Reinsurance refers to the situations where insurance companies insure against losses they may incur.

Insurance companies have a limited amount of capital, and to protect this capital they will often attempt to cap the net losses that they may incur by purchasing reinsurance.

A number of different types of reinsurance are available. The two main types are proportional reinsurance and non-proportional reinsurance.

Contents

1 Proportional 2 Non-proportional (Excess of Loss) 3 Market 4 Comments

Proportional

Proportional reinsurance (mostly known as quota share reinsurance) is where the reinsurer takes a stated share of each policy the insurer writes and then shares in the premiums and losses in that same proportion. The capital held by the insurer might only allow it to accept a risk with a value of $1 million but purchasing proportional reinsurance might allow it to, for example, double or triple its acceptance limit. Premiums and losses are then shared on a pro-rata basis. For example an insurance might purchase a 50% quota share treaty; in this case they would share half of all premium and losses with the reinsurer. In a 75% quota share, they would share (cede) 3/4th's of all premiums and losses.

The other form of proportional reinsurance is surplus share. In this case, a "line" is defined as a certain limit - say $100,000. In a 9 line surplus share treaty the reinsurer could 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). If they issue a $500,000 policy, they would cede 80% of the premiums and losses on that policy to the reinsurer (1 line to the company, 4 lines to the reinsurer 4/5 = 80%) If they issue the maximum policy limit of $1,000,000 the Reinsurer would then get 90% of the premiums and losses from that policy.

Non-proportional (Excess of Loss)

Non-Proportional Reinsurance (or Excess of Loss) only responds if the loss suffered by the insurer exceeds a certain amount (retention). An example of this form of reinsurance is where the insurer is prepared to accept a loss of $1 million for any loss which may occur and purchases a layer of reinsurance of $4m in excess of $1 million - if a loss of $3 million occurs the insurer pays the $3 million to the insured, and then recovers $2 million from their reinsurer(s). In this example, the insurer will retain for their own account any loss exceeding $5 million unless they have purchased a further excess layer (second layer) of say $5 million excess of $5 million.

Excess of Loss Reinsurance can have two forms - Per Risk or Per Occurrence (Catastrophe or "Cat"). In Per Risk, the insurance policy limits are exposed within the reinsurance limits. For example, an insurance company might insure commerical property risks with policy limits up to $10 million and then buy per risk reinsurance of $5 million in excess of $5 million. In Catastrophe Excess the insurance policy limits must be less than the reinsurance retention. For example, an insurance company issues homeowner's policy limits of up to $500,000 and then buys catastrophe reinsurance of $22,000,000 in excess of $3,000,000. In that case, the insurance company would only recover from reinsurers in the event of multiple losses in one event (i.e hurricane, earthquake, etc.).

Most of the above examples concern reinsurance contracts that cover more than one policy (treaty). However, reinsurance can also be purchased on a per policy basis, in which case it is known as facultative reinsurance.

Market

Many reinsurances are not placed with a single reinsurer but are shared between a number of reinsurers. (for example a $30,000,000 xs of $20,000,000 layer may be shared by 30 reinsurers with a $1,000,000 participation each) The reinsurer who sets the terms (premium and contract conditions) for the reinsurance contract is called the lead reinsurer; the other companies subscribing to the contract are called following reinsurers. (They follow the lead)

About half of all reinsurance is placed by reinsurance brokers , who then place business with reinsurance companies. The other half is with "Direct Writing" Reinsurers who reinsure insurance companies directly.

Comments

Reinsurance companies themselves also purchase reinsurance and this is typically known as retrocession. They purchase this reinsurance from other reinsurance companies, who are then known as "retrocesionnaires." The reinsurance company that purchases the reinsurance is know as the "retrocedent." This process can sometimes continues on and on, until the original reinsurance company unknowingly gets some of its own business back. This is known as a "spiral" and is common in specialty lines of business such as marine and aviation.

It is important to note that the insurance company is obligated to indemnify their policyholder for the loss under the insurance policy whether or not the reinsurer actually reimburses the Insurer. Many insurance companies have gotten into trouble by purchasing reinsurance from reinsurance companies that did not pay their share of the loss. In a 50% quota share the insurance company could then be left with half the premium and the entire loss! This is a genuine concern when purchasing reinsurance from a reinsurer that is not domiciled in the same country as the insurer. Many reinsurance companies in Australia and the UK did indeed go out of business in the late 90's and did not pay their losses. Remember that losses come after premium, and for certain lines of casualty business (asbestos or pollution) the losses can come many many years later.