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SUSHIL MOHANTY SUBMITTED BY SURESH PATEL (34) SACHIN NANDHA (23) ACADEMIC YEAR 2007-09 SUBMITTED TO S.V. INSTITUTE OF MANAGEMENT, KADI AFFILIATED TO HEMCHANDRACHARYA NORTH GUJARAT UNIVERSITY PATAN
Reinsurance is a means by which an insurance company can protect itself against the risk of losses with other insurance companies. 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. It is a financial management tool. It is always behind the high quality insurance program or a complex commercial risk of any good insurer. Reinsurance industries are maintaining upward surge all round growth, both in the domestic and global fronts in the last few years. The untapped, both in life and non – life insurance, particularly in growing economies like India and china, is the center of attraction to leading players in insurance and reinsurance, thanks to globalizations and liberalizations of financial services particularly in last decades. It is a tool of risk management, mutually support and supplement each other in providing risk mitigation to the individuals and organizations at micro level and to the country. Reinsurance is instrument of risk transfer and risk financing. Reinsurance can be described as contract made between an insurance company(insurer) and a third party (reinsurer) where in the later will protect the former by paying losses sustained by it under the original contract of insurance, unlike primary insurance, the reinsurance mainly deals with catastrophic risk which are not only highly unpredictable but have the potential capacity to cause huge devastation thereby threatening the solvency of the insurance company.
WHY IS OBLIGATORY REINSURANCE NEEDED?
It is not for nothing that the laws of the land prescribe a minimal portion of the insurance business to be compulsorily reinsured with another insurer / reinsurer. The insurance business is inherently and intrinsically risky as the losses are of a probabilistic nature, and when they take place, they do so with a randomly varying frequency. This is more so, in the case of new or small insurers, or where existing insurance companies underwrite new classes of business. In such cases, a certain portion of their insurance risk cover must, in their own interest, be reinsured to ensure that the risks are spread. In India, at least till the market attains maturity, it is essential for compulsory / obligatory cessions to remain in the statute book (or alternatively in subordinate legislationslikesinsurancesregulations). In medium size and mega value risks, it is inevitable that certain cessions are placed on an optional (what we in insurance business parlance refer to as facultative) basis. Facultative reinsurance arrangements always carry a lower rate of reinsurance commission. For example, in the fire businesses an insurer gets 30 per cent reinsurance commission through obligatory cessions, whereas on high-value risks the optional portion fetches anywhere between 17 per cent and 25 per cent depending on market conditions. Thus, the insurer stands to gain substantially on direct cessions. Obligatory cessions apply to all policies across the board. Motor insurance, particularly, in India is a bleeding portfolio. An insurer, therefore, has the advantage of minimising his losses in motor insurance by at least 20 per cent, thanks to the obligatory cessions. For the national reinsurer, the loss in the motor portfolio due to the obligatory cessions is so high, that it often wipes out the profit earned in other classes of business. As mentioned earlier, in the Indian market, which has a combination of new, small and existing insurers underwriting new businesses, the 20 per cent obligatory cessions has always been a matter of comfort. It is a source of reassurance to the insured as well. Therefore, obligatory cessions create an automatic capacity to the extent of the amount ceded, so that the direct insurers do not become vulnerable to the vagaries and whims of the foreign reinsurance market and brokers.
Obligatory cessions ensure that a minimum of 20 per cent (subject to certain quantum restrictions in fire and engineering) premiums are retained within India provided, of course, the reinsurer again does not cede them on proportionate basis. In case of perils like earthquake and terrorism, among others, foreign reinsurers are usually unwilling to provide full cover. This has paved way for market pools to provide the capacity / cover. Market pools are also a form of obligatory cession, normally managed by the national reinsurer. However, it must be conceded that this concept of obligatory cession should be progressively phased out as the market grows and gets integrated with world markets. The concept of obligatory cession may seem restrictive to insurers, who feel that they should be given the freedom to choose their own reinsurer. Even so, regulators must ensure that even if risks were to be reinsured abroad in the absence of obligatory cessions, the premium loss on account of such cessions should be replaced by corresponding 'inward acceptances'. Through this, they achieve:
• • •
good spread of risks geographically and class-wise foreign exchange cost is restored insurers also learn and get experience in the foreign reinsurance business
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 : (1)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. (2) INCOME SMOOTHING Reinsurance can help to make an insurance company’s results more predictable by absorbing larger losses and reducing the amount of capital needed to provide coverage. (3) SURPLUS RELIEF An insurance company's writings are limited by its balance sheet (this test is known as the solvency margin). When that limit is reached, an insurer can either stop writing new business, increase its capital or buy "surplus relief" reinsurance. The latter is usually done on a quota share basis and is an efficient way of not having to turn clients away or raise additional capital. (4 )ARBITRAGE The insurance company may be motivated by arbitrage in purchasing reinsurance coverage at a lower rate than what they charge the insured for the underlying risk. (5) REINSURER’S EXPERTISE The insurance company may want to avail of the expertise of a reinsurer in regard to a specific (specialised) risk or want to avail of their rating ability in odd risks.
(6) CREATING A MANAGEABLE AND PROFITABLE PORTFOLIO OF INSURED RISKS By choosing a particular type of reinsurance method, the insurance company may be able to create a more balanced and homogenous portfolio of insured risks. This would lend greater predictability to the portfolio results on net basis ie after reinsurance an would be reflected in income smoothing. While income smoothing is one of the objectives of reinsurance arrangements, the mechanism is by way of balancing the portfolio. (7) MANAGING THE COST OF CAPITAL FOR AN INSURANCE COMPANY By getting a suitable reinsurance, the insurance company may be able to substitute "capital needed" as per the requirements of the regulator for premium written. It could happen that the writing of insurance business requires x amount of capital with y% of cost of capital and reinsurance cost is less than x*y%. Thus more unpredictable or less frequent the likelihood of an insured loss, more profitable it can be for an insurance company to seek reinsurance.
TYPES OF REINSURANCE
(1) PROPORTIONAL Proportional reinsurance (the types of which are quota share & 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. (2) 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, the insurer pays the $3 million to the insured, and then recovers $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 ofs$5smillion. 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 Even 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 afford 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. (3) RISK ATTACHING BASIS A basis under which reinsurance is provided for claims arising from policies commencing during the period to which the reinsurance relates. The insurer knows there is coverage for the whole policy period when written. All claims from cedant underlying policies incepting during the period of the reinsurance contract are covered even if they occur after the expiration date of the reinsurance contract. Any claims from cedant underlying policies incepting outside the period of the reinsurance contract are not covered even if they occur during the period of the reinsurance contract. (4) LOSS OCCURING BASIS A Reinsurance treaty from under which all claims occurring during the period of the contract, irrespective of when the underlying policies incepted, are covered. Any claims occurring after the contract expiration date are not covered. As opposed to claims-made policy. Insurance coverage is provided for losses occurring in the defined period.
(5) CLAIMS MADE – BASIS A policy which covers all claims reported to an insurer within the policy period irrespective of when they occurred.
Reinsurance can also be purchased on a per policy basis, in which case it is known as facultative reinsurance. Facultative reinsurance can be written on either a quota share or excess of loss basis. Facultative reinsurance is commonly used for large or unusual risks that do not fit within standard reinsurance treaties due to their exclusions. The term of a facultative agreement coincides with the term of the policy. Facultative reinsurance is usually purchased by the insurance underwriter who underwrote the original insurance policy, whereas treaty reinsurance is typically purchased by a senior executive at the insurance company. Reinsurance treaties can either be written on a “continuous” or “term” basis. A continuous contract continues indefinitely, but generally has a “notice” period whereby either party can give its intent to cancel or amend the treaty within 90 days. A term agreement has a built-in expiration date. It is common for insurers and reinsurers to have long term relationships that span many years. There are two important goals of contract wording which we need to keep in mind: 1. A contract should be short, concise and easy to understand; 2. The contract should contain terms and provisions that lend themselves to ready and uniform interpretation; The focus of the contract should imply the utmost good faith principle. This principle assumes that both parties are so knowledgeable on the subject matter to be dealt with and possess such a degree of sophistication as to preclude the necessity for long complex declarations of intent and implementation
Reinsurance companies themselves also purchase reinsurance and this is known as a retrocession. They purchase this reinsurance from other reinsurance companies. The reinsurance company who sells the reinsurance in this scenario are known as “retrocessionaires.” The reinsurance company that purchases the reinsurance is known as the “retrocedent.” It is not unusual for a reinsurer to buy reinsurance protection from other reinsurers. For example, a reinsurer that provides proportional, or pro rata, reinsurance capacity to insurance companies may wish to protect its own exposure to catastrophes by buying excess of loss protection. Another situation would be that a reinsurer which provides excess of loss reinsurance protection may wish to protect itself against an accumulation of losses in different branches of business which may all become affected by the same catastrophe. This may happen when a windstorm causes damage to property, automobiles, boats, aircraft and loss of life, for example. This process can sometimes continue until the original reinsurance company unknowingly gets some of its own business (and therefore its own liabilities) back. This is known as a “spiral” and was common in some specialty lines of business such as marine and aviation. Sophisticated reinsurance companies are aware of this danger and through careful underwriting attempt to avoid it. In the 1980s, the London market was badly affected by the creation of reinsurance spirals. This resulted in the same loss going around the market thereby artificially inflating market loss figures of big claims (such as the Piper Alpha oil rig). The LMX spiral (as it was called) has been stopped by excluding retrocessional business from reinsurance covers protecting direct insurance accounts. It is important to note that the insurance company is obliged to indemnify its policyholder for the loss under the insurance policy whether or not the reinsurer reimburses the insurer. Many insurance companies have experienced difficulties by purchasing reinsurance from companies that did not or could not pay their share of the loss (these unpaid claims are known as uncollectibles). This is particularly important on long-tail lines of business where the claims may arise.
WHAT TO REINSURE?
The question of what to reinsure has to be considered from both the insurer's and reinsurer's perspectives. Reinsurance replaces the risk of an uncertain large payout, with a certain low payout. The insurer must decide how much of that certain payout to accept in return for avoiding the risk of large payouts. That is, the decision to reinsure is a question of how much risk to cede/retain based on financial management of the trade-off between reinsurance cost and the risk of pay out fluctuations. In deciding how much cover to offer, the reinsurer faces the same issues that determine whether an insurer's risk is reinsurable as the insurer faced in the original contract with the individual. Quite simply, if a risk is insurable it is reinsurable. zecision making process arises because, in practice, decisions on insurability are made for non-underwriting reasons — for example, market building and political reasons. Therefore, the reinsurer needs access to the data on which the original insurancesdecisionswassmade. If that data is not available, the reinsurance market can fail to offer reinsurance, not because they risk is intrinsically not reinsurable but because the default decision is to not reinsure. This default is to err on the side of caution.
WAYS TO REINSURE
There are three basic ways in which MIU can be reinsured:
- Pooled reinsurance — MIUs join together in a relationship that links them only through the pool. There is typically some form of standardization across the pool to ensure transparency and avoid one scheme profiting at the expense of another. The more heterogeneous the MIUs the better the pool advantage, and the more regionally dispersed, the lesser risk of fluctuation due to epidemic or natural disaster. Pooling enables better use of reserves. - Reciprocity also enables a better use of reserves, but in this case the MIUs are known to one another and probably have other ties and commonalities. - Subsidies from government or donors — this may sustain the MIU, but may also send inappropriate signals to the key players. The lessons from previous insurance experience indicates that subsidies can worsen or alleviate market failure depending on where into the system they are paid, that there may not be a perfect method to subsidise, and no matter how well run an MIU subsidy may be essential in the long run due to the gap.
As one of the business market research paper has put it “Reinsurance is an international , multi billion dollar industry that is vital to the financial stability of all types of insurance companies.” It is a method of ceding part of the financial risk the direct insurers assume by accepting risk from risk owners, particularly mega risk, mainly against the earthquakes, tsunami, terrisom, etc. However, in terms of magnitude / size, reinsurance is highly complex global business and for example, it accounts for more than 9% of the total premiums generated from property. The whole mechanism of insurance and reinsurance being a dynamic process. The electronic media and internet technology have substantially added to the efficiency and simplification of mechanism of reinsurance operations. The increased use of information and internet technology by the insurance companies have made collecting, compiling, and data warehousing of updated technical data on millions of mega risk faster and also revolutionized the procedural input on underwritings, accounting and claims processing and settlement by both primary insurance and reinsurance. The new type of electronic system specific transactional methodology since put in place has cut short the embarrassing delays in reinsurance acceptance, cessions and adjustment or settlement among the participating companies. Looking to the latest trend and overwhelming success rate of multi benefit life insurance products like ULIPs and pension plans, which combine risk cover with investment components.
GENERAL INSURANCE COMPANY (GIC)
GIC, the sole reinsurance company of our country, by virtue of its experience and exposure in providing reinsurance support and guidance to its erstwhile non life insurance subsidiaries for more than three dacades, has excellent organizational and technical skills in taking care of reinsurance arrangements for the present insurance market of India – life and non – life and has since adequately established itself as the national reinsurance leader. Meanwhile, GIC reinsurance as part its strategy to expand its operation and to make its present felt globally has recently upgraded its representative offices in London and Dubai. Incidentally, the sole national reinsurer of india also has another representative office in Moscow. GIC has developed necessary skills and has qualified manpower to take care of growing needs of the expanding Indian industry. For the financial year 2006-07, through GIC reinsurance recorded an overall underwriting loss of Rs. 75.95 cr,it has achieved a robust growth of more than 156% in its net profit at Rs. 1531 cr,as against rs.598 cr during the corresponding period period in the previous year. GIC ranks 21st among non life insurers with a net worth of $1.4 bn. As per GIC reinsurance chairman,it is positioned as the lead reinsurer in the Afro-Asian region and other emerging economies. during 200607, the premium income for GIC Re went up from Rs. 200 toRs.270 cr. It is learnt that its international reinsurance business amounted to 22% of its total turnover for the year. 3rd Asian Reinsurers’ Summit was organised by GIC of India, in February 2003 at Mumbai. Eleven reinsurers from Japan, China, Hong Kong, Singapore, Taiwan, Korea, Indonesia, Malaysia, Singapore, Philippines and India participated in the summit with the aim of reinforcing of strengths for mutual development, undertaking joint research, data sharing & information management and furthering business co-operation
CHALLENGES FOR REINSURANCE MARKET
Prior to nationalization in 1973, the reinsurance market in India had a much diluted presence in the industry. The foreign companies operating in India were managing their risk portfolio with their parent companies overseas. To safeguard the identified and limited risk of insurance companies, local companies created India Insurance Pool. The developments after nationalizations insurance industry created a new body with the merger of India Reinsurance and Indian Guarantee for its reinsurance business to support the technology and engineering mega projects. Some of the major issues in accounting have been undertaken considering the recent developments in the business. The return from foreign companies are to be incorporated when received upto 31st march and returns from indian companies and state insurance funds received as of different dates are accepted upto the date of finalization of accounts. Arising out of the occurrence of disastrous like terrorist attack on world trade center etc. which brought about unprecendented loss of life and property and thereby unbearable liability and operational crisis onto the reinsurance industry world over. There is a wide difference between the rates required by the international reinsurers and those charged by the domestic insurers leading to the price affordability as an issue. Where there are tarrifs, like a case of India, the customers cushioned from the rate of increase in the international market. Such impositions are required to be self – absorbed. The Indian market is in absence of the competitive environment of the international reinsurers at the local level, and has depended mainly on the domestic market understanding and basing probability of business ceded rather than on underwriting and risk information criteria. A regular interaction for regional co-operation has to be developed to set up a framework of the areas of co-operation and the mechanism, with this India has to compete with the global reinsurance giants. However, the tightening of reinsurance premium in India has been attributed to the low volumes. As market become global, country regulators face challenges in policy formulation for creating a market that develops and keeps confidence of the industry and for keeping international trade regulation intact.
WHAT INDIA NEED TO DO?
The opening up of the market as a whole and insurance sector in specific has created a potential for the Indian companies also to pool up bigger fund to support the capital intensive sectors. The market has to ensure that the domestic companies increase their own capacities and introduce more strict guidelines as first – hand risk carriers. Insurance companies have to establish the business relations with their reinsurer to prevent them from worldwide reinsurance cycle that affects on capacity and stability. Worldwide the reinsurers are becoming strict on technical results of the insurance, therefore a disciplinary watch is required on insurance business as it is the base of reinsurance. The above problems or difficulties are not very new for a sector that is the transition. Since, some of the products are losing the importance (like proportional treaty), it is necessary to have sufficient premium income to maintain the balance and to bear unexpected losses. To have the best rates and terms from reinsures, the risk profile and exposure to catastrophe risk information transfer to reinsurer should be comprehensive and reliable. Due to the market opening through the WTO operation, there is net outflow expected in the premium from the developing countries as they have a low capitalization in most of the insurance companies. This could lead to weaken the objective of the serious efforts for the regional cooperation developments amongst the nations. The efforts towards developing a synergetic approach to model a successful cooperation will require to work on many areas simultaneously rather than organizing efforts only for one direction and loosing others, they are as follow: • • • • • • • Pooling of financial resources Creating Investment opportunities Pooling of technical resources Joint ventures, alliance and partnership Research and developments Pooling of information Developing standard accounting system for business
Arising out of the occurrence of disastrous like Hurricance,terrorist attack on world trade center etc. which brought about unprecendented loss of life and property and thereby unbearable liability and operational crisis onto the reinsurance industry world over. The huge amount of losses incurred, in the aforesaid events, forced the reisurers to hike the rates substantially and also change the terms and conditions of reinsurance arrangements. The law and regulations governing reinsurance operation in some of the advance and developing countries have seen few changes, making them more stringent in reinsurance acceptance and compulsory cessions to the local reinsurance companies. 2005 Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Top 20 Global P & C Reinsurers 2004 Rank Group GPW US Market Share(%) $ mn 1 Munich Re 17400 12 2 Swiss Re 16046 11 3 Berkshire 8039 5 Harthway 5 Lyoyd’s 7953 5 4 Hannover Re 6569 4 6 GE Insurance 4469 3 Solutions 8 Transatlantic 4141 3 Holdings 11 Partner Re 3471 2 10 Xl Capital 3421 2 9 Everest Re 3411 2 7 Converium 3395 2 12 ACE 2960 2 13 SCOR 2060 1 15 Odyssey Re 1954 1 14 White 1933 1 mountains Re 17 Korean Re 1907 1 23 Platinum 1660 1 Underwriters 18 Arch 1657 1 16 AXA Re 1571 1 19 QBE Re 1480 1 Source : Benfield industry Analysis and Research
Reinsurance mean insuring again. It is transfer of insurance risk from one insurer to another. Under reinsurance the original insurer who has insured a risk, insures a part of that risk with another insurer. Reinsurance premium is an income to the reinsurer and an expense to the insurer. Reinsurance is a good method to diversify and distribute risks of an insurer. Reinsurance even provide technical assistance and rating assistance to the original insurers. Reinsurance is also a contract of indemnity. The object of underwriting is to make a reasonable profit, it is equally essential that the business ceded to reinsurers should also give them a margin. For profit, therefore, the overall quality of business accepted by direct insurers should be good. Today, the environment is more like a business than a gentlemen's club. You have more players, more deals, and contracts can vary greatly between reinsurers. Disputes are no longer resolved by a handshake. They are more frequent and more difficult to resolve.
Principal of insurance management, 1 Insurance Theory and Practice, 3
WEBSITES : WWW.IRDA.com WWW.OUTLOOKMONEY.com WWW.INSURANCETRANSLATION.com
Edition, Author – Neelam C. Gulati, chapter 17, Reinsurance, Pg No. 227 to 248 Edition, Author – Nalini Prava Tripathy & Prabir Pal, chapter 9, Reinsurance – Global Environment and Indian challenges, Pg No. 89 - 103
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