Chapter 1: Introduction to Reinsurance

Basic Reinsurance Concepts and Terms

• Reinsurance is the transfer of financial consequences of loss exposures from a primary insurer to a reinsurer, often termed insurance for insurers.

• A reinsurance agreement specifies the terms and identifies the policies or categories included in the transfer.

• Primary insurers usually retain a portion of the liability, known as the retention. This can be defined as a percentage or a specific dollar amount of loss.

• The primary insurer pays a reinsurance premium for coverage. In return, the reinsurer may pay a ceding commission to help cover the primary insurer's acquisition expenses, such as producer commissions, premium taxes, and underwriting costs.

• A retrocession is a transaction where a reinsurer (the retrocedent) transfers part of its assumed risk to another reinsurer (the retrocessionaire).

Principal Functions of Reinsurance

• Increase Large-Line Capacity: This allows primary insurers to accept larger risks than regulations or financial constraints normally permit. Regulations typically prohibit an insurer from retaining more than $10\%$ of its policyholders' surplus on any single loss exposure.

• Provide Catastrophe Protection: Reinsurance protects against the financial impact of a single event causing multiple losses, such as windstorms, earthquakes, or industrial explosions.

• Stabilize Loss Experience: By smoothing the peaks and valleys of loss results, reinsurance supports financial planning, attracts capital investment, and maintains the confidence of sales forces.

• Provide Surplus Relief: Growing insurers may face a high capacity ratio because they recognize expenses immediately but revenue gradually. Reinsurance provides relief by allowing the primary insurer to deduct ceding commissions from the surplus, helping them stay within the regulatory key ratio of written premiums to surplus, which is generally capped at $3$ to $1$ ($300\%$).

• Facilitate Withdrawal from a Market Segment: Insurers can exit a class of business or geographic area through portfolio reinsurance, where a reinsurer assumes all liability for outstanding policies. Alternatively, a novation can be used, where a substitute insurer assumes direct obligations to the insured.

• Provide Underwriting Guidance: Reinsurers share technical expertise and industry knowledge with primary insurers, particularly those entering new markets.

Reinsurance Transaction Types

• Treaty Reinsurance: Also called obligatory reinsurance, this uses a single agreement (the treaty) to cover an entire class or portfolio of loss exposures.

• Facultative Reinsurance: Known as nonobligatory reinsurance, this involves separate negotiations for each individual loss exposure. It is often used for high-hazard risks, exposures excluded from treaties, or to provide additional capacity beyond treaty limits.

• Hybrid Agreements: These include facultative treaties, which set terms for future individual placements, and facultative obligatory (or semi-obligatory) treaties, where the primary insurer chooses what to cede and the reinsurer is required to accept.

Reinsurance Market Sources and Trade Associations

• Primary Sources:

  • Professional Reinsurers: These entities may work as direct writing reinsurers or through reinsurance intermediaries who earn brokerage commissions for placing programs.
  • Reinsurance Departments of Primary Insurers: These units are typically kept separate from primary operations to ensure confidentiality of other insurers' data.
  • Reinsurance Pools, Syndicates, and Associations: These groups allow members to share risks and administrative costs. Syndicates, such as Lloyd's, function as a single entity where members accept a percentage of the risk.

• Trade Associations:

  • Intermediaries and Reinsurance Underwriters Association (IRU): Composed of those brokering or assuming non-life treaty reinsurance; publishes the Journal of Reinsurance.
  • Brokers & Reinsurance Markets Association (BRMA): Focused on U.S. treaty business and the author of the Contract Wording Reference Book.
  • Reinsurance Association of America (RAA): A not-for-profit association for domestic U.S. reinsurers that engages in data analysis and lobbying.