This post discusses reinsurance – its meaning, operations, and practices.

WHAT IS REINSURANCE?  

Reinsurance is a risk transfer contract between an insurance company (known as the reinsured) and a reinsurance company (known as the reinsurer) whereby the reinsurer undertakes the liability incurred by the reinsured under a primary insurance contract in exchange for payment of a premium to the reinsurer. Reinsurance is a form of insurance based on the principles and practices applicable to the insurance business.

A reinsurance contract is a risk transfer mechanism between a reinsured and a reinsurer. An insurance contract is between two parties, known as the insured and the insurer, whereby the insurer promises to indemnify the insured in the event of a loss caused by the insured perils in exchange for the payment of a consideration known as the premium.

DIFFERENCES BETWEEN INSURANCE AND REINSURANCE CONTRACTS

Reinsurance contract differs fundamentally from other classes of insurance contracts in three primary ways: 

1. A reinsurance contract is between insurers and reinsurers. A reinsurer may also reinsure insurances accepted under its reinsurance contracts. Such a contract is known as retrocession. The ceding company is known as the retrocedent, and the reinsurer is known as the retrocessionaire. 

2. The subject matter of insurance is some property, person or benefit exposed to loss or damage or some potential legal liability the insured may incur arising from activities undertaken by himself, his servants, or agents. A reinsurer only becomes directly interested in such property or loss since he has compensated the reinsured for the latter’s payment. Hence, the subject matter insured under a reinsurance contract is all or part of the contractual liability the reinsured has accepted under the insured policies he has underwritten. 

3. Not all insurance contracts are subject to the principle of indemnity. It is a well-accepted law that insurance covering human life (life, personal accident, and sickness policies) is excluded from the principle and sometimes referred to as benefit policies or contracts. All reinsurance contracts, including life reinsurance, are contracts of indemnity because reinsurance claims are limited to claims payments based on the proportion of risk accepted under the reinsurance contract.

FUNCTIONS OF REINSURANCE

The most common reasons for purchasing reinsurance include: 

1) Capacity relief: The reinsured can write larger insurance amounts. 

2) Catastrophe protection: Protects the reinsured against a large single, catastrophic, or significant loss. 

3) Stabilisation: Helps smooth the reinsured’s overall operating results from year to year. 

4) Surplus relief: Reinsurance eases the strain on the reinsured’s surplus during rapid premium growth.

5) Market withdrawal: Provides a means for the reinsured to withdraw from a line of business, geographic area, or production source. 

6) Market entrance: Helps the reinsured spread the risk on new lines of business until the premium volume reaches a certain point of maturity; can add confidence when in unfamiliar coverage areas. 

7) Expertise and experience: Provide the reinsured with a source of underwriting information when developing a new product and entering a new line of insurance or a new market.

LEGAL PRINCIPLES OF REINSURANCE

Reinsurance contracts are subject to the general law of contract and the rules applicable to insurance contracts. Consequently, provisions of contract law relating to such matters as an intention to create a legal relationship, offer and acceptance, consideration, capacity to enter contracts, and legality apply to the formation, construction, performance, and validity of reinsurance contracts. No general requirement in English law requires that reinsurance contracts take any unique form. A reinsurance contract should comply with the basic needs of a simple contract.

Reinsurance contracts are also subject to the special rules governing insurance contracts, notably: 

1. The must be an insurable interest. 

2. The contract is one of utmost good faith. 

3. The contract is one of indemnity.

METHODS OF REINSURANCE TREATY

The primary methods of reinsurance are proportional and non-proportional. There are many sub-types of both proportional and non-proportional forms. Proportional and non-proportional reinsurance can be transacted on a facultative and a treaty basis.

FACULTATIVE REINSURANCE

Facultative means optional and the power to act according to a free choice. The primary feature of facultative reinsurance is that the reinsurance company is free to accept or decline each proposition. The insurer is not obliged to cede, as in the case of treaty reinsurance. The other important feature is that this reinsurance is effected to cover individual acceptances.

For instance, where a ceding company wished to write a fire and perils policy on a large industrial complex, and its financial capacity was limited to a sum equal to 25% of the overall exposure, it might seek facultative reinsurance to be able to accept the whole risk for its marketing advantage. From the reinsurer’s standpoint, facultative also means the power to accept or decline each risk according to its underwriting judgment and other necessary considerations.

Facultative reinsurances may be on a proportional or non-proportional basis. By effecting proportional facultative reinsurance, a direct insurer can relieve itself of part of the liability accepted on a particular direct risk by ceding a share to one or more reinsurers. The result is that the insurer pays the reinsurer a share (percentage) of the premiums, less commission, and in the event of a loss, the reinsurer that same share of the original claims from the reinsurer. The ceding company would thus be limiting its exposure to its share, provided the reinsurers involved complied with the reinsurance agreement.

TREATY REINSURANCE

Due to the above problems and the ever-larger number of reinsured risks, the treaty method of reinsurance (proportional and non-proportional treaty) evolved to overcome these difficulties. There are two main types of proportional treaty reinsurance: quota share and surplus treaty.

QUOTA SHARE TREATY

Quota share treaty reinsurance is a form of pro-rata reinsurance (proportional). It is a form of reinsurance in which the ceding insurer cedes an agreed-on percentage of every risk it insures that falls within a class or classes of business subject to a reinsurance treaty. The reinsurer assumes an agreed percentage of each insurance being reinsured and shares all premiums and losses accordingly with the reinsured. 

Quota share treaty results in a sharing of the gross retention of the ceding company between itself and its reinsurer in a predetermined proportion. Quota share reinsurance is usually arranged to apply to the insurer’s net retained account (that is, after deducting all other reinsurance except perhaps an excess of loss catastrophe reinsurance), but practice varies. A quota share reinsurer may be asked to assume a quota share of a gross account, paying its share of the premium for other reinsurance protecting that gross account.

SURPLUS TREATY

This type of treaty enables the ceding company to accept more enormous sums insured than its gross retention, the surplus being ceding to reinsurers. Gross retention is the amount the ceding company retains, and its quota shares reinsurers. The ‘net’ retention is the amount retained by the ceding company alone, subject only to catastrophe reinsurance.

The capacity of a surplus treaty is always a multiple of the ceding company’s gross net retention. This retention is often called a ‘line’. Further multiples of the retention or lines can be added beyond the first and second surplus treaties. Generally, however, a first and perhaps a second surplus treaty are deemed sufficient if the ceding company is not to become merely an agency accepting risks but passing nearly all the liability on to others.

However, despite a low insurance penetration, there are several risks in territories where third and fourth surplus treaties can be found. A combination of first, second and third surplus treaties can be used. The obligatory nature of the treaty arrangement obviates the necessity for the ceding company to refer each risk to reinsurers, provided the risk falls within the scope of its treaties. It can give immediate cover.

FACULTATIVE OBLIGATORY REINSURANCE

Facultative obligatory reinsurance arrangements are contracts that combine some of the principles of both the facultative and the treaty methods of proportional reinsurance. Under a facultative obligatory treaty, the ceding company must not cede to its reinsurer’s risks falling within the treaty’s scope. However, where it chooses, reinsurers are obliged to accept the cession, so the facultative obligatory treaty operates as a surplus treaty. Such arrangements provide considerable flexibility to the ceding company. 

The concept of facultative obligatory has been adapted in several ways to suit a particular situation. Facultative excess of loss cover can be purchased to protect the cedant’s retention or the common account of the cedant and its reinsurers. The cedant must ensure that the method chosen is permitted under the terms of its pro-rata treaties. In particular, the second method (the common account of the cedant and its reinsurers) is considered unacceptable by some reinsurers as it significantly affects the pro-rata treaty loss experience. 

The growth of facultative obligatory can be attributed to two primary factors: 

1. The underwriting of high-hazard and high-value business

2. The development of the captive insurance company business

The second factor in increasing facultative excess of loss reinsurance is the captive insurance company business development. A captive is a company operated primarily for underwriting in whole or in part, directly or indirectly, the insurance of its parent. The rise of influential multinational organisations that prefer their risks to be experience-rated rather than class-rated and have been unable to achieve their required terms through the conventional market, has led to an increased tendency for this type of organisation to form its insurance subsidiary.

Reinsurance is then purchased to limit the captive’s exposure to a tolerable level. Given the nature of a captive’s portfolio, this is usually best achieved by using excess loss reinsurance. Although the treaty, the underwriting considerations are such that many companies handle this class of business in their facultative departments.

As an example of facultative excess reinsurance, let us consider a petrochemical plant of value $50 million. The maximum probable loss (MPL) is assessed as $10 million, ignoring an existing vapour cloud hazard, but $30 million if this factor is considered. The cedant writes 100% of this risk and seeks to limit its potential loss to $500,000 anyone loss. Different underwriters have different preferences when accepting excess of loss business.

Some prefer to generate high premium income by writing low-level covers within the MPL, and others prefer to write a large portfolio of high-level covers. It is essential that the underwriter accepting high-level covers, where a little premium is generated regarding liabilities assumed, writes enough of such business to achieve a reasonable balance in his account. This is achieved when no single loss can eliminate his underwriting profit for the year.

Due to varying preferences, the cedant decides could obtain the best terms by purchasing cover in layers: 

• 1st layer: $9,500,000 Xs $500,000 – (To cover the maximum probable loss exposure). 
• 2nd layer: $20,000,000 Xs $10,000,000 – (To cover vapour cloud exposure). and
• 3rd layer: $20,000,000 Xs $30,000,000 – (To cover the maximum probable loss error exposure). 

It is worthwhile to emphasise that the facultative obligatory concept has been adapted in several ways to suit specific situations, including open covers, brokers covers, lines slips, and reinsurance pools.

OPEN COVERS

Generally, an open cover may be synonymous with a facultative obligatory treaty. However, ‘open cover’ strictly refers to an un-lined treaty under which the cession is not linked to the insurer’s retention. The word ‘cover’, imported from direct insurance, gives the impression more of a ‘facility in a particular branch or sub-category than a treaty’s more general and broader scope. Given the more precise nature of such arrangements, the business is often dealt with in the facultative department instead of the treaty department. By their nature, open covers tend to produce selection against the reinsurer, particularly if there is limited spread in quantity and even more limited spread in the type of risk included in the open cover.

BROKERS’ COVERS

It is often common for brokers to hold direct covers to enable them to place clients’ business with certain companies and Lloyd’s underwriters. It is also possible for certain reinsurance brokers to obtain reinsurance covers to allow them to place reinsurance on behalf of their clients. The concept in this instance is entirely different from all methods dealt with so far, as the broker will not be in a legal position to take any share in the reinsurance risks because ceding companies (that is, the primary insurers) have engaged the broker to place the reinsurance business. 

The broking house will be split frequently into an underwriting department or company and a broking department or company to enable both tasks to be carried on effectively. Many brokers have also developed the underwriting side into an underwriting agency. Effectively, this depends on the level of competition within a market and whether participants work harder to increase the profit. In its basic form, the broker’s cover has often produced heavy losses, and in many areas of the reinsurance markets, those covers can be challenging to obtain.

LINES SLIPS

The origin and basis of this arrangement are virtually the same as the broker’s cover. The main difference is that the broker needs to have the authority to accept risks on behalf of participating reinsurers. Instead, he must submit the risks to the leading reinsurer(s), who will decide whether the risk is acceptable. Subject to the agreement of the leading reinsurers, all other reinsurers are obliged to accept risks placed under the facility. Such arrangements are often very convenient to both parties. The broker can fully represent the client and place large amounts rapidly; the acceptance by one or more leading reinsurers binds all the following reinsurers. Also, the reinsurers who must follow have the assurance that the skilled leaders had seen all the risks before being placed under the facility.

REINSURANCE POOLS

A pool is an arrangement whereby a certain number of insurance companies form a collective capacity to accept specific classes of risk, and each company is liable for its share in the pool. There are several types of pools. The most common types of reinsurance pools are:

1. Market Reinsurance Pool

A market pool, where most insurance companies within a country usually participate, is a beneficial method to underwrite significant or hazardous risks. Such risks can range from catastrophic to pooling expertise to provide a new type of insurance. Hence, nuclear risks are commonly covered by a market pool.

2. Government Reinsurance Pools

To prevent the exportation of significant businesses to foreign reinsurers, the government can create a reinsurance company or pool into which all insurance companies must cede or reinsure part or all their reinsurance business subject to the terms of the reinsurance pool. This is known as a government reinsurance pool. The participating insurance companies may be shareholders in the reinsurance pool, thereby receiving a share in the ‘pool’ in return. Government reinsurance pools may be either national or regional reinsurance pools.

3. Underwriting Pools

Smaller, developing companies who wish to enter a new market, class, and type of business may need more expertise or necessary capacity to establish a sound foothold. They may form a pool represented by an experienced underwriter in the chosen developmental fields with sufficient collective capacity to accept competitive shares. There are many such pools around the world to write international reinsurance business.

FEATURES AND OPERATIONS OF NON-PROPORTIONAL REINSURANCE TREATIES

Non-proportional reinsurance is based on claims sharing. The original risk, premium, claims, and acquisition costs will be shared between the cedant (reinsured) and reinsurer for proportional reinsurance. This means the reinsurer usually ‘follows the fortune’ of the cedant or the reinsured. In contrast, non-proportional reinsurance allows for tailor-made flexible solutions fitted to the targeted risk profile of the cedant. 

In proportional reinsurance, risks are shared between the direct insurer and reinsurer based on sums insured. In non-proportional reinsurance, claims are shared on the loss paid. The non-proportional reinsurer is only liable for claims above a certain level. The liability of the direct insurer is capped at a certain amount. This is called the deductible. The reinsurance pays whatever exceeds this amount. 

Non-proportional reinsurance is usually referred to as excess loss because the loss must exceed specific retention or deductible before a claim can be made against the reinsurance. Deductible (also known as retention, the first loss and the excess) is part of a claim borne by an insurer before the reinsurer pays a reinsurance claim. The limit is the amount payable by the reinsurer. An excess of loss treaty provides the insurer capacity to underwrite significant risks. It primarily protects the reinsured against the severity of a loss.

FUNCTIONS OF EXCESS OF LOSS REINSURANCE

Functions of excess of loss reinsurance include:

1) Provide the cedent with the ability to provide more significant coverage limits. 

2) Reduce the fluctuation in loss experience by limiting the number of sustained losses. and

3) Lessen the impact of losses from a large event with multiple losses or the accumulation of losses from frequent events.

CHARACTERISTICS OF EXCESS OF LOSS REINSURANCE

Here are the characteristics of excess of loss reinsurance:

1) Protects the reinsured’s net retained account (i.e., after proportional treaties and facultative reinsurance). 

2) Reinsurers pay only when claims exceed the deductible (net retention), and then only for the excess amount up to agreed limits. 

3) Premiums are shared non-proportionally between ceding company and the reinsurer. Premiums are calculated as a percentage of the primary insurers premium charge. 

4) Reinsurers may pay a profit commission (contingent commission) for an insurer’s favourable loss experience. 

5) It generally involves a much less ceded premium than a pro-rata structure. It, therefore, does not provide the cedant with meaningful surplus relief as would be the case under a pro-rata arrangement.

6) Cover is not primarily intended for catastrophes (affecting many risks). and

7) Excess of loss reinsurance is a working excess of loss when the deductible is set at a level likely to produce a relative frequency of claims.

FORMS AND TYPES OF NON-PROPORTIONAL REINSURANCE

The primary forms of non-proportional reinsurance are:

1. Excess of loss, and 

2. Stop loss.

WORKING EXCESS OF LOSS

Working excess of loss is also known as Per Risk Excess of Loss. With a working excess of loss reinsurance, the reinsurer indemnifies the primary company for any loss above the specified retention on each risk. In per risk, the cedant’s insurance policy limits are more significant than the reinsurance retention. For example, an insurance company might insure commercial property risks with policy limits up to £10 million and then buy per risk reinsurance of N5 million in excess of £5 million. In this case, a loss of £6 million on that policy will recover £1 million from the reinsurer.

CATASTROPHE EXCESS OF LOSS

Catastrophe excess of loss reinsurance is also known as Per event and occurrence excess of loss. This excess of loss cover is designed to protect an insurance company’s overall underwriting results after applying other types of reinsurance it may have. It provides reinsurance for losses incurred during the treaty term, usually one year, in excess of a specified loss ratio or a predetermined dollar or designated currency amount. The purpose of a catastrophe excess treaty is to protect a primary company against adverse loss experiences resulting from the accumulation of losses arising from a single, major natural disaster or event such as a hurricane, tornado, earthquake, flood, and windstorm. For a given event, the treaty applies once the accumulation of losses paid by the primary company reaches predetermined retention.

BASES OF EXCESS OF LOSS COVER

The three bases of excess of loss reinsurance contracts are: 

1. Risk Attaching Basis: A basis under which reinsurance is provided for claims arising from policies commencing during the period to which the reinsurance relates. The insurer knows there is coverage for the whole policy period when written. All claims from cedant underlying policies incepting during the period of the reinsurance contract are covered even if they occur after the expiration date of the reinsurance contract. Any claims from cedant underlying policies incepting outside the period of the reinsurance contract are not covered even if they occur during the period of the reinsurance contract. Reinsurers usually limit claims up to a maximum of 12 months after the expiry of the contract. 

2. Loss Occurring Basis: This is a reinsurance treaty under which all claims occurring during the contract period, irrespective of when the underlying policies are incepted, are covered. Any claims occurring after the contract expiration date are not covered as opposed to a claims-made policy. Insurance coverage is provided for losses arising in the defined period. This is the usual basis of cover for most policies. 

3. Losses Discovered or Claims-Made Basis: A policy covering all claims reported to an insurer within the policy period, irrespective of when they occurred. This solves the problem of long-tail business.

NON-PROPORTIONAL REINSURANCE PRICING

There are two basic methods of non-proportional Reinsurance Pricing: 

1. Experience-Based methods, and

2. Exposure Based methods.

The non-proportional reinsurance premium calculation depends on the type of excess of loss, the claims history and the structure of the layer:  

1. Burning cost calculation is based on claims experience. A more sophisticated way of using claims experience is an extrapolation based on risk theory and modelling the claims profile. 

2. Exposure rating is based on the portfolio’s composition according to sums insured. 

3. Payback calculation depends on how many years the maximum probable losses would take to be ‘repaid’ by future annual premiums.

See the video on Reinsurance: https://youtu.be/bRxzqZwzodo