Section 1: Introduction to Property and Casualty Reinsurance Objectives
Reinsurance is a transaction in which one insurer agrees,
for a premium, to indemnify another insurer against all or part of the loss that insurer
may sustain under its policy or policies of insurance. The company purchasing reinsurance
is known as the ceding insurer; the company selling reinsurance is known as the assuming
insurer, or, more simply, the reinsurer. Described as the "insurance of
insurance companies," reinsurance provides reimbursement to the ceding insurer for
losses covered by the reinsurance agreement. It enhances the fundamental objective of
insurance: to spread the risk so that no single entity finds itself saddled with a
financial burden beyond its ability to pay.
Although to many, reinsurance is a relatively unknown
aspect of the insurance industry, its roots can be traced as far back as the late 14th
century. From that time forward, reinsurance evolved into the business as it operates
today. While the early focus of reinsurance was in the marine and fire insurance lines, it
has expanded during the last century to encompass virtually every aspect of the modern
insurance market.
Reinsurance can be purchased from three distinct sources:
domestic reinsurance companies, reinsurance affiliates of primary U.S. insurance companies
and alien reinsurers that are located outside the U.S. and are not licensed here.
The ceding insurer may purchase reinsurance directly from a reinsurer or through a broker
or reinsurance intermediary.
The two main types of reinsurance agreements are proportional
and excess of loss. A reinsurance contract written on a proportional basis simply
prorates all premium, losses and expenses between the insurer and the reinsurer on a
pre-arranged basis. The proportional approach is used extensively in property reinsurance.
Excess of loss contracts require the primary insurer to keep all losses up to a
predetermined retention and the reinsurer to reimburse the company for any losses
above that retention, up to the limits of the reinsurance contract. In simplest terms, a
retention is analogous to the deductible a policyholder may have on a personal insurance
policy, such as an automobile or homeowner's policy.
Insurers purchase reinsurance for essentially four reasons:
(1) to limit liability on specific risks; (2) to stabilize loss experience; (3) to protect
against catastrophes; and (4) to increase capacity. Depending on the ceding company's
goals, different types of reinsurance contracts are available to bring about the desired
result.
Limiting Liability: By providing a mechanism in
which companies limit loss exposure to levels commensurate with net assets, reinsurance
allows insurance companies to offer coverage limits considerably higher than they could
otherwise provide. This function of reinsurance is crucial because it allows all
companies, large and small, to offer coverage limits to meet their policyholders' needs.
In this manner, reinsurance provides an avenue for small-to-medium size companies to
compete with industry giants.
In calculating an appropriate level of reinsurance, a
company takes into account the amount of its available surplus and determines its
retention based on the amount of loss it can absorb financially. Surplus, sometimes
referred to as policyholders' surplus, is the amount by which the assets of an
insurer exceed its liabilities.
A company's retention may range from a few thousand dollars
to one million dollars or more. The loss exposure above the retention, up to the policy
limits of the reinsurance contract, is indemnified by the reinsurer. Reinsurance helps to
stabilize loss experience on individual risks, as well as on accumulated losses under many
policies occurring during a specified period.
Stabilization: Insurers often seek to reduce the
wide swings in profit and loss margins inherent to the insurance business. These
fluctuations result, in part, from the unique nature of insurance, which involves pricing
a product whose actual cost will not be known until sometime in the future. Through
reinsurance, insurers can reduce these fluctuations in loss experience, thus stabilizing
the company's overall operating results.
Catastrophe Protection: Reinsurance provides
protection against catastrophic loss in much the same way it helps stabilize an insurer's
loss experience. Insurers use reinsurance to protect against catastrophes in two ways. The
first is to protect against catastrophic loss resulting from a single event, such as the
total fire loss of a large manufacturing plant. However, insurers also seek reinsurance to
protect against the aggregation of many smaller claims which could result from a single
event affecting many policyholders simultaneously, such as an earthquake or a major
hurricane. Financially, the insurer is able to pay losses individually, but when the
losses are aggregated, the total may be more than the insurer wishes to retain.
Through the careful use of reinsurance, the disruptive
effects catastrophes have on an insurer's loss experience can be reduced dramatically. The
decisions a company makes when purchasing catastrophe coverage (e.g., size of retention
and coverage limits) are unique to each individual company and vary widely depending on
the type and size of the company purchasing the reinsurance and the risk to be reinsured.
Increased Capacity: Capacity measures the dollar
amount of risk an insurer can assume based on its surplus and the nature of the business
written.
When an insurance company issues a policy, the expenses
associated with issuing that policy -- taxes, agent commissions, administrative expenses
-- are charged immediately against the company's income, resulting in a decrease in
surplus, while the premium collected must be set aside in an unearned premium reserve to
be recognized as income over a period of time. While this accounting procedure allows for
strong solvency regulation, it ultimately leads to decreased capacity because the more
business an insurance company writes, the more expenses that must be paid from surplus,
thus reducing the company's ability to write additional business.
Companies experiencing rapid expansion are particularly
susceptible to the timing problem between expenses (which must be debited immediately) and
income (which must be credited over time) generated by new business. By reinsuring a
portion of the business it writes, an insurance company reduces the problem of decreased
surplus. Through reinsurance, the company shares a portion of its underwriting expenses
with its reinsurer and reduces the drain on surplus.
Reinsurance also permits the ceding company to expand
capacity by permitting the ceding company to take credit for reinsurance on the
annual accounting statement it files with state regulators. Credit for reinsurance can be
described as follows: If the reinsurer satisfies certain regulatory requirements intended
to assure the security of the reinsurance arrangement, the ceding company may count as an
asset reinsurance payments owed to it on claims it has paid, thus expanding its surplus.
The ceding company can also reduce liabilities and loss reserves attributable to the
business ceded to the reinsurer.
In addition, the ceding company often receives a ceding
commission from the reinsurer as reimbursement for expenses, such as agent commissions
and overhead, associated with acquiring the business being reinsured. The ceding
commission is added directly to the ceding company's surplus, thus increasing it further.
Another type of reinsurance transaction which may affect
surplus is known as loss portfolio transfer. In such an arrangement, one insurer
cedes to another insurer its reserves for incurred but unpaid losses and loss adjustment
expenses. Typically, these reserves are associated with a particular class or line of
business, such as medical malpractices. The ceding insurer transfers cash to the assuming
insurer equal to the assuming insurer's estimate of the present value of these
liabilities, plus an amount the reinsurer may require to carry the additional risks
involved in the transfer.
In addition, reinsurers often provide insurers with a
variety of other services. Some reinsurers provide guidance to insurers in underwriting,
claims reserving and handling, investments and even general management. These services are
particularly important to smaller companies or companies interested in entering new lines
of insurance.
In any discussion of reinsurance, limitations of the business must
be considered along with the advantages. First and foremost, reinsurance
does not change the inherent nature of a risk being insured. Thus,
it does not make a bad risk insurable or an exposure more predictable
or desirable. While it may limit an insurance company's exposure
to a risk, the total risk exposure is not altered through the use
of reinsurance.
