Reciprocal Insurance Exchange: Definition, How It Works, Example

Reciprocal Insurance Exchange

Investopedia / Jake Shi

What Is a Reciprocal Insurance Exchange?

Reciprocal insurance exchanges are a form of insurance organization in which individuals and businesses exchange insurance contracts and spread the risks associated with those contracts among themselves. Policyholders of a reciprocal insurance exchange are referred to as subscribers.

Key Takeaways

  • A reciprocal insurance exchange is a type of organization where individuals and businesses exchange insurance contracts.
  • This exchange, which includes two separate entities—an attorney-in-fact (AIF) and reciprocal inter-insurance exchange—is used to lower the risk of insurance contracts.
  • Subscribers use the AIF to exchange policies, who also runs the day-to-day operations of the exchange.
  • The reciprocal insurance exchange is managed by a board of governors, who handles monitoring the AIF and approving rates, among other things.
  • Reciprocal insurance companies can issue both assessable and non-assessable policies.

How a Reciprocal Insurance Exchange Works

A reciprocal insurance exchange is formed by bringing together two separate entities—a reciprocal inter-insurance exchange and an attorney-in-fact (AIF). The reciprocal inter-insurance exchange is used to allow subscribers to exchange policies through the attorney-in-fact, which allows them to spread around risk. Authorized reciprocal insurers are often governed by legislative provisions expressly made separate to domestic reciprocal insurers.

The attorney-in-fact is authorized to perform business transactions on behalf of another entity, which, in this case, is the reciprocal insurance company. The AIF runs the day-to-day operations of the reciprocal and is provided with a power of attorney status by the reciprocal. The AIF may be owned by the reciprocal, referred to as a proprietary reciprocal, or may be contracted from a third party, referred to as a non-proprietary reciprocal.

Some of the largest reciprocal insurance companies include United Services Automobile Association (USAA), State Farm Mutual Automobile Insurance Company, and Nationwide.

Advantages and Disadvantages of Reciprocal Insurance Exchange

Pros of Reciprocal Insurance Exchange

There are many reasons why companies would seek a reciprocal insurance exchange structure. Reciprocal insurance exchanges can and often operate on a nonprofit basis with the goal of giving their policyholders affordable coverage. In comparison to standard insurance choices, premiums may be lower because policyholders share risk and costs.

To assist policyholders in minimizing risks and minimizing losses, the exchange may offer risk management services such as loss control programs, safety training, and risk assessment. In addition, the directness of communication, improved comprehension of the terms, and speedy resolution of any questions or complaints are all made possible by this type of relationship.

In the event that the reciprocal insurance exchange generates a surplus, it may return earnings to policyholders in the form of dividends or premium credits. Because of this potential organization structure, reciprocal insurance exchanges usually place more emphasis on upholding long-term stability and sustainability.

Cons of Reciprocal Insurance Exchange

Reciprocal insurance exchanges frequently target particular industries or professions, so people or organizations outside of those niches might not have access to or use them. There may also be prerequisites or requirements that must be met beforehand; as a result, not everyone may be eligible to join a specific exchange.

Like any traditional insurance entity, reciprocal insurance exchange's financial sustainability and viability are significantly dependent on the combined contributions and premiums from its policyholder members. Plus, it often operates with fewer resources, smaller staffs, or smaller networks. Therefore, reciprocal insurance exchanges often run with stronger financial risk.

In contrast to typical insurance plans, coverage provided by reciprocal insurance exchanges may be difficult to transfer to another insurer. There may be less flexibility if they want to move insurers or change their coverage.

Last, because reciprocal insurance exchanges rely on the concept of risk pooling in which policyholders share risk and monetary obligations, this also means that policyholders indirectly carry the risk of other members' claims. If a small number of policyholders incur large losses or liabilities, it may have an impact on the exchange's general viability and solvency. This may potentially lead to an increase in premiums for all members.

  • May result in policyholders having direct say in more decision-making processes

  • Usually can result in customized coverage

  • May be cost efficient as risk is shared across holders

  • May result in profit sharing

  • May have direct access to underwriters

  • May exclude certain industries as it may not be available to certain sectors

  • Often has membership requirement that must be met

  • Contingent on member contributions for health of entity (like all other forms of insurance)

  • Often lacks portability

  • May indirectly bear the risk of other members' claims

Special Considerations

A board of governors manages a reciprocal insurance company. The board is responsible for choosing and monitoring the attorney-in-fact, approving rates, and providing oversight of the operations of the reciprocal. Surpluses from premiums are held in separate surplus accounts devoted to a specific purpose, though the accounts can be commingled and used to pay claims against the policies.

Reciprocal insurance companies can issue both assessable and non-assessable policies, with the latter being the most common policy issued. A non-assessable policy keeps the policyholder from being charged an additional amount of money if the cost of operating the reciprocal is higher than expected. This means that the financial liabilities of the policyholder are limited to the cost of the policy.

A reciprocal insurance exchange is different than a mutual insurance company, in which individuals and businesses with similar insurance needs, such as doctors, come together to pool risks and obtain better rates.

Example of Reciprocal Insurance Exchange

Reciprocal insurance exchanges got their start in 1881 when six dry-good merchants in New York agreed to indemnify each other because of their shared discontent with insurance companies.

This group's members all had buildings of superior construction and maintained them well, but they were all charged premiums that did not correspond to the potential losses for similar commercial buildings.

At the time, insurance companies applied broad strokes in their classification of risk; modern rate-setting techniques hadn't quite been developed yet. Able to absorb certain losses, the merchants had the incentive and ability to “self-insure” to lower their costs.

What Is the Difference Between a Reciprocal and a Mutual Insurance Exchange?

A reciprocal insurance exchange is owned and governed by its policyholders who are also insured, while a mutual insurance exchange is owned by policyholders who are not necessarily insured. In a reciprocal exchange, the policyholders directly share risk and premiums, whereas in a mutual exchange, the policyholders elect a board of directors to oversee the company's operations.

Who Are Reciprocal Insurance Exchanges Owned By?

Reciprocal insurance exchanges are owned by their policyholders who are also insured.

What Is the Claims Process With Reciprocal Insurance?

Policyholders record claims and give pertinent evidence to the exchange as part of the reciprocal insurance claim process. A claims adjuster evaluates the validity and scope of the claim, examines the coverage, and calculates the loss value. The settlement sum is determined by the reciprocal insurance exchange, which also pays the policyholder the appropriate amount. The procedure comes to an end after the claim is settled, and effective communication between the parties is essential. Exchange-specific procedures may differ, therefore policyholders should consult their insurance instructions for a complete explanation.

The Bottom Line

A mutual insurance company known as a reciprocal insurance exchange allows policyholders to pool their risk and financial obligations. Owners who are also policyholders gain from personalized coverage, low costs, and direct contact with underwriters. The exchange runs on a nonprofit basis with an emphasis on the welfare of its users and long-term stability. It promotes a sense of community among subscribers and provides insurance solutions tailored to specific industries.

Article Sources
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  1. Vermont General Assembly. "Chapter 132: Reciprocal Insurers."

  2. Illinois General Assembly. "215 ILCS 5/123D-10."

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