What is Reinsurance?
Reinsurance is a transaction “whereby the reinsurer, for a consideration, agrees to indemnify the reinsured company against all or part of the loss the company may sustain under the policy or policies it has issued”. In plain English, reinsurers simply insure the insurance companies for potential losses from policies insurance companies may have issued. Insurance for insurance. You can only reinsure something if and only if it can be insured.
Why Get Reinsurance?
The most obvious reason an insurer would want to purchase reinsurance is the same reason for why the villager wanted to purchase insurance in my previous post. However, there’s more than that when it comes to reinsurance. Reinsurance protects insurance companies against losses of a certain size and accumulated losses. Additionally, with reinsurance, an insurance company can issue policy amounts larger than the amount the insurer is willing to retain for its own account. Reinsurance allows insurance companies to respond to potential demand in the insurance market, and allows insurance companies to comply with state law that limit the amount of risk they are allowed to take. Insurance companies can write policies, and transfer the additional risk from those policies by buying reinsurance.
Reinsurance versus Insurance
Reinsurance is less regulated than insurance. Both are regulated with regards to how solvent/insolvent they are, but it boils down to state by state regulators making sure policyholders don’t get screwed over. Because the policyholders’ interests come first, insurance companies are more tightly regulated. Additionally, rates used by insurers can be easily compared across different insurers. This aids regulators in establishing standards for insurance companies. However, reinsurers tailor contracts/rates to meet individual client’s needs. Reinsurance clients’ situations are different, so each solution is unique—so they are not comparable.
Here are some other ways that reinsurers differ from insurers:
- Reinsurers operate on a larger scale than insurers (reinsurance is international).
- Reinsurers are more involved in transactions regarding substantial blocks of monetary value and risk.
- Reinsurers are somewhat dependent on the insurers that they reinsure (there must be an exchange of complete information to price correctly, and the insurers underwriting business performance drives a profitable book of business for the reinsurer).
Kinds of Reinsurance
There are two kinds of reinsurance:
Proportional (pro rata): The insurance company and reinsurer share premiums and losses. Generally, the insurer is obliged to cede the reinsurer an agreed proportion of policy premiums and liabilities
Excess of loss: The reinsurance company covers the insurer only for losses excess of the loss amounts retained by the insurance company.
Fundamentals of Reinsurance
Similar to the four criteria I listed for insurance, it is said there is a list of criteria for reinsurance.
Mutual Trust: Reinsurers rely heavily on the insurers they are insuring for any information about the risk they will be taking on/reinsuring, and the underwriting of the risk. Also, insurers sometimes use reinsurers as ‘consultants’ to help with structuring of insurance programs, estimating reserves for losses yet to be paid, etc. Both parties (the insurer and reinsurer) must trust each other.
Utmost Good Faith: In short, for the relationship between an insurer and reinsurer to work, there must be full and timely disclosure from one party to another.
Following the Fortunes: If the insurer truly acts in good faith, losses from underwriting that look careless or unlucky will be indemnified within the terms of the reinsurance contract. If an insurer must pay a claim, then the reaction to the statement “you have to pay a claim for reasons x, y, and z” should be the same for the insurer and reinsurer. If one party benefits and one doesn’t, then something is wrong.
Will do my best to answer any questions
Parties of Reinsurance transactions:
Ceding insurer is one that gives up risk (To the reinsurer) Assuming insurer, or reinsurer is one that takes risks (From insurer)
types of reinsurers in the U.S:
non-authorized: for insurers to be able to take credits from reinsurance, a 100% trust fund must be in the U.S. to match all reinsurance amounts assumed. authorized: reinsurance credits can be taken by insurers, and reinsurers do not need to have 100% collateral matching the reinsurance amounts.
Add. notes: Reinsurance must be written for future risks Reinsurance should be done in a timely fashion, and the reinsurer must face risks to lose money. (otherwise it could look like a short-term loan)
Correct
Authorized reinsurers are defined as reinsurers that are licensed, accredited, or approved by the ceding entity's state of domicile. You can guess what unauthorized means. Some people call them 'Admitted Reinsurers' instead of Authorized. But, if you look at any life insurance operating company's statutory filing, their Schedule S Part 4, for example, it will read as 'Reinsurance Ceded from Unauthorized Reinsurers'. Becoming authorized is a state by state thing; you need to be licensed in a certain state to do business there.
Reinsurance is not like a loan.
I agree with your points.
Authorized reinsurer can be from other states that "has substantially similar laws".......since all U.S. and Puerto Rico has NAIC accreditation, it mostly implies that reinsurers authorized in any U.S. states will enjoy the reciprocal authroization from other states.
from what I hear, some companies may attempt to use Reinsurace agreements as a loan. (a reinsurance agreement without timely risk transfers and payoff for ceded reinsurance)
Quota Share treaties (aka pro-rata) are de-facto loans in a sense. The ceding company receives a ceding commission back from the reinsurer from the initial unearned premium that gets ceded away to the reinsurer. On a company's balance sheet, this initial ceding commission is essentially moving dollars away from being a liability and moves it to cash - allowing the company to use the cash as it sees fit. But there is still risk that is transferred. Over the (traditionally) 1 year treaty period, this initial ceding commission will find it's way back to being a liability, so that at the end of the treaty period the "loan" will be paid off.
If that makes any sense.
Would a reinsurance business create a bigger and longer term float than insurance? (judging in the sums received and the frequency of paying back)
Hedge funds have sought out reinsurance as a great alternative investment which creates massive float.
Scary to consider though with th recent prominence of natural and 'catastrophic losses'. Imagine a HF insuring a portion of considerably risky coverage.
Create a natural disaster right after a stock market collapse or market downturn and you're looking at systemic destruction of insurance/banking. This is assuming HFs actually become a major player in reinsurance over the next decade but still.
Also you should provide some info on ILA (insurance linked securities) such as cat-bonds.
Not really sure what you mean by the recent prominence of natural and catastrophic losses. 2014 cat losses were 35%-40% below the 10 year average globally, and are on the same track so far this year. And were similar for 2013 as well.
Hedge funds ARE becoming major players in reinsurance, especially in the property catastrophe spaces, as you mention. Nephila, Aeolus, Elementum are some of the larger ones that I know of. Credit Suisse and a few other European ones are beginning to get their feet wet as well.
From the insurance company's view, There really isn't any more risk placing your business with a HF than there is with a traditional reinsurer, and in some cases, there may be less risk. There are generally 2 options for the HF reinsurer - either place the limit they are on risk for in a trust fund, or front through a (generally A+ rated) reinsurer. In the 2nd option, the risk legally resides with the fronting party and they are on risk for any liaiblity from the hedge fund. If the HF decides to use a trust, 100% of the money is available to pay loses. A traditional reinsurer doesn't have to put the same kind of collateral up, so the insurer has to assume the reinsurer can pay losses. Hence, why ceding companies like better rated reinsurers.
To your last point, while I'm certainly not a banking expert by any means, I doubt that the allocation of 1%-2% of overall funds invested in reinsurance would help or hinder any of the banking industry.
Bump
Anyone still interested in discussing reinsurance, generally? I'm almost halfway through my ARe 144 book (working towards the ARe and CPCU designations) and it seems like folks haven't mentioned the second major form of proportional reinsurance: surplus share (lines as opposed to straight percentage like in quota).
With surplus share treaties, the ceded portion of the underlying policy is expressed in lines that represent multiples of the primary carrier's retained limit. For example:
Primary carrier retention: $100k Reinsurer takes 9 lines:. $900k Total coverage:. $1mm
Molestiae non in ut recusandae. Debitis consequatur qui autem impedit. Officiis aut consequatur dolorem magnam ut dolores.
Laboriosam ipsa fugit quis facilis magnam. Assumenda nulla nesciunt quo veniam quod.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...