What is Reinsurance?
Reinsurance is a form of insurance. A reinsurance contract is
legally an insurance contract. The reinsurer agrees to indemnify
the decant insurer for a specified share of specified types of insurance claims paid by the cedant for a single insurance policy
or for a specified set of policies. The terminology used is that
the reinsurer assumes the liability ceded on the subject policies.
The cession, or share of claims to be paid by the reinsurer, may
be defined on a proportional share basis (a specified percentage
of each claim) or on an excess basis (the part of each claim, or
aggregation of claims, above some specified dollar amount).
The nature and purpose of insurance is to reduce the financial cost to individuals, corporations, and other entities arising
from the potential occurrence of specified contingent events. An
insurance company sells insurance policies guarantying that the
insurer will indemnify the policyholders for part of the financial
losses stemming from these contingent events. The pooling of
liabilities by the insurer makes the total losses more predictable
than is the case for each individual insured, thereby reducing
the risk relative to the whole. Insurance enables individuals, corporations and other entities to perform riskier operations. This
increases innovation, competition, and efficiency in a capitalistic
marketplace.
The nature and purpose of reinsurance is to reduce the financial cost to insurance companies arising from the potential
occurrence of specified insurance claims, thus further enhancing
innovation, competition, and efficiency in the marketplace. The
cession of shares of liability spreads risk further throughout the insurance system. Just as an individual or company purchases an
insurance policy from an insurer, an insurance company may purchase fairly comprehensive reinsurance from one or more reinsurers. A reinsurer may also reduce its assumed reinsurance risk
by purchasing reinsurance coverage from other reinsurers, both
domestic and international; such a cession is called a retrocession.
Reinsurance companies are of two basic types: direct writers,
which have their own employed account executives who produce
business, and broker companies or brokers, which receive business through reinsurance intermediaries. Some direct writers do
receive a part of their business through brokers, and likewise,
some broker reinsurers assume some business directly from the
ceding companies. It is estimated that more than half of U.S.
reinsurance is placed via intermediaries.
The form and wording of reinsurance contracts are not as
closely regulated as are insurance contracts, and there is no rate
regulation of reinsurance between private companies. A reinsurance contract is often a manuscript contract setting forth the
unique agreement between the two parties. Because of the many
special cases and exceptions, it is difficult to make correct generalizations about reinsurance. Consequently, as you read this
chapter, you should often supply for yourself the phrases “It is
generally true that:::” and “Usually:::” whenever they are not
explicitly stated.
This heterogeneity of contract wordings also means that
whenever you are accumulating, analyzing, and comparing various reinsurance data, you must be careful that the reinsurance
coverages producing the data are reasonably similar. We will be
encountering this problem throughout this chapter.
The Functions of Reinsurance
Reinsurance does not change the basic nature of an insurance
coverage. On a long-term basis, it cannot be expected to make bad business good. But it does provide the following direct assistance to the cedant.
Capacity
Having reinsurance coverage, a cedant can write higher policy limits while maintaining a manageable risk level. By ceding
shares of all policies or just larger policies, the net retained loss
exposure per individual policy or in total can be kept in line with
the cedant’s surplus. Thus smaller insurers can compete with
larger insurers, and policies beyond the capacity of any single
insurer can be written.
The word “capacity” is sometimes also used in relation to aggregate volume of business. This aspect of capacity is best considered below in the general category of financial results management.
Stabilization
Reinsurance can help stabilize the cedant’s underwriting and
financial results over time and help protect the cedant’s surplus against shocks from large, unpredictable losses. Reinsurance is usually written so that the cedant retains the smaller,
predictable claims, but shares the larger, infrequent claims. It
can also be written to provide protection against a larger than
predicted accumulation of claims, either from one catastrophic
event or from many. Thus the underwriting and financial effects
of large claims or large accumulations of claims can be spread
out over many years. This decreases the cedant’s probability of
financial ruin.
Financial Results Management
Reinsurance can alter the timing of income, enhance statutory
and/or GAAP surplus, and improve various financial ratios by
which insurers are judged. An insurance company with a growing book of business whose growth is stressing their surplus can
cede part of their liability to a reinsurer to make use of the reinsurer’s surplus. This is essentially a loan of surplus from the reinsurer to the cedant until the cedant’s surplus is large enough
to support the new business. We will see other ways that reinsurance can be used to alter a cedant’s financial numbers. As
you might expect in a free market, this aspect of reinsurance
has led to some abuses in its use. As we discuss the various
forms of reinsurance coverage, we will note their financial effects.
Management Advice
Many professional reinsurers have the knowledge and ability
to provide an informal consulting service for their cedants. This
service can include advice and assistance on underwriting, marketing, pricing, loss prevention, claims handling, reserving, actuarial, investment, and personnel issues. Enlightened self-interest
induces the reinsurer to critically review the cedant’s operation,
and thus be in a position to offer advice. The reinsurer typically
has more experience in the pricing of high limits policies and
in the handling of large and rare claims. Also, through contact
with many similar cedant companies, the reinsurer may be able
to provide an overview of general issues and trends. Reinsurance
intermediaries may also provide some of these same services for
their clients.
The Forms of Reinsurance
Facultative Certificates
A facultative certificate reinsures just one primary policy. Its
main function is to provide additional capacity. It is used to
cover part of specified large, especially hazardous or unusual
exposures to limit their potential impact upon the cedant’s net
results or to protect the cedant’s ongoing ceded treaty results in
order to keep treaty costs down. The reinsurer underwrites and
accepts each certificate individually; the situation is very similar to primary insurance individual risk underwriting. Because
facultative reinsurance usually covers the more hazardous or unusual exposures, the reinsurer must be aware of the potential for
antiselection within and among classes of insureds.Property certificate coverage is sometimes written on a proportional basis; the reinsurer reimburses a fixed percentage of
each claim on the subject policy. Most casualty certificate coverage is written on an excess basis; the reinsurer reimburses a share
(up to some specified dollar limit) of the part of each claim on
the subject policy that lies above some fixed dollar attachment
point (net retention).
