Printable Version (including Glossary of Reinsurance Terms)

INTRODUCTION TO PROPERTY AND CASUALTY REINSURANCE

Reinsurance is a transaction in which one insurance company indemnifies, for a premium, another insurance company against all or part of the loss that it may sustain under its policy or policies of insurance. The insurance company purchasing reinsurance is known as the ceding insurer; the company selling reinsurance is known as the assuming insurer, or, more simply, the reinsurer. Described as the “insurance of insurance companies,” reinsurance provides reimbursement to the ceding insurer for losses covered by the reinsurance agreement. The fundamental objective of insurance, to spread the risk so that no single entity finds itself saddled with a financial burden beyond its ability to pay, is enhanced by reinsurance.

Although to many reinsurance is an unknown aspect of the insurance industry, its roots can be traced as far back as the late 14th century. Since that time, reinsurance has evolved into the business it is today. While the early focus of reinsurance was in the lines of marine and fire insurance, it has expanded during the last century to encompass virtually every aspect of the modern insurance market. 

Reinsurance can be purchased from three distinct sources: reinsurance companieslocated in the United States, reinsurance departments of U.S. primary insurance companies, and alien reinsurers that are located outside the U.S. and not licensed here. The ceding insurer may purchase reinsurance directly from a reinsurer or through a broker or reinsurance intermediary.

Reinsurance may be written on either a proportional basis or excess of loss basis. A reinsurance contract written on a proportional basis simply prorates all premiums, losses and expenses between the insurer and the reinsurer on a pre-arranged basis. The proportional approach is used extensively in property reinsurance. Excess of loss contracts, on the other hand, require the primary insurer to keep all losses up to a predetermined level of retention, and the reinsurer to reimburse the company for any losses above that level of retention, up to the limits of the reinsurance contract. In simplest terms, a retention is analogous to the deductible a policyholder may have on a personal insurance policy, such as an automobile or homeowner’s policy. 

PURPOSES OF REINSURANCE

Insurers purchase reinsurance for essentially four reasons: (1) to limit liability on specific risks; (2) to stabilize loss experience; (3) to protect against catastrophes; and (4) to increase capacity. Depending on the ceding company’s goals, different types of reinsurance contracts are available to bring about the desired result.

1. Limiting Liability: By providing a mechanism through which insurers limit their loss exposure to levels commensurate with their net assets, reinsurance enables insurance companies to offer coverage limits considerably higher than they could otherwise provide. This function of reinsurance is crucial because it allows all companies, large and small, to offer coverage limits to meet their policyholders’ needs. In this manner, reinsurance provides an avenue for small-to-medium size companies to compete with industry giants. 

In calculating an appropriate level of reinsurance, a company takes into account the amount of its own available surplus, and determines its level of retention based on the amount of loss it can absorb financially. Surplus, sometimes referred to as policyholders’ surplus, is the amount by which the assets of an insurer exceed its liabilities.

2. Stabilization:  Insurers often seek to reduce the wide swings in profit and loss margins inherent to the insurance business. These fluctuations result, in part, from the unique nature of insurance, which involves pricing a product whose actual cost will not be known until sometime in the future. Through reinsurance, insurers can reduce these fluctuations in loss experience, and stabilize the company’s overall operating results.

3. Catastrophe Protection: Reinsurance provides protection against catastrophic loss in much the same way it helps stabilize an insurer’s loss experience. Insurers use reinsurance to protect against catastrophes in two ways. First, reinsurance protects against catastrophic financial loss resulting from a single event, such as the total fire loss of a large manufacturing plant. Second, reinsurance also protects against the aggregation of many smaller claims resulting from a single event, such as an earthquake or major hurricane, that affects many policyholders simultaneously. While the insurer is able to cover losses individually, the aggregate may be more than the insurer wishes to retain.

Through the careful use of reinsurance, the disruptive effects that catastrophes have on an insurer’s loss experience can be reduced dramatically. The decisions a company makes when purchasing catastrophe coverage (e.g., size of retention and coverage limits) are unique to each individual company and vary widely, depending on the insured risk.

4. Increased Capacity: Capacitymeasures the dollar amount of risk an insurer can prudently assume based on its surplus and the nature of the business written.

When an insurance company issues a policy, the expenses associated with issuing that policy, such as taxes, agent commissions, and administrative expenses, are charged immediately against the company’s income, resulting in a decrease in surplus. Meanwhile, the premium collected must be set aside in an unearned premium reserve to be recognized as income over a period of time. This accounting procedure allows for strong solvency regulation; however, it ultimately leads to decreased capacity. As an insurance company sells more policies, it must pay more expenses from its surplus. Therefore, the company’s ability to write additional business is reduced.

Rapidly expanding companies are particularly susceptible to the timing problem between expenses that must be debited immediately, and income that must be credited over time. By reinsuring a portion of its insurance policies, an insurance company reduces the problem of decreased surplus. Through reinsurance, the company shares a portion of its underwriting expenses with its reinsurer and reduces the drain on surplus.

If the reinsurer has satisfied certain regulatory requirements intended to assure the security of the reinsurance arrangement, a ceding insurer can expand its own capacity by supplementing it with reinsurance payments it is owed on its paid claims. This is known as credit for reinsurance, and allows the ceding insurer to expand its capacity. The ceding company can also reduce liabilities and loss reserves attributable by ceding that business to a reinsurer.

A reinsurer will often give the ceding company a ceding commission as reimbursement for expenses, such as agent commissions, taxes and overhead, associated with acquiring the business being reinsured. When added directly to the ceding company’s surplus, the ceding commission further increases its capacity.

In addition, reinsurers often provide insurers with a variety of other services. Some reinsurers provide guidance to insurers in underwriting, claims reserving and handling, investments and even general management. These services are particularly important to smaller companies or companies interested in entering new lines of insurance.

In any discussion of reinsurance, its limitations must be considered along with its advantages. Reinsurance does not change the inherent nature of a risk being insured. It cannot make a bad risk insurable or an exposure more predictable or desirable. And while reinsurance may limit an insurance company’s exposure to a risk, the total risk exposure is not altered through the use of reinsurance.

THE REINSURANCE CONTRACT

Based on its business needs, an insurer negotiates with a reinsurer to determine the terms, conditions and costs of a reinsurance contract. Under a reinsurance contract, an insurer is indemnified for losses occurring on its insurance policies and covered by the reinsurance contract. While there are no standard reinsurance contracts, treaty and facultative contracts are the two basic types used and adapted to meet individual insurers’ requirements. Both facultative and treaty contracts may be written on a proportional or an excess of loss basis, or a combination of both.

A reinsurance treaty is a broad agreement covering some portion of a particular class or classes of business (e.g., an insurer’s entire workers’ compensation or property book of business). Historically, treaties remain in force for long periods of time and are renewed on a fairly automatic basis unless a change in terms is desired. Reinsurance treaties automatically cover all risks written by the insured that fall within their terms unless they specifically exclude exposures. While treaty reinsurance does not require review of individual risks by the reinsurer, it demands a careful review of the underwriting philosophy, practice and historical experience of the ceding insurer, including a thoughtful evaluation of the company’s attitude toward claims management, engineering control, as well as the management’s general background, expertise and planned objectives.

In contrast, facultative reinsurance contracts cover individual underlying policies and are written on a policy-specific basis. A facultative agreement covers a specific risk of the ceding insurer. A reinsurer and ceding insurer agree on terms and conditions in each individual contract. Facultative reinsurance agreements often cover catastrophic or unusual risk exposures. 

Because it is so specific, facultative reinsurance requires the use of substantial personnel and technical resources for underwriting individual risks. Furthermore, facultative business often presents significant potential for loss. Therefore, a reinsurer must have the necessary staff knowledge to underwrite each exposure accurately.

Facultative reinsurance contracts may also supplement treaty arrangements when the treaties contain specific exclusions, such as exposures involving long haul trucking or munitions manufacturing. Insurers may fill voids in coverage created by reinsurance treaty exclusions by negotiating a separate facultative reinsurance contract for a particular policy or group of policies.

In addition, certain classes of risks that may develop significant losses could adversely affect an insurer’s treaty experience. Although not excluded from a treaty, these risks may be placed facultatively. For example, to accommodate a policyholder, an insurance company that would not ordinarily provide commercial automobile coverage might agree to provide the coverage. The insurer may then seek facultative reinsurance to protect its losses under applicable treaty agreements. The reinsurer providing an insurer’s treaty coverage may not necessarily provide its facultative reinsurance.

Reinsurers also purchase their own reinsurance protection, called retrocessions, in the same forms and for the same reasons as ceding insurers. By protecting reinsurers from catastrophic losses, as well as an accumulation of smaller losses, retrocessions stabilize reinsurer results, thereby spreading the risk.

Reinsurance relationships range from simple to complex. An insurer may enter into a single reinsurance treaty to cover certain loss exposures or may purchase numerous treaties until the desired level of reinsurance protection is achieved. This process, known aslayering, uses two or more reinsurance agreements to obtain a desired level of coverage. At the time a claim comes due, the reinsurers respond in a predetermined sequence, as necessary, to cover the loss. Layering of reinsurance coverage is similar in principle to the purchase of specific risk coverage through a rider on an insurance policy. Layering allows an insurer to secure the type and amount of insurance or reinsurance protection desired.

There are certain fundamental principles underlying all reinsurance contracts regardless of how simple or complex the transaction. First, the only parties to a reinsurance contract are a reinsured company and its reinsurer. All contractual rights and obligations run only between these two companies. Second, the payments that may be collected under the reinsurance contract are an asset of the ceding company. Finally, as a contract of indemnification, the reinsurance is payable only after the ceding insurer has paid losses due under its own insurance or reinsurance agreements. The exception to this final principle falls under an insolvency clause, which allows the receiver of an insolvent insurer to collect on reinsurance contracts.

CHARACTERISTICS OF REINSURANCE RISK  

As stated previously, the two major types of reinsurance are proportional and excess of loss. Under proportional reinsurance, the ceding insurer and the reinsurer automatically share all premiums and losses covered by the contract on a pre-agreed prorated basis, thus there are no characteristics uniquely attributable to the risk associated with proportional reinsurance.

Insurance loss costs are determined by a combination of frequency (how many claims per unit), severity (average cost of each claim) and the total number of units insured. Generally, the higher the number of similar units insured, the more reliable the data. This is particularly true in automobile property damage liability insurance. There are many automobiles insured and the frequency of claims is relatively stable year to year.

This method of evaluating insurance risk, however, is often not applicable to reinsurance. Relevant and credible loss data are often unavailable. In contrast to an insurance underwriter, a reinsurance underwriter depends much more on professional judgment and experience to evaluate the nature of an exposure.

General liability insurance contracts traditionally provide coverage for losses occurring during the policy term, regardless of when the loss is reported. This type of contract, called anoccurrence policy, leaves the insurer exposed to claims which may be filed many years after the policy expires. Certain exposures, such as environmental liability, are particularly susceptible to this latency factor commonly referred to as thelong tail.

Reporting delays create serious problems for all insurers, but marked differences exist in reinsurer loss development patterns, due primarily to the retention feature of excess of loss reinsurance. Many claims are not initially valued at ultimate cost. Because the ceding insurer’s reserve is within the retention established in the reinsurance contract, the ceding insurer may not report such claims to its reinsurer. 

However, when the claim is ultimately paid, it may exceed the retention. It is only at this point, usually after considerable time has passed, that the reinsurer is notified. Reinsurers are trying to mitigate this problem by requiring all serious injuries to be reported, regardless of the insurer’s reserve, and by conducting on-site visits to examine ceding insurers’ claims files to better determine the likelihood of losses under the reinsurance contract.

Over the past several years, commercial lines of insurance that often have long tails have demonstrated considerable instability regarding frequency and severity of losses. As a result, commercial insurers rely heavily on reinsurance.

All insurers and reinsurers set aside loss reserves for claims that have been incurred but not reported (IBNR). As claims are reported to the company, these reserves, which represent future loss payments, are reduced.

Because IBNR is such a major component of reinsurers’ reserves, much effort is taken to determine and make these calculations. Despite the use of sophisticated professional techniques, however, these reserves are extremely sensitive to changes in social, legal and economic environments. Therefore, they represent a “best guess estimate” of future loss payments.

If IBNR reserves represent only a small portion of a company’s total loss reserves, the impact of these unknown claims on total losses reported on past policies is likely to be small. In contrast, if IBNR reserves represent a large portion of a company’s reserves, the impact on total losses reported on past policies may be significant. Reinsurers, particularly those participating in casualty and workers’ compensation lines, fit into this latter category.

The impact of inflation on insurers’ claims liability typically results from increases in the cost of living, increases in the number of claims paid, and increases in large jury verdicts which raise settlement costs. The impact has been most pronounced on reinsurers because their losses develop more slowly and may not be capped to a retention limit.

If losses are paid within a relatively short period following the issuance of an insurance policy, inflation has little effect on claims payments. In many instances, the reinsurer may not become aware for years of a loss it will pay. As a result, the impact of inflation on reinsurers may be dramatic. In fact, over the last decade, retention levels were reached and exceeded with unexpected frequency in nearly all lines of insurance.

REINSURANCE REGULATION

Since reinsurance regulation focuses on solvency, it safeguards the validity of reinsurance policies and, at the same time, maintains flexibility in the business of reinsurance. By focusing on the reinsurer, rather than on the reinsurance contract, primary insurance companies are allowed to purchase reinsurance to suit their particular business needs. Of course, reinsurance contracts are entered into by two or more insurance companies -- the reinsurer(s) and the insurer(s). Recognizing that there are always some exceptions to the rule, the two companies are generally expected to be knowledgeable about the insurance business. Therefore, the oversight necessary in primary insurance to protect consumer interests is not essential in the reinsurance business.

In addition, reinsurance contracts must be shaped to the ceding insurer’s unique requirements. No two contracts are alike -- all have marked variations in retention levels, coverages and exclusions. An insurance company’s needs for reinsurance depend on its book of business and financial and underwriting strategies. The reinsurance contract, and hence reinsurance premiums, must be individually tailored and determined by the parties.

Reinsurance laws do not require insurers to purchase reinsurance from a U.S. company. With few exceptions, an insurer can purchase reinsurance from a reinsurer located anywhere in the world. The U.S. insurance and reinsurance marketplace needs the additional capacity provided by reinsurers worldwide. State insurance departments, however, are unable to assess the strength of companies located in other countries and cannot measure the extent of regulation under which these alien reinsurers operate. Therefore, to ensure that reinsurance purchased overseas can be collected, state insurance departments impose regulatory restrictions on U.S. insurers, frequently requiring security arrangements between the ceding insurer and reinsurer.

Since recoverable reinsurance is usually a substantial asset, insurers attempt to satisfy the state credit for reinsurance laws. In order to balance insurer capacity and security, virtually every state enforces some type of credit for reinsurance law, regulation or internal departmental standard. Although there is no uniform standard in existence, credit for reinsurance requirements can be met through a variety of alternatives.

First, credit is allowed if the reinsurer is licensed or accredited in the same state where the primary insurer does business. A license is the best means for an insurance department to ensure the solvency of a reinsurer. Some companies, however, have chosen to become accredited rather than licensed. The process of accreditation usually requires a company to submit data to the state insurance department comparable to that of a company seeking licensure.

Second, credit is usually allowed if the reinsurer is domiciled and licensed in a state that employs substantially similar credit for reinsurance standards to those imposed by the primary insurer’s state of domicile.

Most U.S. reinsurers satisfy one of these tests, and primary insurers doing business with these companies will usually receive favorable treatment of assets and liabilities on their annual statement. However, the primary insurer is not required to purchase reinsurance from a reinsurer licensed in the U.S.

If a company chooses to buy from an alien reinsurer, the reinsurer must usually satisfy one of two requirements for the ceding company to receive credit for reinsurance. First, credit is allowed if the alien reinsurer establishes a substantial U.S. trust fund which satisfies various state requirements on reporting, solvency and collectibility. Second, credit is typically allowed if the alien reinsurer establishes security in the U.S., such as a clean, irrevocable and unconditional letter of credit issued by an acceptable bank.

These alternatives provide state insurance departments with a means to assess the ability of a reinsurer, domestic or alien, to meet its obligations. They also allow U.S. reinsurers access to the international reinsurance marketplace needed for greater capacity and stability.

It is important to note that nearly all primary insurers may sell reinsurance. State insurance laws usually allow an insurer to offer reinsurance in the same lines it writes on a direct basis. In most states, an insurer who wishes to get into the reinsurance market need not satisfy any additional financial requirements.

Taken together, the direct and indirect regulation of reinsurance contracts is significant, if not the same as required of the primary insurance industry. This does not place the policyholder at risk if all other solvency and contract oversight is in place. The goal of reinsurance regulation, beginning with credit for reinsurance laws, is to assure that reinsurance will be paid. This is accomplished in two ways: by direct solvency regulation of the reinsurer or by providing sufficient collateral to meet the reinsurer’s obligations. This goal encourages ceding insurers to do business with reinsurers, domestic or alien, that are well-funded, solvent, responsible and will be there to pay when insurance claims come due.