“Insurance for Insurance Companies”

What is Reinsurance?
• Reinsurance is a form of insurance. A reinsurance contract is legally an insurance contract. • The reinsurer agrees to indemnify the cedant insurer for a specified share of specified types of insurance claims paid by the cedant for a single insurance policy or for a specified set of policies. • The terminology used is that the reinsurer assumes the liability ceded on the subject policies. • The cession, or share of claims to be paid by the reinsurer, may be defined on a proportional share basis (a specified percentage of each claim) or on an excess basis (the part of each claim, or aggregation of claims, above some specified dollar amount).

• A reinsurer may also reduce its assumed reinsurance risk by purchasing reinsurance coverage from other reinsurers, both domestic and international; such a cession is called a retrocession.

Types of Reinsurance companies
• Direct writers,which have their own employed account executives who produce business, and • Broker companies or brokers, which receive business through reinsurance intermediaries. • Some direct writers do receive a part of their business through brokers, and likewise, some broker reinsurers assume some business directly from the ceding companies.

Types of Reinsurance
• There are two types of reinsurance
– Facultative – Treaty

• Each type of reinsurance can be structured in one of two ways
– Excess of Loss (i.e., limit and retention) – Pro Rata

• Treaty excess of loss reinsurance can apply on one of the three basis:
– Per Risk – Per Occurrence – Aggregate

Forms of Facultative reinsurance
• Facultative Certificates – Proportional basis- the reinsurer reimburses a fixed percentage of each claim on the subject policy. – Excess basis- the reinsurer reimburses a share (up to some specified dollar limit) of the part of each claim on the subject policy that lies above some fixed dollar attachment point (net retention). Facultative Automatic Agreements or Programs – It may be thought of as a collection of facultative certificates underwritten simultaneously. – cover on either a proportional or excess basis. – usually written to cover new or special programs marketed by the cedant, and the reinsurer may work closely with the cedant to design the primary underwriting and pricing guidelines. – written on a fixed cost basis, without the retrospective premium adjustments or variable ceding commissions sometimes used for treaties

Facultative reinsurance
• Facultative reinsurance applies to an individual risk, i.e., one commercial fire policy or even only one location. Insurer and reinsurer agree to the reinsurance terms on each individual agreement. It is generally used to reinsure:
a) extra-hazardous or unusual risks which might be excluded from treaty reinsurance agreements. b) high valued risks with policy limits exceeding maximum treaty parameters.

• For Property risks, specific information about construction, usage, contents, fire protections and other safety attributes will be assessed by the underwriter. • For Casualty exposures, revenue, coverage type, and claims history are key underwriting considerations. • Both pro rata and excess of loss forms are used. • Facultative premiums are usually based on the ceding company’s exposures, not its premiums. So, $ 25 per car and 2% of the premium.

Treaty reinsurance
• Treaty reinsurance applies to an insurance company’s entire book of business, such as all commercial fire polices, all automobile policies, all workers’ compensation policies, all homeowners policies, or, more generally, any combination of the above. • Certain risks are inevitably excluded to help define the exposure for the treaty underwriter, who must rely on the capabilities of the ceding carrier in determining the worth of any particular risk. • Both pro rata and excess of loss forms are used. • Treaty reinsurance premiums is usually set as a percentage of the ceding companies original premiums.

Pro rata or Proportional Reinsurance
• • • • Insurer shares with the reinsurer all of the premiums and losses in a certain percentage. Two forms of pro rata: Quota Share and Surplus Share. Quota Share Quota share reinsurance is a form of pro rata whereby the ceding company is indemnified for a fixed percent of loss on each risk covered by the treaty contract. All liability and premiums are shared from the first dollar. “Quota” or “definite” share relates to the fixed percentage as stated in the treaty. On premiums ceded, the reinsurer pays the ceding company a commission. The commission to the ceding company is an important factor in quota share reinsurance as it provides a financial benefit to the primary company (illustrated on next page). Also referred to as an “obligatory reinsurance contract,” the quota share treaty requires the primary company to cede and the reinsurer to accept each and every policy underwritten by the reinsured. The treaty will usually include a maximum dollar amount over which the reinsurer is not willing to be committed on any one risk.

• Example 1:
– The primary company has a 60% quota share treaty. Therefore, 40% of all premiums and losses will be retained by the company and 60% of all premiums (less commission) and losses will be ceded to the reinsurer subject to the limit of the treaty. The commission to the ceding company is agreed upon at 30%. – Assume a risk is written for a limit of $400,000 at a premium of $2,000. – Premium retained by ceding company:40% of $2,000 = $ 800 Premium paid to reinsurer:60% of $2,000 = $ 1,200 Commission to ceding company:30% of $1,200 = $ 360. – Assume a total loss of $400,000 occurs. For this loss, the ceding company pays $160,000 (40% of $400,000) and the reinsurer pays $240,000 (60% of $400,000).

• Example 2:
– As a financing mechanism, a quota share treaty written on an existing entire book or class of business operates to reduce the ceding company’s unearned premium reserve (by premiums ceded to the reinsurer) and increases ceding company’s surplus (commission on ceded premium paid by reinsurer). The insurer’s assets are reduced by the premium paid to the reinsurer and the insurer’s liabilities (reserves) are reduced by the change in unearned premium reserve. The decrease in liabilities is greater than the decrease in assets by the amount of the commission received. The net result is an increase in the insurer’s surplus by the amount of the commission.

Surplus Share
• Under a surplus share type of treaty, the pro rata proportion ceded depends on the size and type of risk. • The ceding company has the right to decide how much it wants to retain on any one risk. This retention is called a “line.” • Any risk that falls within this retention or line is handled totally by the primary company. • Whenever the company insures a risk that is larger than the retention, the amount over the retention is ceded to the surplus share treaty as a multiple of the retention. • All losses between the insurer’s retention on the risk and reinsurer’s participation are pro rated.

– Assume the minimum retention or line is $50,000. The limit of the treaty is then expressed as a multiple of the line. A 9-line surplus treaty would be (9 x $50,000) or $450,000. The total capacity to the insurer is $500,000. – Any risk with a value of $50,000 or less is retained and not ceded to the treaty. For risks greater than $50,000, the insurer determines how many lines it will retain above the $50,000 and how many lines will be ceded up to the $450,000 limit.

• Risk A – A low hazard risk with a limit of $350,000. The insurer may retain 5 lines or $250,000 and cede 2 lines or $100,000 to the treaty.

• Risk B – A moderate hazard risk with a limit of $400,000. The insurer may retain 3 lines or $150,000 and cede 5 lines or $250,000 to the treaty.

• Risk C – A high hazard risk with a limit of $500,000. The insurer may retain 2 lines or $100,000 and cede 8 lines or $400,000 to the treaty.

Excess of Loss Reinsurance
• Reinsurer indemnifies reinsured ( up to a stated limit) once a loss(es) exceeds a pre-determined level ( i.e., the deductible or retention). • Excess of Loss reinsurance is expressed as, for example, $ 400,000 excess $100,000. (If the insurer incurs a $ 500,000 loss, it is responsible for the first $ 100,000 of paid loss, and is reimbursed for the next $ 400,000). • Pricing: Percentage rate applicable to insurer’s original premium ( i.e., “ subject premium”) for policies covered by reinsurance.

Excess of Loss Reinsurance
• Functions: • Per Risk: Capacity for Individual Risks • Catastrophe: Protection against accumulation of loss • Aggregate: Stabilization – i.e., net income protection ( Finance, Catastrophe)

The Functions of Reinsurance
• On a long-term basis, reinsurance cannot be expected to make bad business good. But it does provide the following direct assistance to the cedant. • Financial Results Management • Capacity • Stabilization • Management Advice

Functions: i) Financial Results Management
• An insurance company’s growth may be limited because of unearned premium reserve requirement(s). A company is forced to put all written premium into a UEP reserve account while still paying business ( acquisition) costs, ( agents’ commissions must be paid on written premium). The premium on an annual policy is earned at the rate of 1/12th per month. Because acquisition costs must be paid immediately, there can be a substantial drain on surplus, particularly when premium volume is expanding rapidly. The accounting system used by insurance companies is designed to enhance financial strength, with state insurance regulators monitoring such items as the ratio of written premium to surplus. A general rule of thumb used to be 3 to 1, but now 2 to 1 is more often used. A ratio above 2.5 to 1( varies by Company) could result in a company being viewed as over extended, leading to rating agency action. Pro rata reinsurance enables a company to continue to write polices without draining capital and surplus. It reduces written premium and increases the surplus, by means of a ceding commission recouping pre-paid acquisition expenses.

Functions: ii) Capacity
• The ability to offer significant capacity on any given risk allows an insurance company to compete in the market. Most companies require greater capacity than their own resources can provide. By reinsuring portions of risk, through pro rata and/or excess of loss, a company can compete in the market. • A company writing to a maximum policy limit of, say, $ 10,000,000 could double that capacity by arranging a surplus share reinsurance treaty. Thus, a $ 20,000,000 policy can be written with 50% of $ 10,000,000 ceded to a surplus share reinsurer(s). • Alternatively, a per risk excess of loss contract of $ 10,000,000 excess $ 10,000,000 has similar effect. On a $ 20,000,000 policy, all losses over $ 10,000,000 are paid by the reinsurers for a predetermined premium.

Functions: iii) Stabilization
• Insurance companies generally prefer stable year-to-year underwriting results, rather than wide fluctuations. • Excess of loss reinsurance enables a company to determine the loss it will assume on any one risk, in any one occurrence, or in the aggregate for the entire year. Thus, losses are stopped at a certain level above which reinsurers pay.

Functions: iv) Management Advice
• Another reason may include product expertise held by the reinsurer and not the reinsured.

• General Considerations • difficult and sometimes impossible to get credible loss experience • low claim frequency and high severity nature of many reinsurance coverages, • Lengthy time delays between the occurrence, reporting, and settlement of many covered loss events, • leveraged effect of inflation upon excess claims.

The Cost of Reinsurance to the Cedant
• • • • • The Reinsurer’s Margin Brokerage Fee Lost Investment Income Additional Cedant Expenses Reciprocity

Reinsurance Pricing Method
• • • • • • • • • • • The pricing formula a reinsurance actuary would use depends upon the reinsurer’s pricing philosophy, information availability, and complexity of the coverage. A Flat Rate Reinsurance Pricing Formula RP = PVRELC (1-RCR-RBF)X(1-RIXL)X(1-RTER) Where: RP = reinsurance premium PVRELC = PV of RELC RELC = reinsurer’s estimate of the reinsurance expected loss cost, RL = reinsurance loss RCR = reinsurance ceding commission rate (as a percent of RP) RBF = reinsurance brokerage fee (as a percent of RP) RIXL = reinsurer’s internal expense loading (as a percent of RP net of RCR and RBF) RTER = reinsurer’s target economic return (as a percent of reinsurance pure premium.

• PVRELC = $100,000 (calculated by actuarial analysis and formulas) • RTER = 20% (The reinsurer believes this is appropriate to compensate for the uncertainty and risk level of the coverage.) • RIXL = 10% (The reinsurer’s allocation for this type of business.) • RCR = 25% (specified in the contract) • RBF = 5% (specified in the contract)

Requirements of IRDA on reinsurance
• Every insurance company shall draw a program of reinsurance duly mentioning the name of reinsurer(s) and file with the IRDA at least 45 days before the commencement of each financial year. • A compulsory cession by the insurers carrying on general insurance business at 20 percent. • IRDA requires that reinsurance be ceded to only those reinsurers who enjoy rating of at least BBB (with Standard & Poor) or equivalent rating of any other international rating agency over a period of the past five years.

Indian Scenario
• While GIC's subsidiaries look after general insurance, GIC itself has been the major reinsurer. Currently, all insurance companies have to give 20 per cent of their reinsurance business to GIC. The aim is to ensure that GIC's role as the national reinsurer remains unhindered. However, GIC reinsures the amount further with international companies such as Swissre (Switzerland), Munichre (Germany), and Royale (UK). Reinsurance premiums have seen an exorbitant increase in recent years, following the rise in threat perceptions globally.

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