The Basics to Reinsurance - RMC Group

Reinsurance is an arrangement where an insurance company transfers some of its risk to another insurance company.  It involves a contract between an insurance company – also called the ceding company or the primary insurer— and a reinsurer, whereby the primary insurer transfers some of the financial exposure associated with issuing insurance policies to the reinsurer. The reinsurance sector plays a valuable role in the overall insurance landscape, giving carriers the opportunity to take on additional business and effectively allocate their risk. As such, it’s vital to understand how this arrangement works.

This article provides more information on reinsurance, outlines the different types of reinsurance, and highlights the benefits for carriers and the insurance market.

What Is Reinsurance?

Reinsurance is a critical tool that primary insurers—those that write insurance policies for their insureds—can utilize to maintain an ideal risk profile and cede a portion of the financial exposures they face arising from the policies they write.  These exposures could be related to a particular type of insurance (e.g., a commercial building or vehicle), an individual policy or several policies. Under a reinsurance agreement, a reinsurer typically agrees to pay a portion of the primary insurer’s losses, as specified by the contract terms. The agreement will generally clearly identify the policy, group of policies or other insurance components receiving reinsurance protection.

It’s important to note that reinsurance usually requires the primary insurer to retain some of the losses incurred under its policies, often expressed as a proportion of the original amount of insurance or a set loss value. Reinsurance does not change the primary insurer’s obligations to its insureds under its policies. Further, when a reinsurer accepts a particularly large risk from a primary insurer, it may seek other reinsurers to share this risk in an arrangement known as a retrocession. Like a policyholder pays a premium for insurance, a primary insurer must pay a premium for reinsurance. Yet, since the primary insurer remains responsible for the expenses related to issuing the underlying policy (or policies), the reinsurer may also pay what is known as a ceding commission to the primary insurer. This commission could include costs such as premium taxes and underwriting expenses.

Reinsurance is generally provided by insurance companies that solely engage in the business of providing reinsurance.  These companies may directly offer their services to primary insurers or leverage reinsurance intermediaries. In addition, some primary insurers may also provide reinsurance services to other insurance companies through dedicated reinsurance departments or collective associations.

Types of Reinsurance

Reinsurance typically falls within one of two categories: treaty or facultative. Under a treaty agreement, the reinsurer takes on a broad group of exposures identified in advance, such as the entirety of the primary insurer’s commercial auto business.

Through this type of reinsurance arrangement, all policies that fall within the coverage terms—including both new and existing policies—will automatically receive reinsurance protection from the effective date of the reinsurance agreement until the agreement is no longer in force. Treaty agreements are often leveraged as the foundation of primary insurers’ reinsurance programs, providing long-term risk protection, and offering the financial certainty needed to develop specific underwriting guidelines.

In contrast, under a facultative agreement, a reinsurer usually agrees to cover a particular risk (e.g., a particularly hazardous property or vehicle listed in a policy issued by the primary insurer) that might not be covered under a treaty agreement.  A facultative reinsurance agreement does not require the reinsurer to accept all exposures of the primary insurer.  A facultative agreement covers a specific time frame and risk and usually cannot be canceled until the risk no longer exists.  Before entering into a facultative reinsurance agreement, a reinsurer will usually impose stricter underwriting standards and want to be confident that both the primary insurer and its policyholder have adequate risk management measures in place. Once the facultative treaty has been signed, the reinsurer will provide a facultative certificate attached to the primary insurer’s underlying policy. Due to the high level of risk associated with facultative agreements, this type of coverage is generally available for fewer exposures and is more expensive than treaty agreements.

Both treaty and facultative reinsurance agreements can be arranged on either a pro-rata or excess-of-loss basis. Through a pro-rata (also called proportional) agreement, the reinsurer and primary insurer share the underlying policyholders’ premiums and losses on a proportional basis. In this type of arrangement, the primary insurer will pay a portion of the original policy premium as its reinsurance premium. The reinsurer may also pay a ceding commission to the primary insurer for expenses incurred by the primary insurer in issuing the ceded policies.  In a pro-rata arrangement, insurance premiums and losses are split between the primary insurer and the reinsurer in accordance with the ratio provided in the agreement.  For example, if a reinsurer takes on 70% of the liability for each policy issued by the primary insurer, the reinsurer is responsible for the same percentage of each loss and entitled to the same share of underlying policyholders’ premiums.

Under an excess-of-loss (also called nonproportional) agreement, the primary insurer retains a set amount of liability under the reinsured policies.  The reinsurer then takes responsibility for losses that exceed that amount, up to a fixed limit. In other words, the reinsurer solely provides coverage for losses that exceed the primary insurer’s retention, known as the attachment point. The reinsurance premium for such an agreement is determined by the likelihood that losses will exceed the attachment point.  Excess-of-loss agreements differ from pro-rata agreements in that premiums are divided between the parties in a nonproportional manner.  In addition, reinsurers usually don’t offer ceding commissions. These agreements could be applied to a single policy, a certain event (e.g., a natural disaster affecting multiple underlying policyholders) or aggregate losses.

How Reinsurance Benefits Carriers and the Insurance Market

Reinsurance can benefit carriers, and—in turn—the overall insurance market in the following ways:

• Reduced liability—Reinsurance provides carriers with a mechanism to spread their risk to other parties. In other words, reinsurers are equipped to accept financial liability that carriers are unwilling or incapable of retaining. As a result, reinsurance permits carriers of all sizes to increase their available coverage limits far more than they could have otherwise, thus enabling them to better meet their policyholders’ needs and promoting greater market competition.
• Expanded capacity and surplus relief—Also called a premium-to-surplus ratio, a carrier’s capacity ratio refers to the amount of risk it can assume, determined by dividing its net written premiums by its surplus (how much the carrier’s assets exceed its liability). Regulators generally monitor carriers’ capacity ratios to ensure they are financially stable and capable of writing additional business; a lower ratio is ideal. However, a carrier’s capacity ratio can be negatively impacted when its written premiums experience rapid growth, forcing it to incur immediate expenses pertaining to the issuance of new policies at a faster rate than its revenue stream. In this case, a carrier would experience a decreased surplus and elevated capacity ratio, making it appear more volatile to regulators and restricting its ability to keep writing business. Fortunately, a reinsurer’s ceding commission can reimburse many of the immediate expenses associated with providing new policies, allowing the carrier to attain a higher surplus and lower capacity ratio amid continued premium growth.
• Stabilized underwriting results—As with any company, carriers aim for a steady flow of revenue to support successful operations. Nonetheless, the unique nature of the insurance landscape can often contribute to substantial fluctuations in profit and loss margins among carriers. After all, carriers have the difficult responsibility of pricing a product that could easily shift in cost over time and be heavily influenced by unanticipated social, economic, and natural forces. By securing reinsurance, carriers can minimize these peaks and valleys and maintain more stabilized underwriting results. Depending on their exposures, carriers could utilize reinsurance to stabilize their loss experience across a designated class, line, or entire book of business.
• Increased catastrophe protection—Catastrophes (e.g., wildfires, hurricanes and floods) have become more frequent and severe in many geographic areas, significantly driving up losses for carriers (especially those that insure policyholders in concentrated locations) and threatening their financial stability. For instance, just one hurricane could lead to millions in losses for a carrier, potentially exceeding its retention and depleting its earnings. To combat these concerns, carriers can purchase reinsurance and transfer their risk for certain catastrophes—whether it’s protection for an individual large-scale loss or for an aggregation of smaller claims from the same event.
• Greater withdrawal capabilities—A carrier may opt to withdraw from a particular coverage market or line of insurance due to a lack of profitability or a shift in its business strategy. This may entail a halt in writing new business and the cancellation of existing policies. Unfortunately, this process can be costly and create tension between carriers, regulators, and insureds. Instead of dealing with this challenging process, a carrier can transfer the remainder of its risk associated with any outstanding policies issued in the coverage segment to a reinsurer via portfolio reinsurance. This coverage essentially allows the reinsurer to indemnify the carrier for future losses incurred from outstanding policies.
• Additional expertise—Reinsurance services often expand beyond the coverage itself. In many cases, reinsurers also offer carriers additional industry expertise on topics such as claims reserving and handling, investments, and overall management. What’s more, reinsurers may even provide carriers with specialized underwriting guidance, giving them the resources and information needed to tap into new coverage segments and enhance their product offerings.

Conclusion

Reinsurance programs are complex and may consist of varying layers and agreements. These programs also require customization based on specific exposures and applicable regulations. In any case, reinsurance can make all the difference in helping insurance carriers spread out their risk, bolster their business, ensure continued growth, and, as a result, provide policyholders with the best possible coverage. Contact us today for further insurance solutions at 239-298-8210 or rmc@rmcgp.com.