Did you know that insurance companies buy insurance from other companies? Parts or all of the policies that an insurance company writes may be sold to other insurance companies, mainly to spread risk, and all is done without the policyowner knowing any difference. Reinsurance is the term that describes this distribution of policies and the attendant risk among insurers. The insurance company that wrote the policy for the insured is called the primary insurer, otherwise known as the direct writer or as the ceding company or, simply, as the cedent. The insurance company that accepts the transference is the reinsurer. The reinsurer usually pays a ceding commission to the direct writer to compensate it for the acquisition of the new business.
The amount of the insurance that the primary insurer retains is the retention limit (aka net retention), and the amount that is ceded to the reinsurer is the cession. The reinsurer may transfer some of the insurance to another reinsurer—the retrocessionaire—and the amount transferred is the retrocession.
Reinsurance is also used to cover major disasters, such as hurricanes, earthquakes, and nuclear accidents. While a catastrophe is often referred to as a loss event, a major loss that affects several reinsurers is deemed an industry loss event.
Reinsurance Benefits the Insurer
The main benefits of reinsurance to insurance companies are the following:
- increases the underwriting capacity of the insurer;
- protects against a catastrophic loss, which helps to stabilize profits;
- reduces the unearned premium reserve;
- allows an insurer to exit a territory or line of insurance by transferring the whole policies of the territory or insurance line to a reinsurer;
- and reinsurers can provide advice about specific lines of insurance to insurance companies that are starting up or entering a new line of insurance business.
Sometimes reinsurance is used by a mutual company that wants to convert into a stock insurance company. The stock company is either acquired or organized by the mutual insurer, then the policy liabilities are transferred by reinsurance to the stock insurance company, and then the mutual company is liquidated.
Because reinsurance increases the underwriting capacity of a primary insurer, the primary insurer can sell policies that normally it would not accept because the policy limit is above the insurer's retention limit. If the insurer refuses the policy, then it will lose business to competitors. Using reinsurance, the primary insurer can write the policy, retain an amount up to its retention limits, and sell the rest to a reinsurer. Transferring insurance amounts above the retention limit also prevents catastrophic losses that may result from the crash of a commercial airliner, a terrorist attack, or a natural disaster.
When an insurer sells a policy, the entire amount of the premium goes into an unearned premium reserve, which is required by law and is the unearned part of the premium. Premiums are paid for future insurance coverage, so the premium is earned when a specific amount of time elapses during coverage. The insurer cannot use the money in the unearned premium reserve to pay its own expenses. For example, if you pay $1,200 per year for auto insurance, then the insurer can only transfer $100 per month from the unearned premium reserve into a general account that the insurer can use to pay expenses.
Furthermore, insurers must pay acquisition expenses, such as commissions for sales agents and administrative processing, so when an insurer sells a policy, it initially has less money than before it issued the policy. This limits how fast an insurance company can expand. Reinsurance lowers the unearned premium reserve requirement for the primary insurer, and increases its surplus, thus allowing it to expand its business more rapidly than would otherwise be possible.
The reinsurer also pays a commission to the direct writer for its acquisition of the customer, so the assets of the direct writer decrease less than the liabilities that are transferred to the reinsurer. So if a direct writer transfers $100,000 in premiums to the reinsurer, minus a ceding commission of $40,000, then the assets of the direct writer are reduced by $60,000, but its liabilities are reduced by $100,000, resulting in a net increase in the direct writer's surplus of $40,000. So, in essence, the ceding commission paid to the direct writer increases its surplus by the same amount.
Older reinsurance companies are often named after their place of origin — such as Cologne Re (now known as General Reinsurance AG), Hannover Re, Munich Re (the largest reinsurer in the world), and Swiss Re — and they are often started after a disaster. For instance, Cologne Re was formed after about a quarter of Hamburg, Germany was destroyed by fire in 1842 and Swiss Re was formed in 1863 after a good part of Glarus, Switzerland was destroyed by fire. In fact, at least several reinsurance companies crop up after every major disaster, since insurance companies are more apt to buy reinsurance after such major events. For instance, 8 new reinsurers were created after Hurricane Andrew in 1992, 8 more were formed after the terrorist attacks on September 11, 2001, and 5 more after Hurricanes Katrina, Rita, and Wilma in 2005.
Whereas most insurance companies use the law of large numbers to calculate premiums, reinsurance companies must use computerized statistical models, since major events occur only rarely. Lloyd's of London publishes an annual list of Realistic Disaster Scenarios, which is a list of the greatest possible disasters that could conceivably occur.
However, if a reasonable estimate of the probability of an event cannot be determined, then a reinsurer will exclude it from its coverage. Such is the case for terrorism, which reinsurers excluded after the September 11 attacks. Previous to that, terrorism that resulted in major destruction was considered an unlikely event.
Reinsurance companies often learn something new from each major disaster — particularly on what to exclude or to limit. For instance, before the 1960s, reinsurance treaties did not have an hours clause for hurricanes that would limit the time that the insured could file a claim for damages. Nowadays, the standard hours clause limits the time to 96 hours.
Reinsurers also update their computer models based on the new information, so that future predictions would hopefully be more accurate. However, statistical models for predicting major disasters are often woefully inaccurate, causing reinsurers to suffer major losses. Nonetheless, reinsurers can easily raise their premiums based on the new information, since insurance companies are more than eager to buy reinsurance after a major disaster.
Facultative and Treaty Reinsurance
There are 2 basic types of reinsurance: facultative and treaty reinsurance. Facultative reinsurance is based on individual agreements to cover specific losses. When the primary insurer needs reinsurance for a particular coverage, it enters the market, and negotiates the amount of coverage and the premium with different reinsurance companies, seeking the best value. Under most agreements, the reinsurer pays a ceding commission to the primary insurer to pay for acquisition costs.
Treaty reinsurance (aka automatic reinsurance) involves a standing agreement with a particular reinsurer. The amount of insurance sold by the primary insurer that is transferred and the services provided by both parties are specified by contract. There are various types of treaty reinsurance arrangements that differ according to the liability of the reinsurer.
Pro rata reinsurance (aka quota-share treaty) is the proportionate sharing of premiums, losses, and expenses between the primary insurer and the reinsurer. For example, the primary insurer may decide to retain 70% of new business and transfer 30% to the reinsurer, and dividing income, losses, and expenses by the same proportion. The retained limit is specified as a percentage. The main benefit of the quota-share treaty is that it allows the primary insurer to reduce its unearned premium reserve significantly at the cost of transferring a lot of profitable business to the reinsurer.
Excess-of-loss reinsurance (aka excess-of-loss treaty) is an arrangement where the reinsurer only covers losses that are greater than the primary insurer's retained limit, which is usually expressed as a dollar amount. This coverage is bought mainly to cover catastrophic events, and can be written to cover a single occurrence, a single exposure, or as a dollar amount that pays for losses that exceed the primary insurer's cumulative losses within a given period.
Surplus-share treaty is an agreement that shares some of the qualities of the quota-share and excess-of-loss treaties. The retention limit for each policy, known as a line, is specified as a dollar amount, and the reinsurer pays anything above the line, up to a specified maximum amount. If there is a loss, then the primary insurer and the reinsurer pay for the same proportion as the provided coverage for that policy. For example, suppose that the primary insurer sold 2 policies with policy limits of $400,000 and $500,000 dollars, and its own line is $200,000 on each policy. Then the reinsurer would cover $200,000 on the 1st policy and $300,000 on the 2nd policy. If the policies eventually pay out $300,000 each for losses, then the reinsurer would pay 50% ($200,000/$400,000) of the loss for the 1st policy, or $150,000, and 60% ($300,000/$500,000) of the 2nd policy, or $180,000. The main benefit of the surplus-share treaty is that it increases the primary insurer's underwriting capacity, but, because the coverage provided by the reinsurer depends on each policy, there is more recordkeeping and greater administrative expenses.
A reinsurance pool is formed by a group of insurers that combines their financial assets to underwrite insurance jointly. These pools are formed to provide coverage for aviation disasters, nuclear accidents, and exposure in foreign countries, where losses can be catastrophic and that could easily exceed the financial capability of any single insurer. Reinsurance coverage can be provided as a set proportion of each policy, or as an excess-of-loss arrangement, where each insurer pays for their own claims up to their retention limit. Losses greater than the retention limit are shared among the other insurers of the pool.
Sometimes, the state government provides reinsurance at lower rates than that of commercial reinsurers to lower insurance costs for its residents. For example, Florida has set up the Florida Hurricane Catastrophe Fund that insurers can draw upon to pay large claims from major storms.
- Like insurance companies, there are both admitted and nonadmitted reinsurers. If an insurance company purchased reinsurance from an nonadmitted carrier, then, previously, it could not show it as a credit on its financial statements unless the reinsurer posted collateral. The Credit for Reinsurance Model Act and Regulation reduced the collateral requirements, if the reinsurers were supervised by an approved jurisdiction.