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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 (aka ceding company), and the insurance company that accepts the transference is the reinsurer. 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.
The main benefits of reinsurance to insurance companies are the following:
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 transfer $100 per month from the unearned premium reserve into a general account that the insurer can use to pay expenses.
Furthermore, the insurer must pay acquisition expenses, such as commissions for the sales agent 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.
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, searching for 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 quote-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 quote-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 quote-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.
Reinsurance Association of America
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