When Things Go Awry, Insurers Get Reinsured

Did you know that even the insurance companies need insurance? That's where reinsurance steps in.

Insuring The Insurer

Technically, reinsurance is an insurance bought by an insurer from the reinsurer with the expectation of passing on the larger risks to the reinsurer. Finance guru Warren Buffett has invested billions of dollars in this area of insurance, as shown by his purchases in the reinsurance divisions of ING (NYSE:ING) and the reinsurance companies Cologne Re and Swiss Re. (Continue reading about Buffett's investing style in Think Like Warren Buffett and Warren Buffett: How He Does It.)

How does reinsurance play out? Let's look at an example to see where a reinsurer would step in and then break down each type of reinsurance.

Let\'s say ABC Life Insurance Co. has written an $8 million life insurance policy on the life of the famous industrialist, Mr. Smith. Indeed, the death of Mr. Smith would have a significant effect on ABC\'s profits from the $8 million claim. As a result, ABC purchases coverage for the life of Mr. Smith from XYZ Reinsurance Co. ABC decides to buy $4 million of coverage from XYZ.
In the event that Mr. Smith dies of a heart attack, ABC will be obliged to pay the entire amount of $8 million to Mr. Smith\'s beneficiary. But because ABC already has $4 million coverage from XYZ Reinsurance Co., the two insurers would share the loss. Thus, ABC would only pay up $4 million while XYZ would be responsible for the remaining $4 million.
Obviously, both companies would have a share in the premiums and profits of the coverage as well as the losses. Here, ABC Life Insurance Co. is the primary insurer or ceding company, whereas XYZ Reinsurance Co. is the reinsurer. The amount of the insurance, here $4 million, that the primary insurer retains is the retention limit (or net retention), and the amount that is ceded to the reinsurer is the cession ($4 million). In short, ABC has ceded some of its life insurance business to XYZ through the reinsurance arrangement.

Through the above illustration, we see that reinsurance is an insurance contract between an insurer and a reinsurer, wherein the reinsurer agrees to bear a certain amount of fixed risk borne by the insurer under the policies that it has issued. In exchange for providing reinsurance services, the reinsurer usually gets a premium from the ceding company, which may be a share of the original premium minus commissions or another mutually agreed-upon amount. The main aim of reinsurance is to spread risk to enable the insurance industry to function effectively and efficiently. Reinsurance allows the ceding company to take on more business than would be possible without a significant increase in capital and risk. (To learn the basics of insurance, see Understand Your Insurance Contract and Exploring Advanced Insurance Contract Fundamentals.)

Types Of Reinsurance

1. Facultative Reinsurance
Facultative reinsurance is coverage in which the reinsurer evaluates a specific risk on a case-by-case basis. Therefore, when ABC Life Insurance Co. passes the risk information of its particular policy to the reinsurer, XYZ Reinsurance Co., XYZ may or may not want to take the risk. ABC doesn't have any obligation to submit all the risks to the reinsurer.

Facultative reinsurance is negotiated separately for each insurance contract that is to be reinsured. The flexibility of facultative reinsurance allows many ceding insurers to reinsure hazardous risks not covered by ongoing treaty arrangements, thereby reducing the insurer's liability in certain high-risk areas. Facultative reinsurance also allows the primary insurers to obtain the reinsurer's advice on doubtful risks. This type of reinsurance contract can be in pro-rata form (a percentage-sharing plan for both premiums and losses) or excess of loss (reinsurer accepts certain losses past a pre-set breakpoint).

Facultative Reinsurance
Advantages Disadvantages
Flexibility - The ability to arrange a reinsurance contract to fit any particular case. Uncertainty - The ceding insurer cannot plan in advance as it does not know whether the reinsurer will accept the risk.
Stability - Stability in the operations of the insurer as the large losses can be transferred to the reinsurer. Delays for the Insurer - Because the policy will not be issued unless and until the reinsurance is obtained, it leads to delay.
More business - Increases the insurer\'s capacity to take on larger amounts of insurance business. Unreliability - Bad market conditions and poor loss outcomes can weaken the reinsurance market, making it difficult for the insurer to obtain reinsurance.

2. Treaty Reinsurance (or Automatic Treaty)
Treaty reinsurance is a standing contract between insurers and reinsurers. The ceding company is contractually obligated to cede and the reinsurer is bound to assume a specified portion or type of risk insured by the ceding company.

Once the negotiations of the contract are over, the reinsurer must automatically accept all business included within the terms of the reinsurance (treaty) contract with the ceding company. Thus, the reinsurer XYZ Reinsurance Co., as per the treaty arrangement with ABC Life Insurance Co., must agree to assume a certain percentage of entire classes of business, such as various kinds of auto insurance, up to predetermined limits. As with facultative reinsurance, treaty reinsurance contracts can be grouped into both pro-rata and excess of loss subsets.

Treaty Reinsurance
Advantages Disadvantages
Economical - The insurer does not have to shop for a reinsurer before underwriting the policy. Expensive - Administrative expenses can be quite high.
Fast - There is no delay or uncertainty involved. Complex - It is complicated and requires greater record keeping.

3. Proportional Reinsurance (or Pro-Rata Reinsurance)
Proportional reinsurance involves one or more reinsurers taking a predetermined percent share of each policy that an insurer writes. Here, premiums and losses are shared on specific risks in proportion to an agreed upon percentage between reinsurer and ceding company. There are two types of pro rata reinsurance - quota share and surplus share.

  • Quota Share Reinsurance
    The ceding company and the reinsurer take a proportionate share of losses and premiums, which is normally expressed as a fixed percentage of loss on each risk. A ceding commission (i.e. expenses such as retail brokerage, taxes, fees, home office expenses) is paid by the reinsurer to the primary insurer to reimburse for the expenses incurred in writing the business. For instance, ABC Life Insurance Co. may decide to retain 60% of new business and transfer 40% to the reinsurer XYZ Reinsurance Co., thereby dividing income, losses and expenses in equal proportion.
  • Surplus Share Reinsurance
    Surplus share reinsurance is similar to quota share, except that all the risks are not ceded to the reinsurer; instead, only risks exceeding a minimum dollar amount, or "line", are ceded. A line is described as the preset policy limit - say $100,000. Any risk with a value of $100,000 or less is retained, whereas for risks greater than $100,000, the insurer decides how many lines will be retained and ceded to the reinsurer. In a six-line surplus share treaty, the reinsurer can accept up to $600,000 or six lines.

    Suppose ABC sells a policy of $500,000 and its own retention line is $200,000 (two lines) on that policy. Then the reinsurer XYZ would cover $300,000 (or three lines) on that policy.

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Here too, the reinsurer pays a ceding commission to the primary insurer to compensate for the initial acquisition expenses.

4. Non-Proportional Reinsurance
With non-proportional reinsurance, the reinsurer does not share similar proportions of the premiums earned and losses with the ceding company. Here, the reinsurer's participation in the loss depends on the size of the loss. Excess of loss is an example of non-proportional reinsurance.

  • Excess Of Loss Reinsurance
    Here, losses exceeding the insurer's retention limit are paid by the reinsurer up to a predetermined limit. Assume that an insurer needs the capacity to write casualty business of $800,000, wherein its retention limit is a $300,000 loss on any risk. In the excess of loss reinsurance arrangement, the reinsurer would cover the part of the loss that exceeds the retention limit. If the insurer suffers a loss of $500,000, the ceding insurer would pay $300,000 and the reinsurer the remaining $200,000. For a loss of $250,000, the insurer would have to pay the entire loss because it is within the retention limit of $300,000. Likewise, for a loss of $800,000, the insurer would be responsible for the $300,000, while the reinsurer would pay $500,000.

    Excess of loss reinsurance can be purchased on a per-risk basis or a per-occurrence (catastrophe) basis, or a combination of both. Stop-loss reinsurance or aggregate stop-loss reinsurance provides reinsurance for losses incurred during the reinsurance contract term (usually one year) in excess of either a specified loss ratio or a predetermined dollar amount.

5. Retrocession
Retrocession is the reinsurance bought by reinsurers to protect their financial stability - to cover their own risk exposure or to increase their capacity. Here, the ceding reinsurer is referred to as retrocedent and the reinsurer that assumes the risk in retrocession is called the retrocessionaire.

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The term "reinsurance" is complex technical jargon for most of us. However, just as we need insurance, insurance companies require insurance as well. Basically, reinsurance provides stability, financing, capacity and protection against catastrophic events.