March 12 2009 | Filed Under Casualty Insurance , Health Insurance , Insurance
, Life Insurance , Property Insurance , Warren Buffett
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.
Example:
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.
Copyright 2009 Investopedia.com
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.
Conclusion
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.
by Pooja Dave