Midlands State University
Practice of Insurance IRM 101
Reinsurance in Outline
- Introduction
Reinsurance is the insurance policy taken out by an insurer for risks he has accepted. The insurer who wants cover is called the ceding office and the reinsurer is the insurer who gives the cover. The reinsurance contract is between the reinsurers and the ceding office. The policyholder has no claim under the reinsurance contract and is not even aware of it in many cases.
Reinsurers can also repeat the process by passing risks to other reinsurers. This is called retrocession.
Direct insurers reinsure for the following reasons:
(a)Capacity
Reinsurance gives direct insurers capacity to write business beyond their capacity. Excess beyond the office is ceded to reinsurers.
The capacity to accept large risks allows businesses to grow as their risks can be insured.
(b)Stabilisation
Reinsurance stabilizes or smoothes out the claims experience of the ceding office. The direct insurer is able to even out peaks and troughs of claims and premiums by spreading the risks over a bigger pool and produce better estimates and budgets.
(c)Confidence
Insurance gives peace of mind and confidence to the insured. Reinsurance has the same effect to direct insurers.
(d)Risk spreading
Reinsurance spreads risk.
(e)Catastrophe protection
Direct insurers’ financial resources would be stretched if a lot of claims happened at the same time. Reinsurance allows them to weather such storms by receiving reimbursement from their reinsurers all over the world.
- Treaty reinsurance
A reinsurance treaty is an agreement between a ceding office and a reinsurer. Under the agreement the reinsurers agree in advance to accept business ceded to them by the ceding office.
The treaty lays down the parameters of the agreement, for example:
-Type of insurance business to be ceded
-Maximum amounts of liability to be ceded
The treaty has the following benefits
-The direct insurer is guaranteed of reinsurance cover on risks accepted from customers provided they fall within the treaty parameters. A direct insurer usually has treaties with various reinsurers depending on the type of business written.
Treaties fall into two categories, viz.
Proportional reinsurance
Under this arrangement the reinsurer agrees to a proportion of the risk and gets the same proportion the premium and pays that proportion of the claim. For example, the reinsurer accepts a cession of 80% of the risk receives 80% of the premium and pays 80% of the claim. This arrangement is popular with the reinsurance of property and business interruption.
Proportional reinsurance falls into two categories:
(a)Quota share
The ceding office cedes a fixed proportion of all the business it writes, e.g. Retains 30% for its account and cedes 70% of every risk underwritten. Mostly used in the formative years of the ceding years when it has little experience in underwriting. The risk may be ceded 100% in cases where the direct insurer is writing the business on an “accommodation basi
(b)Surplus treaties
Under this arrangement agrees to accept the surplus (hence the name) risk that is above the ceding office’s retention. This is subject to a maximum e.g. 10 lines. This means the reinsurer will accept ten times the direct office’s retention. It is normal to have several layers of treaties so that if the first treaty is fully utilized more surplus can be placed on the second treaty until the whole risk is reinsured. Alternatively, the surplus can be ceded under a facultative treaty.
Non-proportional reinsurance
(a) Excess of loss treaty
This arrangement is popular with liability insurance direct insurers (but also can be used in property insurance) who wish to retain most of the premium. They feel that they are able to meet most of the small claims without reinsurance support. Reinsurance arrangement is used required for losses or claims exceeding predetermined amounts subject to maximum i.e. in excess of loss treaty. If an insurer who has an excess of loss reinsurance treaty, which pays for losses in excess of $20 million up to $100 million, received a claim of $80 million under a liability policy, the reinsurer will pad $60 million.
Premium calculation is based on the burning cost method by considering the ceding office claims experience for the past 3 or 5 years
(b)Catastrophe excess of loss treaty
A catastrophe excess of loss treaty can be arranged to cover events that affect large numbers of policyholders at the same time. It deals with an accumulation of losses from one event e.g. flood, earthquake can damage at the same time, a number of insured small shops which the direct office has not reinsured. The cumulative might beyond the insurer’s capacity and will need a catastrophe excess of loss treaty.
Premium calculation is based on a flat rate.
(c)Excess of loss ratio (stop loss)
Treaty is similar to the excess of loss treaty but instead of fixing limits in monetary values fixes limits in percentages. They are used in protecting portfolios of particular classes of insurance from fluctuations in their claims experience. This promotes stability and confidence.
Loss ratio is the ratio of premiums to claims in a given year. An insurer may want to limit its ratio on motor insurance to 50%. The excess of loss ratio treaty will cover losses over the chosen figure subject to a limit e.g. up to a loss ratio of 110%.
Premium calculation is based on the burning cost method by considering the ceding office claims experience for the past 3 or 5 years
2. Facultative reinsurance
Facultative reinsurance has the following characteristics: -
-Has to be requested by the ceding office when required
-A proposal has to be made to the reinsurer disclosing all materials facts such as the rate of premium and ceding office’s net retention.
-The reinsurer has the option to accept or decline the risk
-If declined the ceding office has to shop elsewhere for cover
-On acceptance a reinsurance policy will be issued
With facultative reinsurance acceptance of the proposal is always uncertain. The shopping around for cover is both expensive as time consuming.
Despite the setbacks, facultative reinsurance is very useful in the following instances: -
-when the ceding office’s treaty has been filled
-when the risk is outside the terms of the treaty
-when the risk is unusual e.g. heavy risks because of occupation or geographical location fall outside normal treaty arrangements.
To overcome the time problem, insurers and reinsurers have devised the following methods:
-The risk is taken reinsured during the time it is being considered.
-Facultative treaty is used. This obliges or commits the reinsurers to accept certain types of facultative business from the ceding office. The reinsurers are obliged to accept but the ceding office is not obliged to cede.
-Brokers play a very important role in reinsurance when they are attempting to place large risks in the market. They have similar arrangements with reinsurers.
- Reinsurance pools
These are formed by a group of insurers who pool their risks, premiums and claims. Pools have been arranged by:
-Groups of associated companies that share risks of a certain type before considering reinsurance outside the group. The risk can be accommodated internally without needing external help.
-Insurers in high risks activities e.g. high risk motor insurance especially the number of exposures is low, agree to pool their resources in order to spread risk.
-Regional insurers (in the Middle East, Asia and Africa) sharing all risks around themselves instead of seeking reinsurerance.
- State as a reinsurer
Emergence of terrorism in recent times has led to a demand of insurance. However, there is no possibility that insurers will be able to pay claims arising from mass terrorism.
A recent development in Great Britain was the enactment of the Reinsurance (Acts of Terrorism) Act 1993. The Act makes provision for the government to reinsure certain risks linked to acts of terrorism. Funding will be provided by parliament to meet any obligations under the Act.
- Captive insurers
A captive is an insurer that is formed and wholly owned by a parent company for the purposes of underwriting particular risks of the parent.
Captives are formed by large multinational, industrial and commercial businesses as they have the size to have a spread. They have a lot of areas of risks justifying the setting up of their own insurance companies.
Advantages include:
-Retention of any profits within the organisation
-They enjoy low premiums as they are not affected by poor claims experience of other organisation
-There are no disputes with external insurers
-Financial benefits are possible if captive is formed in offshore tax haven
-Direct access to the reinsurance market at lower premium rates
Reinsurance
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