Reinsurance is a form of insurance contract which protects insurance firms from risks relating to the policies they underwrite. Reinsurance firms contract with insurers to undertake to cover all or part of the cost of certain policies, in exchange for a cash payment (as with regular insurance) or a percentage of the premiums of the policies reinsured. In addition to protecting against risk, liabilities assumed by the reinsurer no longer count against the primary insurer’s underwriting capacity, enabling the company to underwrite more policies.
Functions Insurers commonly use reinsurance as part of their risk and capital management, transferring a portion of their underwriting risk to reinsurers in exchange for a premium. The structure and extent of a reinsurance programme can vary with an insurer's business strategy, risk appetite and cost of capital, and some insurers may choose to retain all risk.
Risk transfer With reinsurance, the insurer can issue policies with higher limits than would otherwise be allowed, thus being able to take on more risk because some of that risk is now transferred to the re-insurer. See Financial risk management § Insurance.
Income smoothing Reinsurance can make an insurance company's results more predictable by absorbing large losses. This is likely to reduce the amount of capital needed to provide coverage. The risks are spread, with the reinsurer or reinsurers bearing some of the loss incurred by the insurance company. The income smoothing arises because the losses of the cedent are limited. This fosters stability in claim payouts and caps indemnification costs.
Surplus relief Proportional Treaties (or "pro-rata" treaties) provide the cedent with "surplus relief"; surplus relief being the capacity to write more business and/or at larger limits.
Arbitrage The insurance company may be motivated by arbitrage in purchasing reinsurance coverage at a lower rate than they charge the insured for the underlying risk, whatever the class of insurance. In general, the reinsurer may be able to cover the risk at a lower premium than the insurer because:
The reinsurer may have some intrinsic cost advantage due to economies of scale or some other efficiency. Reinsurers may operate under weaker regulation than their clients. This enables them to use less capital to cover any risk, and to make less conservative assumptions when valuing the risk. Reinsurers may operate under a more favourable tax regime than their clients. Reinsurers will often have better access to underwriting expertise and to claims experience data, enabling them to assess the risk more accurately and reduce the need for contingency margins in pricing the risk. Even if the regulatory standards are the same, the reinsurer may be able to hold smaller actuarial reserves than the cedent if it thinks the premiums charged by the cedent are excessively conservative. The reinsurer may have a more diverse portfolio of assets and especially liabilities than the cedent. This may create opportunities for hedging that the cedent could not exploit alone. Depending on the regulations imposed on the reinsurer, this may mean they can hold fewer assets to cover the risk. The reinsurer may have a greater risk appetite than the insurer.
Reinsurer's expertise The insurance company may want to avail itself of the expertise of a reinsurer, or the reinsurer's ability to set an appropriate premium, in regard to a specific (specialised) risk. The reinsurer will also wish to apply this expertise to the underwriting in order to protect their own interests. This is especially the case in Facultative Reinsurance.
Creating a manageable and profitable portfolio of insured risks By choosing a particular type of reinsurance method, the insurance company may be able to create a more balanced and homogeneous portfolio of insured risks. This would make its results more predictable on a net basis (i.e. allowing for the reinsurance). This is usually one of the objectives of reinsurance arrangements for the insurance companies.
Types of reinsurance
Proportional Under proportional reinsurance, one or more reinsurers take a stated percentage share of each policy that an insurer issues ("writes"). The reinsurer will then receive that stated percentage of the premiums and will pay the stated percentage of claims. In addition, the reinsurer will allow a "ceding commission" to the insurer to cover the costs incurred by the ceding insurer (mainly acquisition and administration, as well as the expected profit that the cedent is giving up). The arrangement may be "quota share" or "surplus reinsurance" (also known as surplus of line or variable quota share treaty) or a combination of the two. Under a quota share arrangement, a fixed percentage (say 75%) of each insurance policy is reinsured. Under a surplus share arrangement, the ceding company decides on a "retention limit": say $100,000. The ceding company retains the full amount of each risk, up to a maximum of $100,000 per policy or per risk, and the excess over this retention limit is reinsured. The ceding company may seek a quota share arrangement for several reasons. First, it may not have sufficient capital to prudently retain all of the business that it can sell. For example, it may only be able to offer a total of $100 million in coverage, but by reinsuring 75% of it, it can sell four times as much, and retain some of the profits on the additional business via the ceding commission. The ceding company may seek surplus reinsurance to limit the losses it might incur from a small number of large claims as a result of random fluctuations in experience. In a 9 line surplus treaty the reinsurer would then accept up to $900,000 (9 lines). So if the insurance company issues a policy for $100,000, they would keep all of the premiums and losses from that policy. If they issue a $200,000 policy, they would give (cede) half of the premiums and losses to the reinsurer (1 line each). The maximum automatic underwriting capacity of the cedent would be $1,000,000 in this example. Any policy larger than this would require facultative reinsurance.
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