the deductible is the amount of expenses that must be paid out of pocket before an insurer will pay any expenses. It is normally quoted as a fixed quantity and is a part of most policies covering losses to the policy holder. The deductible must be paid by the insured,...

 expressed as percentages and amounts. Such covers are then known as "Stop Loss" or annual aggregate XL.

Risk-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 for the whole policy period when written.

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.

Loss-occurring basis

A Reinsurance treaty from under which all claims occurring during the period of the contract, irrespective of when the underlying policies incepted, are covered. Any claims occurring after the contract expiration date are not covered.

As opposed to claims-made policy. Insurance coverage is provided for losses occurring in the defined period. This is the usual basis of cover for most policies.

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 (treaty). 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 is usually purchased by the insurance underwriter who underwrote the original insurance policy, whereas treaty reinsurance is typically purchased by a senior executive at the insurance company.

Reinsurance treaties can either be written on a “continuous” or “term” basis. A continuous contract continues indefinitely, but generally has a “notice” period whereby either party can give its intent to cancel or amend the treaty within 90 days. A term agreement has a built-in expiration date. It is common for insurers and reinsurers to have long term relationships that span many years.

Fronting

Sometimes insurance companies wish to offer insurance in jurisdictions where they are not licensed: for example, an insurer may wish to offer an insurance programme to a multi-national company, to cover property and liability risks in every country in the world. In such situations, the insurance company may find a local insurance company which is authorised in the relevant country, arrange for the local insurer to issue an insurance policy covering the risks in that country, and enter into a reinsurance contract with the local insurer to transfer the risks. In the event of a loss, the policyholder would claim against the local insurer under the local insurance policy, the local insurer would pay the claim and would claim reimbursement under the reinsurance contract. Such an arrangement is called "fronting". Fronting is also sometimes used where an insurance buyer requires its insurers to have a certain financial strength rating and the prospective insurer does not satisfy that requirement: the prospective insurer may be able to persuade another insurer, with the requisite credit rating, to provide the coverage to the insurance buyer, and to take out reinsurance in respect of the risk. An insurer which acts as a "fronting insurer" (or a "front") usually receives a fronting fee for this service. The fronting insurer is taking a risk in such transactions, because it has an obligation to pay its insurance claims even if the reinsurer becomes insolvent and fails to reimburse the claims.

Markets

Most reinsurance placements are not placed with a single reinsurer but are shared between a number of reinsurers. For example a $30,000,000 excess of $20,000,000 layer may be shared by 30 or more reinsurers. The reinsurer who sets the terms (premium and contract conditions) for the reinsurance contract is called the lead reinsurer; the other companies subscribing to the contract are called following reinsurers.

About half of all reinsurance is handled by reinsurance brokers who then place business with reinsurance companies. The other half is with “direct writing” reinsurers who have their own production staff and thus reinsure insurance companies directly. In Europe reinsurers write both direct and brokered accounts.

Using game-theoretic
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

 modeling, Professors Michael R. Powers
Michael R. Powers
Michael Roland Powers is Professor of Risk Management and Insurance at Temple University’s Fox School of Business, and Distinguished Visiting Professor of Finance at Tsinghua University’s School of Economics and Management. An internationally recognized insurance scholar, he is particularly...

 (Temple University
Temple University
Temple University is a comprehensive public research university in Philadelphia, Pennsylvania, United States. Originally founded in 1884 by Dr. Russell Conwell, Temple University is among the nation's largest providers of professional education and prepares the largest body of professional...

) and Martin Shubik
Martin Shubik
Martin Shubik is an American economist, who is Professor Emeritus of Mathematical Institutional Economics at Yale University. He was educated at the University of Toronto and Princeton University...

 (Yale University
Yale University
Yale University is a private, Ivy League university located in New Haven, Connecticut, United States. Founded in 1701 in the Colony of Connecticut, the university is the third-oldest institution of higher education in the United States...

) have argued that the number of active reinsurers in a given national market should be approximately equal to the square-root of the number of primary insurers active in the same market. Econometric analysis
Econometrics
Econometrics has been defined as "the application of mathematics and statistical methods to economic data" and described as the branch of economics "that aims to give empirical content to economic relations." More precisely, it is "the quantitative analysis of actual economic phenomena based on...

 has provided empirical support for the Powers-Shubik rule.

Insurers (that is to say, reinsureds) tend to choose their reinsurers with great care as they are exchanging insurance risk for credit risk. Risk managers monitor reinsurers' financial ratings (S&P, A.M. Best, etc.) and aggregated exposures regularly.

Reinsurers

  1. Munich Re
    Munich Re
    Munich Re Group is a reinsurance company based in Munich, Germany. It is one of the world’s leading reinsurers. ERGO, a Munich Re subsidiary, is the Group’s primary insurance arm....

     – Germany ($31.4 billion Gross Written Premiums)
  2. Swiss Re
    Swiss Re
    Swiss Reinsurance Company Ltd , generally known as Swiss Re, is a Swiss reinsurance company. It is the world’s second-largest reinsurer, after having acquired GE Insurance Solutions. The company has its headquarters in Zurich...

     – Switzerland ($30.3 billion)
  3. Berkshire Hathaway
    Berkshire Hathaway
    Berkshire Hathaway Inc. is an American multinational conglomerate holding company headquartered in Omaha, Nebraska, United States, that oversees and manages a number of subsidiary companies. The company averaged an annual growth in book value of 20.3% to its shareholders for the last 44 years,...

     / General Re
    General Re
    Gen Re is a leading property/casualty and life/health reinsurance company and is owned by Berkshire Hathaway Inc.-History:General Reinsurance Corporation’s history began in 1921 when two Norwegian companies, Norwegian Globe and Norwegian Assurance, merged and took the name General Casualty and...

     – USA (n.a.)
  4. Hannover Re
    Hannover Re
    Hannover Re , with a gross premium of around €11 billion, is one of the leading reinsurance groups in the world...

     – Germany ($12 billion)
  5. SCOR
    Scór
    Scór is a division of the Gaelic Athletic Association charged with promotion of cultural activities, and the name of a series of annual competitions in such activities.Rule 4 of the GAA's official guide reads:...

     – France ($6.9 billion)
  6. Reinsurance Group of America
    Reinsurance Group of America
    Reinsurance Group of America, Incorporated, is a leader in the global life reinsurance industry, with more than $2.4 trillion of life reinsurance in force and assets of more than $27,2 billion...

     – USA ($5.7 billion)
  7. Transamerica Re – USA ($4.2 billion)
  8. Everest Re – Bermuda ($4.0 billion)
  9. Partner Re – Bermuda ($3.8 billion)
  10. XL Re – Bermuda ($3.4 billion)

(Based on company figures; in US$)


In addition, syndicates at Lloyd's of London
Lloyd's of London
Lloyd's, also known as Lloyd's of London, is a British insurance and reinsurance market. It serves as a partially mutualised marketplace where multiple financial backers, underwriters, or members, whether individuals or corporations, come together to pool and spread risk...

 wrote £6.3 billion of reinsurance premium in 2008.

Major reinsurance brokers include:
  • Guy Carpenter
    Marsh & McLennan Companies
    Marsh & McLennan Companies, Inc. is a US-based global professional services and insurance brokerage firm. In 2007, it had over 57,000 employees and annual revenues of $10.49 billion. Marsh & McLennan Companies was ranked the 221st largest corporation in the United States by the 2009 Fortune 500...

  • Aon Corporation
  • Willis Re
    Willis Group Holdings
    Willis Group Holdings is a global insurance broker headquartered in the Willis Building, London, United Kingdom. It has more than 400 offices in 120 countries, and approximately 17,000 employees...

  • Towers Watson
    Towers Watson
    Towers Watson is a global consulting firm. Its principal lines of business are risk management and human resource consulting. It also has strong actuarial, investment consulting, and reinsurance brokerage practices. The Towers Watson corporate offices are in New York, New York.Towers Watson was...

  • Cooper Gay Swett & Crawford
  • Atlantic Intermediaries


Retrocession

Reinsurance companies themselves also purchase reinsurance, a practice known as a retrocession. They purchase this reinsurance from other reinsurance companies. A reinsurance company that sells reinsurance is a "retrocessionaire". A reinsurance company that buys reinsurance is a "retrocedent".

It is not unusual for a reinsurer to buy reinsurance protection from other reinsurers. For example, a reinsurer that provides proportional, or pro rata, reinsurance capacity to insurance companies may wish to protect its own exposure to catastrophes by buying excess of loss protection. Another situation would be that a reinsurer which provides excess of loss reinsurance protection may wish to protect itself against an accumulation of losses in different branches of business which may all become affected by the same catastrophe. This may happen when a windstorm causes damage to property, automobiles, boats, aircraft and loss of life, for example.

This process can sometimes continue until the original reinsurance company unknowingly gets some of its own business (and therefore its own liabilities) back. This is known as a "spiral" and was common in some specialty lines of business such as marine and aviation. Sophisticated reinsurance companies are aware of this danger and through careful underwriting attempt to avoid it.

In the 1980s, the London market was badly affected by the creation of reinsurance spirals. This resulted in the same loss going around the market thereby artificially inflating market loss figures of big claims (such as the Piper Alpha
Piper Alpha
Piper Alpha was a North Sea oil production platform operated by Occidental Petroleum Ltd. The platform began production in 1976, first as an oil platform and then later converted to gas production. An explosion and resulting fire destroyed it on 6 July 1988, killing 167 men, with only 61...

 oil rig). The LMX spiral (as it was called) has been stopped by excluding retrocessional business from reinsurance covers protecting direct insurance accounts.

It is important to note that the insurance company is obliged to indemnify its policyholder for the loss under the insurance policy whether or not the reinsurer reimburses the insurer. Many insurance companies have experienced difficulties by purchasing reinsurance from companies that did not or could not pay their share of the loss. (These unpaid claims are known as uncollectibles.) This is particularly important on long-tail lines of business where the claims may arise many years after the premium is paid.

See also

  • Catastrophe bond
    Catastrophe bond
    Catastrophe bonds are risk-linked securities that transfer a specified set of risks from a sponsor to investors...

  • Catastrophe modeling
    Catastrophe modeling
    Catastrophe modeling is the process of using computer-assisted calculations to estimate the losses that could be sustained due to a catastrophic event such as a hurricane or earthquake...

  • Financial reinsurance
    Financial reinsurance
    Financial Reinsurance , is a form of reinsurance which is focused more on capital management than on risk transfer. In the non-life segment of the insurance industry this class of transactions is often referred to as finite reinsurance....

  • Industry Loss Warranties
    Industry Loss Warranties
    Industry Loss Warranties, often referred to as ILWs, are a type of reinsurance or derivative contract through which one party will purchase protection based on the total loss arising from an event to the entire insurance industry rather than their own losses...

  • International Society of Catastrophe Managers
    International Society of Catastrophe Managers
    The International Society of Catastrophe Managers is a professional association that promotes catastrophe management professionalism within the insurance industry.-Goal and objectives:...

  • Life insurance securitization
    Securitization
    Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...

  • Reinsurance sidecar
    Reinsurance Sidecar
    Reinsurance sidecars, conventionally referred to as "Sidecars," are financial structures that are created to allow investors to take on the risk and return of a group of insurance policies written by an insurer or reinsurer and earn the risk and return that arises from that business...



External links

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