Reinsurance is a means by which an insurance company can protect itself with other insurance companies against the risk of losses. Individuals and corporations obtain insurance policies to provide protection for various risks (hurricanes, earthquakes, lawsuits, collisions, sickness and death, etc.). Reinsurers, in turn, provide insurance to insurance companies. The company requesting the cover is called the cedant and the reinsurer can be called the ceded, although the latter term is not in common use.
Functions of Reinsurance
There are many reasons why an insurance company would choose to reinsure as part of its responsibility to manage a portfolio of risks for the benefit of its policyholders and investors.
Risk transfer
The main use of any insurer that might practice reinsurance is to allow the company to assume greater individual risks than its size would otherwise allow, and to protect a company against losses. Reinsurance allows an insurance company to offer higher limits of protection to a policyholder than its own assets would allow. For example, if the principal insurance company can write only $10 million in limits on any given policy, it can reinsure (or cede) the amount of the limits in excess of $10 million.
Reinsurance’s highly refined uses in recent years include applications where reinsurance was used as part of a carefully planned hedge strategy.
Types of reinsurance
Proportional
Proportional reinsurance (the types of which are quota share and surplus reinsurance) involves one or more reinsurers taking a stated percent share of each policy that an insurer produces ("writes"). This means that the reinsurer will receive that stated percentage of each dollar of premiums and will pay that percentage of each dollar of losses. In addition, the reinsurer will allow a "ceding commission" to the insurer to compensate the insurer for the costs of writing and administering the business (agents' commissions, modeling, paperwork, etc.).
The insurer may seek such coverage for several reasons. First, the insurer may not have sufficient capital to prudently retain all of the exposure that it is capable of producing. For example, it may only be able to offer $1 million in coverage, but by purchasing proportional reinsurance it might double or triple that limit. Premiums and losses are then shared on a pro rata basis. For example, an insurance company 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) 3/4 of all premiums and losses.
The other form of proportional reinsurance is surplus share or surplus of line treaty. In this case, a retained “line” is defined as the ceding company's retention - say $100,000. 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 underwriting capacity of the cedant would be $ 1,000,000 in this example. Surplus treaties are also known as variable quota shares.
Non-proportional
Non-proportional reinsurance only responds if the loss suffered by the insurer exceeds a certain amount, which is called the "retention" or "priority." 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 they purchase a layer of reinsurance of $4 million in excess of $1 million. If a loss of $3 million occurs,then insurer will retain 1 Million and will recover $2 million from its reinsurer(s). In this example, the reinsured will retain any loss exceeding $5 million unless they have purchased a further excess layer (second layer) of say $10 million excess of $5 million.
The main forms of non-proportional reinsurance are excess of loss and stop loss.
Excess of loss reinsurance can have three forms - "Per Risk XL" (Working XL), "Per Occurrence or Per Event XL" (Catastrophe or Cat XL), and "Aggregate XL". In per risk, the cedant’s insurance policy limits are greater than the reinsurance retention. For example, an insurance company might insure commercial property risks with policy limits up to $10 million, and then buy per risk reinsurance of $5 million in excess of $5 million. In this case a loss of $6 million on that policy will result in the recovery of $1 million from the reinsurer.
In catastrophe excess of loss, the cedant’s per risk retention is usually less than the cat reinsurance retention (this is not important as these contracts usually contain a 2 risk warranty i.e. they are designed to protect the reinsured against catastrophic events that involve more than 1 policy). For example, an insurance company issues homeowner's policies with 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 policy losses in one event (i.e., hurricane, earthquake, flood, etc.).
Aggregate XL affords a frequency protection to the reinsured. For instance if the company retains $1 million net any one vessel, the cover $10 million in the aggregate excess $5 million in the aggregate would equate to 10 total losses in excess of 5 total losses (or more partial losses). Aggregate covers can also be linked to the cedant's gross premium income during a 12 month period, with limit and deductible expressed as percentages and amounts. Such covers are then known as "Stop Loss" or annual aggregate XL.
Functions of Reinsurance
There are many reasons why an insurance company would choose to reinsure as part of its responsibility to manage a portfolio of risks for the benefit of its policyholders and investors.
Risk transfer
The main use of any insurer that might practice reinsurance is to allow the company to assume greater individual risks than its size would otherwise allow, and to protect a company against losses. Reinsurance allows an insurance company to offer higher limits of protection to a policyholder than its own assets would allow. For example, if the principal insurance company can write only $10 million in limits on any given policy, it can reinsure (or cede) the amount of the limits in excess of $10 million.
Reinsurance’s highly refined uses in recent years include applications where reinsurance was used as part of a carefully planned hedge strategy.
Types of reinsurance
Proportional
Proportional reinsurance (the types of which are quota share and surplus reinsurance) involves one or more reinsurers taking a stated percent share of each policy that an insurer produces ("writes"). This means that the reinsurer will receive that stated percentage of each dollar of premiums and will pay that percentage of each dollar of losses. In addition, the reinsurer will allow a "ceding commission" to the insurer to compensate the insurer for the costs of writing and administering the business (agents' commissions, modeling, paperwork, etc.).
The insurer may seek such coverage for several reasons. First, the insurer may not have sufficient capital to prudently retain all of the exposure that it is capable of producing. For example, it may only be able to offer $1 million in coverage, but by purchasing proportional reinsurance it might double or triple that limit. Premiums and losses are then shared on a pro rata basis. For example, an insurance company 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) 3/4 of all premiums and losses.
The other form of proportional reinsurance is surplus share or surplus of line treaty. In this case, a retained “line” is defined as the ceding company's retention - say $100,000. 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 underwriting capacity of the cedant would be $ 1,000,000 in this example. Surplus treaties are also known as variable quota shares.
Non-proportional
Non-proportional reinsurance only responds if the loss suffered by the insurer exceeds a certain amount, which is called the "retention" or "priority." 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 they purchase a layer of reinsurance of $4 million in excess of $1 million. If a loss of $3 million occurs,then insurer will retain 1 Million and will recover $2 million from its reinsurer(s). In this example, the reinsured will retain any loss exceeding $5 million unless they have purchased a further excess layer (second layer) of say $10 million excess of $5 million.
The main forms of non-proportional reinsurance are excess of loss and stop loss.
Excess of loss reinsurance can have three forms - "Per Risk XL" (Working XL), "Per Occurrence or Per Event XL" (Catastrophe or Cat XL), and "Aggregate XL". In per risk, the cedant’s insurance policy limits are greater than the reinsurance retention. For example, an insurance company might insure commercial property risks with policy limits up to $10 million, and then buy per risk reinsurance of $5 million in excess of $5 million. In this case a loss of $6 million on that policy will result in the recovery of $1 million from the reinsurer.
In catastrophe excess of loss, the cedant’s per risk retention is usually less than the cat reinsurance retention (this is not important as these contracts usually contain a 2 risk warranty i.e. they are designed to protect the reinsured against catastrophic events that involve more than 1 policy). For example, an insurance company issues homeowner's policies with 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 policy losses in one event (i.e., hurricane, earthquake, flood, etc.).
Aggregate XL affords a frequency protection to the reinsured. For instance if the company retains $1 million net any one vessel, the cover $10 million in the aggregate excess $5 million in the aggregate would equate to 10 total losses in excess of 5 total losses (or more partial losses). Aggregate covers can also be linked to the cedant's gross premium income during a 12 month period, with limit and deductible expressed as percentages and amounts. Such covers are then known as "Stop Loss" or annual aggregate XL.
