20 December 2016
13 October 2018
This article was last updated by the author in October 2016.
A brief introduction to reinsurance.
- Overview »
- Typical cover provided »
- Optional extensions »
- Key exclusions »
- Ratings factors »
- Product providers »
An insurer must manage the pool of premiums for each class of insurance to ensure that it is always adequate for any claims to be paid. Each insurer will, therefore, only accept risks up to a certain size (its acceptance limits). For example, for property insurances there is usually a range of acceptance limits for different trades, with higher limits for low risk trades such as office risks and lower limits for higher risk trades such as woodworking.
If an insurer is offered a risk which exceeds its acceptance limits it could just decline to provide a quotation. However, this may mean it is missing out on what is otherwise good business, simply because of its' size. Instead insurers have developed a number of ways of sharing risks with other insurers; the most common being through reinsurance
In relation to individual risks, risk sharing is mainly used for commercial classes of business, such as property, business interruption and liability, although large personal insurance risks (such as country mansions) may also be shared.
When an insurer places part of a risk with a reinsurer, the insured does not usually know that this has happened. There is no contractual relationship between the original insured and the reinsurer. If a claim occurs the insurer must meet the loss in full and will separately seek to recover their share of the loss from the reinsurer.
The purpose of reinsurance is:
- to smooth peaks and troughs in the claims experience and, therefore, the trading results of an insurer
- to protect the portfolio from an accumulation of losses from a single event, such as a storm or a hurricane
- to provide improved customer service by making the placing of large risks much easier
- to provide support for insurers entering new areas of business, whilst an insurer is gaining experience in that particular class of business.
Reinsurance may be arranged on an individual risk basis; an event basis; or on a portfolio of risks, covering catastrophe losses from the operation of prescribed perils, such as a hurricane or earthquake.
There are two methods of reinsurance:
- Facultative.This involves the reinsurance of large or hazardous risks on an individual basis. Its' use is much less common than is treaty reinsurance as it is more cumbersome to arrange. The placing of facultative reinsurance is much like the placing of the primary insurance with an insurer. The direct insurer offers the risk to the reinsurer, who then has the option of accepting or declining the risk, creating uncertainty and sometimes resulting in delays.
Facultative reinsurance tends to be used only where other forms of reinsurance (treaty reinsurance) have been exhausted, where the risk is outside the terms of other reinsurance arrangements or where the risk is unusual or particularly high hazard.
- Treaty.Treaty reinsurance was developed to overcome the difficulties associated with having to place risks individually through facultative reinsurance. Treaty reinsurance is an arrangement where one or more reinsurers agree to automatically accept all reinsurance which falls within predetermined parameters. The reinsurer is obliged to accept all risks which fall under the terms of the treaty.
The treaty wording will specify the class of insurance business involved (for example, property damage), as well as the type and share of risks that will be ceded. An insurer will usually have a number of treaties covering the different types of business underwritten.
The key benefit of treaty reinsurance is that the insurer knows in advance that it can reinsure most of the risks which it wishes to accept from its' own proposers, provided that the risks fall within the treaty arrangements.
Both facultative and treaty reinsurance can be further divided into two broad methods:
- Proportional (shared on the basis of a percentage of the risk);
- Non-proportional (shared on the basis of amounts, usually an amount in excess of the insurer's net retention).
Under proportional reinsurance, the reinsurer accepts a fixed proportion of each risk, in return for the same proportion of the premium (less commission) and in turn pays the same proportion of any losses. The most common types of proportional reinsurance are:
- Quota share treaties. Under a quota share treaty a fixed proportion (for example 60%) of any risk which is defined in the treaty is reinsured. The proportion varies depending on the risk capacity of the insurer. This arrangement may be used particularly where the direct insurer has little experience of certain types of risk.
- Surplus treaties. In this form of treaty, the reinsurers agree to accept the surplus risk above the insurer's own retention, subject to a maximum limit. The proportion to be accepted is usually expressed in 'lines', where a line is the monetary amount of the insurer's retention (for example, £5 million). Unless the sum insured for the individual risks exceeds the retention level, the surplus treaty is not involved. However, where the sum insured exceeds the retention level, any claims are paid in proportion to each insurer's/reinsurer's respective liabilities.
- Facultative-obligatory treaties. This is a form of surplus treaty where the direct insurer is not obliged to share any risks with the reinsurer, whilst the reinsurer must accept any business which the insurer wishes to cede. It is usually used only in relation to very large cases, after all other surplus treaties have been fully used.
Under non-proportional reinsurance, the reinsurer accepts losses in excess of an agreed amount, subject to an upper limit. There is no proportionate sharing of premium and losses. The reinsurer instead calculates a premium based on the loss experience and exposure for which cover is provided. The main types of non-proportional reinsurance are:
- Risk excess of loss. Under this arrangement, the direct insurer pays the first £x of losses (for example, £ 1 million) arising from an event and the reinsurer pays £y in excess of £x (for example, £4million in excess of £1 million). There is often more than one excess of loss treaty and the cover is expressed in layers, each one building on the layer below.
- Catastrophe excess of loss. In addition to protecting individual risks, the insurer must also consider the likelihood and possible effects of catastrophic events, such as hurricanes, that will result in an accumulation of a large number of smaller individual claims on its policies. Catastrophe excess of loss reinsurance is designed to reduce the effects of such infrequent but major losses. The insurers net retention may be as high as £50 - £100 million.
- Excess of loss ratio (stop loss). Thistype of reinsurance is designed to prevent wide fluctuations in the net claims ratio of a particular insurer's account from one financial year to another. The treaty will come into operation when the loss ratio for the specified class of business exceeds an agreed percentage (for, example 90%) and provides protection up to an agreed upper loss ratio (for example 125%). Once the upper limit of the treaty has been reached, the direct insurer is liable for any further losses.
Reinsurance programmes can be quite complex and may combine more than one of the types noted above.
The main extension available is in relation to non-proportional reinsurance, which allows a policy to be brought back to life after being exhausted by claims payments. This is called the reinstatement provision.
The key exclusions will be defined in two ways:
- the reinsurance cover will in the first instance follow that provided by the underlying policy
- the treaty will define the parameters of the risks and cover which are included, which will vary from one treaty to another
For proportional reinsurance, the reinsurance premium with be calculated as a proportion of the underlying insurance premium, which reflects the amount of risk transferred. In addition, the reinsurer will pay the insurance company a proportionate share of the original costs of acquiring the business. This is called a ceding commission. If the reinsurance turns out to be profitable a profit commission may also be paid.
For non-proportional reinsurance, reinsurers use two main methods of rating:
- exposure rating: which is based upon the sums insured exposed to a particular level of coverage
- experience rating; which is based on the estimated or projected loss experience
The main types of reinsurer are:
- Specialist reinsurance companies, that do not transact original (direct) insurance business
- Lloyd's syndicates
- Insurance companies that also act as reinsurers
They accept risks either directly from the insurer (also known as the reinsured) or through a reinsurance broker. The insurer who buys the reinsurance cover is known as the reinsured, cedant or the ceding office.
Reinsurance is an international business; insurers usually spread their risks over a number of reinsurers both at home and abroad. The UK reinsurance market transacts most of its business in the City of London.