Reinsurance is a very specific sector in the sphere of insurance. A complex business, it allows insurers to cover their risks by ceding them to a reinsurer. In this context, the reinsurer is obliged to indemnify the "ceding company" in the event of a claim. The principles of reinsurance Reinsurance is a contract under which a company, the reinsurer. agrees to indemnify an insurance company, the ceding company. against all or part of the primary insurance risks underwritten by the ceding company under one or more insurance contracts.
Reinsurance differs from insurance primarily in terms of its inherent complexity, which is linked to its broader range of activities and international nature. Reinsurance can provide a ceding company with several benefits. including a reduction in net liability on individual risks and catastrophe protection from large or multiple losses. Reinsurance also provides ceding companies with the necessary capacity to increase their underwriting capabilities, in terms of both the number and size of risks. Reinsurance does not, however, discharge the ceding company from its liability to policyholders. Reinsurers themselves may feel the need to transfer some of the risks involved to other reinsurers (known as retrocessionnaires).
Reinsurance provides three essential functions:
- it offers the direct insurer greater security for its equity and solvency. as well as stable results when unusual and major events occur, by covering the direct insurer above certain ceilings or against accumulated individual commitments;
- it allows insurers to increase their available capacity - i.e. the maximum amount they can insure for a given loss or category of losses, by enabling them to underwrite policies covering a larger number of risks, or larger risks, without excessively raising their administrative costs and their need to cover their solvency margin and, therefore, their shareholders' equity;
- it makes substantial liquid assets available to insurers in the event of exceptional losses.
In addition, reinsurers also provide advisory services to ceding companies by:
- defining their reinsurance needs and devising the most effective reinsurance program to better plan their capital needs and solvency margin;
- supplying a wide array of support services, specifically in terms of technical training, organisation, accounting and information technology;
- providing expertise in certain highly specialised areas such as the analysis of complex risks and risk pricing;
- enabling ceding companies to build up their business even if they are temporarily under-capitalised, particularly in order to launch new products requiring heavy investment.
Types of reinsurance 1. Treaty and Facultative
The two basic types of reinsurance arrangements are Treaty and Facultative reinsurance.
In Treaty reinsuranc e, the ceding company has a contractual obligation to cede, and the reinsurer to accept, a specified portion of a type or category of risks insured by the ceding company. Reinsurers producing treaties, such as the SCOR group, do not separately evaluate each of the individual risks assumed under the treaty. Rather, after reviewing the ceding company’s underwriting practices, they base their decision on the coverage decisions made originally by the the ceding company's policy writers.
Such dependence subjects reinsurers in general, including SCOR, to the possibility that the ceding companies have not adequately evaluated the risks to be reinsured and, therefore, that the premiums ceded in connection therewith may not adequately compensate the reinsurer for the risk assumed. Therefore the reinsurer’s evaluation of the ceding company’s risk management and underwriting practices, as well as its claims settlement practices and procedures, will usually impact the pricing of the treaty.
In Facultative reinsurance. the ceding company cedes and the reinsurer assumes all or part of the risk covered by a single specific insurance policy. Facultative reinsurance is negotiated separately for each insurance contract reinsured. Facultative reinsurance is normally purchased by ceding companies for individual risks not covered by their reinsurance treaties, for amounts in excess of the monetary limits of their reinsurance treaties and for unusual
risks. Underwriting expenses and, in particular, personnel costs, are higher than premiums written on facultative business, because each risk is individually underwritten and administered. The ability to separately evaluate each risk reinsured, however, means that the underwriter is more likely to price the contract to accurately reflect the risks involved.
2. Proportional and Non-Proportional reinsurance
Both Treaty and Facultative reinsurance can be underwritten on a proportional (or quota share) basis, a non-proportional (excess of loss) basis or on a stop-loss basis.
With respect to Proportional or quota share reinsurance, the reinsurer, in return for a predetermined portion or share of the insurance premium charged by the ceding company, indemnifies the ceding company against the same predetermined portion or share of the losses of the ceding company under the covered insurance contract or contracts. In the case of reinsurance written on a non-proportional, excess of loss or excess of stop-loss basis, the reinsurer indemnifies the ceding company against all or a specified portion of losses, on a claim by claim basis or with respect to a specific event or line of business, in excess of a specified amount, known as the ceding company’s retention or reinsurer’s attachment point, and up to a negotiated reinsurance treaty limit.
Although the losses under a quota share reinsurance treaty are greater in number than under an excess of loss contract, it is generally simpler to predict these losses on a quota share basis and the terms and conditions of the contract can be drafted to limit the total coverage offered under the contract. A quota share reinsurance treaty does not, therefore, necessarily require that a reinsurance company assume greater risk exposure than on an excess of loss contract. In addition, the predictability of the loss experience may better enable underwriters and actuaries to price such business accurately in light of the risk assumed, thereby reducing the volatility of results.
Excess of loss reinsurance is often written in layers. One or a group of reinsurers accepts the risk just above the ceding company’s retention up to a specified amount, at which point another reinsurer or a group of reinsurers accepts the excess liability up to a higher specified amount or such liability reverts to the ceding company. The reinsurer taking on the risk just above the ceding company’s retention layer is said to write working layer or low layer excess of loss reinsurance. A loss that reaches just beyond the ceding company’s retention will create a loss for the lower layer reinsurer, but not for the reinsurers on the higher layers. Loss activity in lower layer reinsurance tends to be more predictable than that in higher layers due to a greater historical frequency, and therefore, like quota share reinsurance, enables underwriters and actuaries to more accurately price the underlying risks involved.
Premiums payable by the ceding company to a reinsurer for excess of loss reinsurance are not directly proportional to the premiums that the ceding company receives, because the reinsurer does not assume a directly proportionate risk. By contrast, premiums paid by the ceding company to the reinsurer under a quota share contract are strictly proportional to the premiums received by the ceding company, and correspond to its share of the risk coverage. In addition, in a quota share reinsurance treaty, the reinsurer generally pays the ceding company a ceding commission. The ceding commission is usually based on the cost for the ceding company of acquiring the business being reinsured (commissions, premium taxes, assessments and miscellaneous administrative expense) and may also include a profit ratio.
Reinsurers typically purchase reinsurance to cover their own risk exposure or to increase their capacity. Reinsurance of a reinsurer’s business is called a retrocession. Reinsurance companies cede risks under retrocession agreements to other reinsurers, known as retrocessionnaires, for reasons similar to those that cause primary insurers to purchase reinsurance: to reduce net liability on individual risks, protect against catastrophic losses and obtain additional underwriting capacity.