Reinsurance is the practice whereby one party called the Reinsurer; for a consideration (premiums); agrees to indemnify another party called the Reinsured, for part of or all of the liability assumed by the latter party under a policy or policies of insurance which it has issued. The fundamental nature is to insure again by transferring to another insurance company or reinsurer all or part of an assumed liability, thus spreading the risk any one company has tocarry.
- Reinsurance entails the Insurance of the risks already assumed by the Insurer.
- It is a means that an insurance company uses to reduce possible material losses from perils
- which it has accepted.
- Reinsurance makes it easier for the Insurance Company to carry material consequences of
- the loss.
- Reinsurance is the insurance of Insurance
- Additional Capacity:- Reinsurer helps the Insurance Company to write more business than his capital and reserveswould allow him to do.
- Protection of Solvency Requirements:- Solvency ratio is expressed as the ratio between the assets (Capital & Free Reserves) and NetPremium Income. (Capital/Premium x100)Legal requirements in most countries require a minimum of 15%.
- Economic Advantage:-Reinsurance commission obtained covers administration expenses of the business cededand forms a revenue item for the Insurance Company.
- Automatic Capacity:-Obligatory treaties provide automatic capacity which is vital for the development of theinsurer’s business.
- Security:-Good securities translate into ability to pay claims. An insurer having top class Reinsurers on their programme commands more confidence in itsfinancial viability than its competitors.
- Global Spread:-Reinsurer helps to achieve a wider geographical spread of risks which helps in recovery ofmajor losses following a single or catastrophic event.
- There are basically two types of reinsurance:
- Facultative Reinsurance
- Treaty Reinsurance (Obligatory or Automatic Reinsurance).
- Proportional Treaties
- Non-Proportional Treaties
Facultative Reinsurance is the oldest and original form of Reinsurance and can be arrangedboth on proportional and non- proportional basis. The method was first used in the 14thCentury.Fundamental features:
- Facultative means optional. i.e. the power to act according to free choice. Both parties to the reinsurance for an individual risk have a choice as to enter into a contract or not.
- The Insurer is free to offer a risk to the Reinsurer but is not compelled to cede the business.
- The Reinsurer is free to accept or reject the business offered in accordance with his own underwriting judgment and other consideration that are important to its financial or marketing position.
- Facultative reinsurance is arranged at the point of risk acceptance by the insurer and cover is for that particular individual risk and applies to one insurance policy.
- Each risk is a separate reinsurance contract and is offered individually with full details provided, to enable the Reinsurer make a decision whether or not to accept the risk,
- The reinsurer is free to state the terms on which he will accept the risk.
Facultative Reinsurance is still in use today in all classes, mainly when:
a. The automatic covers have been used up i.e. large risks where the sum insured exceedsthe treaty capacity.b. The risk is excluded from the obligatory treaties e.g. risks located out of territorial scopeof treaty, excluded by type etc. It thus facilitates reinsurance of risks where no treatyprotection is available.
- To obtain capacity where volume of business is small and does not justify treaty arrangements e.g. when writing new lines of business
- To seek expertise and experience of reinsurers on risks of special nature.
- Where the insurer does not want his treaty contracts to be overburdened with heavy risks because:
a. They are very large,b. They are unusualc. The physical hazards of the risks are abnormally high.d. There are unique commercial, financial and strategic reasons.
- Facultative Reinsurance enables small developing companies with limited capital and expertise to write large risks beyond their capacity using expertise and capacity of large Reinsurers.
- Facultative Risks are considered by underwriters whose judgment and experience can be used to improve the risk and reduce the exposure.
- Facultative reinsurance increases the insurer’s competitive edge within its chosen market.
- Facultative Reinsurance protects the insurer’s treaty reinsurance to ensure better overall results, and lower reinsurance cost in the long run.
- Facultative Reinsurance gives both parties an opportunity to develop a successful and professional relationship. A successful facultative relationship with a reinsurer might be a precursor to the insurer offering it a place on its schedule of treaty reinsurers.
- Facultative Reinsurance helps in creating and maintaining a balanced portfolio (homogeneity through level retentions). The insurer would get rid of large or hazardous risks where a significant loss would result in an overall loss for the treaty.
- Under Facultative Reinsurance, the original underwriter can pick and choose those risks which require protection; allowing them to keep maximum amount of original premiums on other risks.
- Facultative Reinsurance protects the cedant’s other treaties from adverse underwriting results.
- Facultative Reinsurance enables spread of business. Like all forms of reinsurance, facultative reinsurance facilitates the spread of risk over a wider number of underwriters. Risk spreading is a major benefit of reinsurance.
- Reinsurance brokers may make money on facultative reinsurance if they are involved.
- Under Facultative Reinsurance, losses are settled immediately in cash. No quarterly statements are issued.
- For commercial reasons, Facultative Reinsurance allows the insurer to accept risks outside scope of its business in terms of capacity or class excluded by its treaty arrangement.
- Under facultative Reinsurance, both parties have the option of accepting or rejecting the proposal.
- Uncertainty- as risks are considered individually, the original insurer does not know whether he will get facultative support, and this could affect its ability to write the underlying risk.
- Acceptance has to be delayed until reinsurance cover is obtained for the risk in full. This could mean losing business to competitors with larger capacities.
- Delay in issuing a policy can create problems with clients. For example, a reinsurer might insist on survey and certain recommendations from the surveyor’s report being carried out before it commits cover.
- The cedant has to disclose full details of the risk at the time of placement to the competitors, who may pursue the risk directly. In addition the reinsurers approached will gain an insight into the underwriting policies and portfolio of ceding company.
- Facultatives transactions are sometimes arranged under time pressure. This opens up the transactions to potential misunderstandings or failure in communication between parties involved.
- Errors and disputes are inevitable and facultatives are subject to the full rigors of duty of utmost good faith.
- The process of negotiations is repeated at each renewal.
- The right to reject or accept a risk on merit
- Profits are expected by the Reinsurer in the short and the long run.
- There is a lot of administrative work involved; and therefore higher cost of doing business.
- Difficult to administer due to protracted negotiations, wordings, accounts submissions. A contract or certificate is written to confirm each transaction.
- Lower commissions due to the difficulties cited above.
- Due to the problems associated with the facultative method, obligatory or treaty type of reinsurance evolved.
- A treaty is an agreement invariably in writing between a ceding company and one or more reinsurers, whereby the ceding company agrees to cede and the reinsurers agree to accept the reinsurance of all the risks written by the ceding company, which falls within the terms of the treaty agreement.
- Treaty agreements are usually annual contracts, whose terms are negotiated at the beginning of the contract period before the original risks are accepted.
- One contract encompasses all subject risks i.e. a treaty covers many risks, of a certain type or class, or in a geographical scope etc.
- The treaty provides an automatic cover, and the insurer is guaranteed a definite amount of reinsurance protection on every risk which it accepts.
- Unlike facultative reinsurance, the obligatory nature of the treaty requires the insurer to cede and reinsurers to accept the cessions, which falls within the terms of the agreement. That is, the cedant is bound to cede a certain amount of his business, and the Reinsurer is obliged to accept that portion.
- A formal treaty document will describe:-
- The period of the agreement.
- The Monetary limits and mode of operation;
- The classes of business covered, territorial scopes and risks excluded;
- The methods of calculation and payments of premiums and claims;
- The Insurance Company is free in the underwriting of its business i.e. it can select and rate, and also settle its claims as it wishes. The Reinsurer cannot intervene except in the case of grave negligence and/or fraud.
- There is no individual risk scrutiny by the Reinsurer.
- There is obligatory acceptance by the Reinsurer if the business meets the conditions of the contract.
- Treaty contracts lead to long term relationship in which reinsurers’ profitability is accepted, but measured and adjusted over a period of time.
- Cedant gets ceding commission, which supplements his income and can get additional profit commission if business is profitable.
- Administration of treaty business is quicker and easier than for facultative reinsurance.
- Treaties are less costly to operate than the per risk (facultative) covers.
- Treaties help in smoothening of financial results as losses are shared between insurer and reinsurer hence variation of loss experience is smoothened and underwriting results are stabilized. This improves the Insurer’s financial position.
- Under treaty Reinsurance, accounting procedures are simplified by the use of quarterly statements.
- Treaty Reinsurance increases capacity because insurer can take more than what its balance sheet (capital) can sustain.
- Treaty Reinsurance provides catastrophe protection since treaty covers the entire book of business. Insurer is protected if many policies are involved in a single loss occurrence.
- Computer technology can be used for data storage and analysis, since risks are homogenous and many.
- There is no freedom of choice since both parties are tied into the contract.
- A disproportionate amount of premiums may be ceded to reinsurers on small and good risks which an insurer would otherwise wish to retain for own account.
Retention is the net amount that an insurer or the reassured is willing to put at stake for its own account when underwriting a single risk or a group of risks. The term retention is used mostly in proportional treaties.The company’s retention is the maximum amount it is prepared to pay as any loss affecting a policy, risk or group of risks. The difference between the retention amount and the amount of the original acceptance on the risk is reinsured.Per Risk Retention: This is the amount a company is willing to risk for its own account on a single loss from one risk.Per Event Retention: This is the amount a company is willing to risk for its own account in the event of an unexpected catastrophic event.
Setting retention levels is a major aspect in any company’s activities and forms the foundation of a reinsurance programme. Often, the decision is taken at the highest level.The principal purpose of a retention policy is to help the insurance company’s management achieve stability in the development of the company.
Fixing retention is not a precise science. It is often a compromise between:-
- Rule of thumb guides,
- Tried and tested market practice and
- Dynamic financial analysis of the insurance company involving capital modeling.
- To maximize on the retained premium income;
- To minimize retained exposure;
- A compromise between (i) & (ii).
It is usually the duty of the ceding company to fix his retention considering the following key factors:-
- The relationship between the retention and the paid up capital and free reserves of the company.
- The amount of liquid assets (cash in bank, easily realizable bonds, and shares) at the company’s disposal to immediately settle losses for own account.
- The structure of the portfolio with regard to sums insured, or to amounts actually at risks.
- The premium volumes written and needed to absorb fluctuations.
- Size of the Company - Companies fix retentions related to their financial capacities. A small company with low capital may be forced to retain a significant portion of their capital than the large companies, whilst remaining within the legal requirements, and norms of natural prudence and market practice.
- Management attitude - The people factor will come into play, that is aggressive or conservative management;
- Aggressive management would want rapid growth and therefore retain more business, while conservative management may not cherish rapid growth and therefore retain less.
- Territory/location - The territories being considered and the classes themselves will all influence the decision.
- Reinsurer’s attitude & Requirements: - The reinsurer might not want to write the business at the retention level chosen by the insurer.
- The reinsurers may demand that the insurer take enough risk to encourage adequate risk and loss control.
- On a profitable account, the reinsurers may want insurer to retain less for selfish reasons.
All in all, the retentions are expected to be meaningful to both the parties.
- Reinsurance Market Conditions - Soft or hard reinsurance market conditions will both have an impact on the retention decision.
- Soft market means too much reinsurance capacity, and the reinsured is in control. Price of reinsurance is low and consequently the insurance companies will tend to purchase more cover, thus retaining more business.
- Hard market means shortage of reinsurance capacity, and Reinsurers are in control. Price of reinsurance is high and insurance companies will tend to purchase less cover; thus retainingless business.