Chapter-1 Principles of Reinsurance

Certificate in Reinsurance

Page 1 of 20
 Confidentiality statement

This document should not be carried outside the physical and virtual boundaries of TCS and its
client work locations. The sharing of this document with any person other than TCS associate
would tantamount to violation of confidentiality agreement signed by you while joining TCS.

Notice
The information given in this course material is merely for reference. Certain third party
terminologies or matter that may be appearing in the course are used only for contextual
identification and explanation, without an intention to infringe.
Certificate in Reinsurance TCS Business Domain Academy

Contents
Chapter – 1 Principles of Reinsurance .............................................................................4
1.1 Reinsurance - Overview........................................................................................ 5
1.2 Fundamental Terminologies of Reinsurance .......................................................8
1.3 Functions, Need and Benefits of Reinsurance ................................................... 10
1.4 Types, Players and Pricing of Reinsurance ........................................................ 14

Page 3 of 20
Certificate in Reinsurance TCS Business Domain Academy

Chapter – 1 Principles of Reinsurance

Introduction
Insurance is a part of financial system as an important risk mitigation tool. Insurance firms
carry high amounts of risks, which they may not be able to withstand alone. Hence, they
transfer some amount of risk to another firm. This prevents collapse of an insurance firm
and its claimants due to disproportionate amount of risk in its portfolio. This chapter gives
an overview of reinsurance, and the principles involved in the business.

Learning Objective
After reading this chapter you will know:
• What reinsurance is and its terminologies
• Functions of reinsurance
• The need for reinsurance and its benefits thereof

Page 4 of 20
Certificate in Reinsurance TCS Business Domain Academy

1.1 Reinsurance - Overview

The only thing certain in life is that future is uncertain! From times immemorial humans and
their businesses have strived to protect against this kind of uncertainty. While individuals
have adopted measures such as insurance to shield against and transfer risk, businesses
have attempted to take on other structures. Reinsurance is one of the key risk management
techniques adopted by the insurance industry.

Direct insurance can be traced back to marine commerce. Though there has been some
evidence of insurance for transport even before Christian era, the oldest seen reinsurance
contract was made in Genoa in the year 1370.

Reinsurance evolved from the growth of insurance for marine and commercial purposes.
With growing trade across the world, need for insurance grew and the risk volume increased
for insurers as well. They began seeking insurance companies who would be willing to
accept a portion of their risk, in the form of “reinsurance”. This was important as insurers of
the times worked without any statistics or probability tables. The only other risk sharing
instrument prevalent during that period was co-insurance. But with the issues inherent to
coinsurance treaties like unfair competitive practices, where underwriting knowledge is to
be shared, reinsurance not only addressed those issues but have spread the risk through
their global presence and developed new reinsurance products through specialization.

Reinsurance concept is essentially the same as insurance except that the person being
offered financial protection is the insurance company rather than the insured.

Insurance spreads risk among members of a population. Similarly, reinsurance levels

the playing field among insurers, offering relief to those that serve a disproportionate
share of high-cost enrollees.

There is something new called as the public reinsurance where the government organizes
and sponsors the reinsurance program which may or may not be subsidized by the
government.

Page 5 of 20
Certificate in Reinsurance TCS Business Domain Academy

Reinsurance is defined as a financial transaction whereby risk is transferred (ceded) from an

insurance company (cedant) to a reinsurance company (reinsurer) in exchange of a payment
(reinsurance premium). The cedant insurer is also called primary insurer or direct insurer.

Reinsurance is generally provided by professional reinsurers who operate exclusively in the

business. However, in several locations insurance companies also function in the capacity of
reinsurers.

Here are some of the definitions in order to gain an understanding as to what reinsurance
actually is.
• “Reinsurance is the insurance of the risk assumed by the insurer”- German
Commercial Law.
• “Reinsurance is insurance for insurance companies”.
• “Reinsurance is the transfer of part of the hazards or risks that a direct insurer
assumes by way of insurance contract or legal provision on behalf of an insured,
to a second insurance carrier, the reinsurer, who has no direct contractual
relationship with the insured” – M. Grossmann.
• “Reinsurance is a transaction whereby one insurance company (the reinsurer)
agrees to indemnify, in consideration of a premium, another insurance
company (the ceding or primary company) against all or part of the loss that the
latter sustains under a policy or policies that it has issued”.
• “Reinsurance is a contract of insurance whereby one insurer (called the reinsurer
or assuming company) agrees, for a portion of the premium, to indemnify
another insurer (called the reinsured or ceding company) for losses paid by the
reinsured under insurance policies issued by the reinsured to its policyholders”.
• “Insurance companies themselves seek insurance protection in order to offset
some of the uncertainty they have assumed. This ‘insurance of insurance’ is
known as ‘reinsurance’ ” – Joe Monk.
• “Reinsurance is the insurance of contractual liabilities to pay claims incurred
under contracts of direct insurance or reinsurance” – Guy Carpenter.

Page 6 of 20
Certificate in Reinsurance TCS Business Domain Academy

Historical Milestones of Re-Insurance

• From 1746 to 1864, England imposed a ban on the usage of reinsurance and was
allowed only when the insurers went bankrupt.
• The first reinsurance company was founded in 1842 in Hamburg following a
catastrophic fire accident, and it was called the Cologne Reinsurance Company.
• First retrocession dates back to a treaty concluded in 1854.
• In USA, the first reinsurance company was established in 1890.
• Initially, reinsurance business was confined to facultative transactions.
• In 19th century, with commercial & industrial progress, automatic forms of
reinsurance known as treaties emerged.
• Around World War I, proportional treaties became the main vehicle of reinsurance.
• Invention & technique of excess of loss (XL)-20th century’s most significant
reinsurance development.
• Reinsurance is converging with financial markets. Reinsurance today requires multi-
disciplinary specialists.
• In India, after nationalization of general insurance business in 1971, GIC (General
Insurance Corporation) became the reinsurer and post liberalization GIC is
designated as the National Reinsurer
The type of reinsurance covers granted also grew gradually from single risk (facultative) to
group of risks (treaty). Today there are more than 200 professional reinsurers worldwide.

Did You Know?

Insurance industry witnessed the biggest ever claims of $105 billion in the year 2011 because
of the earthquake in New Zealand and Japan, floods in Thailand and Australia. More than
half of it is borne by the reinsurance industry. It surpassed the previous catastrophic record
of $101 billion in the year 2005. Due to which the catastrophic insurance premiums have
risen by more than 50% across the world.

World’s Largest Reinsurance Companies

Today reinsurance generates a premium of about $200 billion annually across the world. In
terms of gross premiums written by the reinsurance companies for the year 2010, here is
the list of top 10 reinsurance companies. (Premium in $ million)
• Munich Reinsurance Company—31,280
• Swiss Reinsurance Company Limited—24,756

Page 7 of 20
Certificate in Reinsurance TCS Business Domain Academy

• Hannover Rueckversicherung AG—15,147

• Berkshire Hathaway Inc. —14,374
• Lloyd’s—12,977
• SCOR S.E. — 8,872
• Reinsurance Group of America Inc. — 7,201
• Allianz S.E. — 5,736
• PartnerRe Ltd.— 4,881
• Everest Re Group Ltd. —4,201

1.2 Fundamental Terminologies of Reinsurance

• Reinsurance: Reinsurance is a transaction whereby one insurance company (the

“reinsurer”) agrees to indemnify another insurance company (the “ceding” or
“primary” company) against all or part of the loss that the latter sustains under a
policy or policies that it has issued. For this service, the ceding company pays the
reinsurer a premium.
• Reinsurer: An insurer who assumes a part/complete risk underwritten by a primary
insurer to a policy holder.
• Primary Insurer: The insurer who transfers/cedes complete or part of the insurance
risk underwritten to another insurer or a reinsurer. Also called as the ceding
company, cedant or the direct insurer.
• Reinsurance Premium: It is the premium in consideration paid by the primary
insurer to the reinsurer for assuming the primary insurer’s insurance risk.
• Retrocession: It is an agreement between two reinsurers, wherein one reinsurer
(the retrocedent) transfers/cedes complete or part of the reinsurance risk to another
reinsurer ( the retrocessioniare)
• Retrocedent: The reinsurer who transfers/cedes complete or part of the
reinsurance risk to another reinsurer
• Retrocessionaire: The reinsurer who assumes complete or part of the reinsurance
risk accepted by another reinsurer
• Retention: It denotes the amount/percentage of risk retained by the primary
insurer and not transferred/ceded to the reinsurer
• Cession: It denotes the amount/percentage of risk transferred to the reinsurer

Page 8 of 20
Certificate in Reinsurance TCS Business Domain Academy

• Ceding Commission: It is the amount paid by the reinsure to reimburse the primary
insurer’s policy acquisition costs.

Difference between Reinsurance and Coinsurance

There is a lot of difference between reinsurance and coinsurance. Coinsurance is where the
risk is shared among several insurance companies where each insurer will accept apportion
of the risk and there is a direct contractual relationship with the insured for the same. On
the other hand, reinsurance is where the risk is transferred from one insurance company
(cedant) to another (reinsurer). Hence in reinsurance only the legal entities participate.

But in certain special circumstances of reinsurance treaty, with the provision of cut through
clause, reinsurer is liable to the claims in case of primary insurer becoming insolvent.

Figure 1.1: Coinsurance Vs Reinsurance

Page 9 of 20
Certificate in Reinsurance TCS Business Domain Academy

1.3 Functions, Need and Benefits of Reinsurance

A primary insurer buys reinsurance to satisfy some or all of the following needs:
Increase Risk Capacity
• Regulations typically prohibit an Insurer from risking more than 10% of its surplus on
any one risk. With reinsurance, the insurer can increase its large line capacity, i.e. its
ability to insure large individual risks.
• Reinsurance can also help to increase an insurer’s premium capacity, which is usually
limited by regulations
• Through reinsurance, insurer can attain Large Line Capacity, where the insurer can
provide insurance covers that otherwise are beyond its scope in terms of the coverage
amount and coverage limits.
Provide Stability
• Reinsurance is used to smoothen the peaks and valleys of its profits & losses.
• By reinsuring some of its risk, an insurer gains a steady flow of profits which improves its
ability to attract and retain capital.
• Stabilizing the losses can be attained by obtaining reinsurance for three categories,
liability limit for a single loss exposure, liability limit for exposure to a catastrophic
events, liability limit for aggregate amount of exposure.
Provide Catastrophe Protection
• Generic catastrophic perils could range from earthquakes, windstorms and fire, whereas
specific catastrophic perils include industrial accidents, product recalls, airplane crashes
which leads to
• Often a reinsurance arrangement is created specifically for Catastrophe losses, to limit
an Insurer’s maximum potential loss to some fixed and manageable amount.
• The contract will cover multiple losses under multiple policies all caused by a single
event.
Provide Surplus Relief
• Often an Insurer’s ability to grow is limited by statutory requirements dealing with the
accounting of Policy Acquisition Costs (PAC), associated premium income and the
policy holders’ surplus.
• By purchasing reinsurance, the expenses of the insurance company are indirectly
reimbursed by way of ceding commission. Also, the reserve requirements are
proportionately reduced.

Page 10 of 20
Certificate in Reinsurance TCS Business Domain Academy

• Capacity ratio of the insurer increases with the reinsurance, thus enabling the rapid
growing companies to meet the regulatory requirements
Provide Underwriting Expertise
• A small insurer wishing to enter a new & untested category of business could
supplement its own underwriting capabilities with those of a reinsurer with prior
relevant experience.
• A benefit multiplier would be choosing multiple reinsurers with expertise in diverse
areas.
Facilitate Withdrawal from Territory or Line of Business
• Reinsurance can be used to extricate an insurer from a particular geographical territory
or line of business or production source.
• This can be accomplished through portfolio transfer, finite reinsurance or other financial
mechanisms such as bonds.

Need for Reinsurance

• Transfer of Risk: A principal reason is to shift risk, just as any other insured does,
because an insurer’s pool of risks is too concentrated. There may also be economies
of scale in managing risk through reinsurance that may make it attractive to use
reinsurance to consolidate the risks of an affiliated group in one entity, before
subsequently shifting the risk to third parties or managing risk within the group.
• Regulatory Compliance: State insurance rules generally require that an insurance
company maintain surplus, and the States limit the amount of new business the
company can write based on a ratio of net premiums to surplus. Reinsuring some of
the company’s risks can lower the ratio of net premiums to surplus and allow the
company to write more insurance. Thus, reinsurance can serve in effect as a form of
financing for growth in the primary insurance company’s business.
o Solvency II norms of Europe for SCR (Solvency Capital Requirements) and
ALM (Asset Liability Management) by IRDA in India asks insurers to comply
with adequate capital and solvency margins, which is usually a percentage
of risk underwritten; reinsurance is the simplest and flexible solution to
adhere to such norms.
• Protection against Large Unforeseen Losses: A primary insurer can use
reinsurance to reduce exposure to extremely large losses from one source such as a

Page 11 of 20
Certificate in Reinsurance TCS Business Domain Academy

catastrophic event (for example, a hurricane) or a particular environmental hazard

(for example, asbestos). By reinsuring amounts above a certain level, the primary
insurer can smooth loss payments over the year or between years. This can reduce
volatility in the company’s earnings.
o For instance, in the events of catastrophes which create devastating losses
to the economy that triggers huge and large number of claims, reinsurance
saves the insurance company from going bankrupt.
• Business Acquisition Technique for Reinsurer: A reinsurance transaction can also
function as a business acquisition technique for the reinsurer. By reinsuring a block
of business, for example, a reinsurer can enter a new line of business more easily
than by directly writing policies in that line of business. Similarly, a primary insurer
can divest itself of a line of business by reinsuring its entire book of business in that
line.
• Capital Management: The transaction can serve to move capital within a group of
related parties, or to consolidate capital in a central location to maximize its
efficient management. Further, the parties may know more about each other and
about the risks than in the case of unrelated parties, which can reduce the pricing of
the reinsurance.
• Tax Benefits: The related party reinsurance transaction can have U.S. tax benefits
as well as book or financial benefits. In general, premiums ceded for reinsurance are
deductible in determining a company’s Federal income tax. If the transaction
effects a transfer of reserves and reserve assets to the reinsurer, the tax liability for
earnings on those assets generally is shifted to the reinsurer as well. If earnings on
these assets are shifted to a related foreign-owned reinsurer, the earnings generally
are not subject to U.S. income taxation, and could be untaxed (if the related foreign
reinsurer is in a no- or low-tax foreign jurisdiction).
o Reinsurance companies are generally setup in the tax heaven nations to
avoid or minimize taxation, where the insurance companies redirect funds
to such reinsurance companies not only in the name of premiums but in
terms of various consulting and advisory fee.

Benefits of Reinsurance

Reinsurance can be compared to the shock absorbers on a car. They do not make the road
smoother but passengers feel the bumps less because these are absorbed by the device

Page 12 of 20
Certificate in Reinsurance TCS Business Domain Academy

fitted to the car. Similarly, reinsurance does not reduce losses but merely smoothes out the
effect on the insurer.
Continuing the analogy with the car, to ensure that the shock absorbers do not become
worn out and the car cease to function, the road must be repaired. So it is with reinsurance
in that the underlying problem of inadequate rates must be addressed in order to secure the
successful operation of the insurer.
Reinsurance Benefits for the Direct Insurer:
• Reinsurance allows flexibility and realization for the Insurer to increase capacity to
accept risks.
• Reinsurance acts as shock absorber for stabilizing loss ratio
• Reinsurance protects Insurer against accumulation of small risks by a catastrophe.
• Reinsurance reduces the impact of each risk by geographic spread and achieving
homogeneity.
Consequences for the Reinsurer:
• Reinsurer is offered highly exposed risks, Catastrophe risks & other severe or
hazardous business.
• Reinsurer seeks to balance his portfolio by spreading his activities over many
countries (geographical distribution) & throughout all branches of the insurance
business.
• Reinsurer keeps his probability of ruin low through:
o Exposure & accumulation control together with a suitable acceptance & u/w
policy;
o Maintaining long-term client relationships, to achieve compensation in
time;
o Underwriting more balanced portions of the direct insurer’s business;
o Further reinsuring (retro ceding) those risks which exceed his own capacity.

Page 13 of 20
Certificate in Reinsurance TCS Business Domain Academy

1.4 Types, Players and Pricing of Reinsurance

There are different types of reinsurance which are summarized in figure 1.2:

Figure 1.2: Types of Reinsurance

Treaty: Insurer and the reinsurer formulate and execute a reinsurance contract where all the
losses falling under the terms of the treaty will become part of the reinsurance contract.
• Proportional: Involves one or more reinsurers taking a stated percent share of each
policy that an insurer produces
o Quota Share: Reinsurer accepts a stated percentage of each and every risk
within a defined category of business on a pro rata basis.
o Surplus: Reinsurer assumes pro rata responsibility for only that portion of
any risk which exceeds the company’s established retentions.

Page 14 of 20
Certificate in Reinsurance TCS Business Domain Academy

o Auto-Fac: A ceding company reinsures up to a defined limit after cession of

its surplus treaties and it is obligatory for the reinsurer to accept cessions
within the purview of the agreement.
o Pools: An organization of insurers or reinsurers through which particular
types of risks are underwritten with premiums, losses, and expenses shared
in agreed ratios.
• Non-Proportional: Reinsurer only responds if the loss suffered by the insurer
exceeds a certain amount
o Excess of Loss: A form of reinsurance under which recoveries are available
when a given loss exceeds the cedant’s retention defined in the agreement.
o Catastrophe Reinsurance: A form of reinsurance that indemnifies the
ceding company for the accumulation of losses in excess of a stipulated sum
arising from a catastrophic event
o Stop Loss: A form of reinsurance under which the reinsurer pays some or all
of a cedant’s aggregate retained losses in excess of a predetermined dollar
amount or in excess of a percentage of premium.
o Aggregate Stop Loss: It is similar to a stop loss treaty with the difference
that both the limits are expressed as absolute amounts instead of
percentages.
Facultative: In this type, only individual losses which the primary insurer is willing to
reinsure and is accepted by the reinsurer would become part of the reinsurance contract.
• Proportional: Involves one or more reinsurers taking a stated percent share of each
policy that an insurer produces
• Non-proportional: Reinsurer only responds if the loss suffered by the insurer
exceeds a certain amount
Program: A hybrid reinsurance product that combines elements of both Facultative &
Treaty disciplines

Reinsurance Players

There are different types of reinsurance entities active in the reinsurance industry as given
below:
• Professional Reinsurers: Companies specialized only in reinsurance. They can be a
stock company or a mutual company.

Page 15 of 20
Certificate in Reinsurance TCS Business Domain Academy

• Pools, Syndicates and Associations: Two/more insurers may form a Pool under an
agreement whereby its members cede therein a pre-determined proportion of a
particular category of business directly written by them. They also share the total
premiums & claims in the proportion of premium ceded by each. There are two
types of pools:
o Special Purpose: These pools are formed under following circumstances:

When specialized underwriting and claims expertise is not available
with the individual insurers

When reinsurance is provided only to member companies

When reinsurance is provided only to narrowly defined classes of
business
o General Purpose: These pools are formed under following circumstances:

When reinsurance available in the market is not adequate enough

Reinsurance intermediaries forming pools for providing reinsurance
services to their clients
o In India, examples of this system are Indian Market Fire Pool and Hull Pools
• Reinsurance department of Primary Insurers: Insurance companies professional
reinsurance department that assumes reinsurance business.

Other Players in the Reinsurance Industry

As mentioned above, major participants in the reinsurance industry are the different types
of reinsurers, retrocessionaires and the primary insurers. In order to facilitate reinsurance
programs reinsurance brokers play a vital role, while captives, pools and offshore
reinsurance companies supplement the professional reinsurers.
• Reinsurance Brokers: If the reinsurance availability is scarce or reinsurers are
finding it difficult to find clients, reinsurance brokers come into picture. They
provide business for reinsurers by bringing together parties of reinsurance and
negotiating reinsurance terms. They are compensated by the reinsurer. They
also act as the agents of the ceding company.
• Captives: Wherever captive reinsurance is used, primarily risk is underwritten
through a fronting company (conventional general reinsurer) where the parent
pays premiums to fronting company in exchange for cover and also upon an

Page 16 of 20
Certificate in Reinsurance TCS Business Domain Academy

agreement that majority of such risk would be reinsured by the captive

reinsurer.

Figure 1.3 – Captive Reinsurance

Parent is the ultimate owner of the captive reinsurance company. Most of the
times, it is based off-shore to gain tax advantages. Reasons for setting captives are:
o taking advantage of good claims experience,
o earning profits offshore,
o beneficial fiscal/tax allowances etc..,
• Pools: In this case, multiple reinsurance companies form a group/pool to
underwrite a risk, where each reinsurer assumes a specific portion of the
ceded by the pool.
• Off-shore Reinsurance Companies: These are generally set-up in the tax-
free or less tax jurisdictions to gain tax advantages.

Pricing of Reinsurance

The primary determining factor for reinsurance premium is the underlying insurance
premium and would generally be a percentage of that premium. Also the reinsurer will have
to pay the cedant a reinsurance commission, which compensates the cost incurred in
acquiring and administering the business.

Page 17 of 20
Certificate in Reinsurance TCS Business Domain Academy

For proportional reinsurance, sophisticated stochastic models are used in determining the
profit sharing formula. A lot of aspects like cost of capital, business risk, future profits etc..,
are taken into consideration while pricing the reinsurance.
Pricing a non-proportional reinsurance is much complex where experienced actuarial are
used in determining the price of reinsurance. Non-proportional reinsurance contracts will
generally be annual as there will be changes in the market conditions and the economy
which is going to have a direct impact on the reinsurance costs. Some of the predominant
costing methods are
• Burning Cost Evaluation: It takes into consideration past claims and present
conditions and inflation for pricing
• Scenario Modeling : It uses various mathematical models which simulate the claims
utilization to predict probable loss which is above the priority and below the
capacity of the treaty
• Exposure Pricing: It takes into consideration the existing reinsurance portfolio and
empirical probabilities are assigned for above priority claims of each risk reinsured.

Page 18 of 20
Certificate in Reinsurance TCS Business Domain Academy

Summary
• Reinsurance is one of the key risk management techniques adopted by the
insurance industry.
• Reinsurance is insurance for insurance companies
• Functions of reinsurance include – increase risk capacity, provide stability, provide
catastrophe protection, provide surplus relief, provide underwriting expertise,
facilitate withdrawal from a line of business or territory
• Reinsurance is needed due to these reasons – risk transfer, regulatory compliance,
protection against large unforeseen losses, business acquisition method for
reinsurer, capital management and tax benefits
• There are different types of reinsurance mainly categorized as facultative, treaty
and program. Again under these, there are two main sub-categories – proportional
and non-proportional
• Main categories of proportional reinsurance are – quota share, surplus, pools
• Non proportional reinsurance includes excess of loss, catastrophe reinsurance, stop
loss, aggregate stop loss
• The main types of reinsurance players are professional reinsurers, Pools, Syndicates
and Associations, and reinsurance department of primary insurers
• The primary determining factor for reinsurance premium is the underlying
insurance premium and would generally be a percentage of that premium. Also the
reinsurer will have to pay the cedant a reinsurance commission, which compensates
the cost incurred in acquiring and administering the business.

Page 19 of 20
Page 20 of 20