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Friday, March 18, 2005

Reinsurance

Reinsurance refers to the situations where insurance companies insure against losses they may incur.

Insurance companies have a limited amount of capital, and to protect this capital they will often attempt to cap the net losses that they may incur by purchasing reinsurance.
A number of different types of reinsurance are available. The two main types are proportional reinsurance and non-proportional reinsurance.

Proportional
Proportional reinsurance is where the reinsurer takes a stated share of each policy the insurer writes and then shares in the premiums and losses in that same proportion. The capital held by the insurer might only allow it to accept a risk with a value of $1 million but purchasing proportional reinsurance might allow it to, for example, double or triple its acceptance limit. Premiums and Losses are then shared on a proportional basis.

Non-proportional (Excess of Loss)
Non-proportional reinsurance (or Excess of Loss) only responds if the loss suffered by the insurer exceeds a certain amount (retention). An example of this form of reinsurance is where the insurer is prepared to accept a loss of $1 million for any loss which may occur and purchases a layer of reinsurance of $4m in excess of $1 million - if a loss of $3 million occurs the insurer pays the $3 million to the insured, and then recovers $2 million from their reinsurer(s). In this example, the insurer will retain for their own account any loss exceeding $5 million unless they have purchased a further excess layer (2nd layer)of say $5 million excess of $5 million.

Excess of Loss Reinsurance can have two forms - Per Risk or Per Occurrence ( Catastrophe or "Cat"). In Per Risk, the Insurance policy limits are exposed within the Reinsurance limits. for example, the insurance company might insure commerical property risks with policy limits up to $10 million, and then buy per risk reinsurance of $5 million xs $5 million. In Catastrophe Excess the insurance policy limits must be less than the reinsurance retention. for example, an insurance company issues homeowner's policy limits of up to $500,000 and then buys catastrophe reinsurance of $22,000,000 xs of $3,000,000. In that case, the insurance company would only recover from reinsurers in the event of multiple losses in one event (i.e hurricane, earthquake, etc.).

Most of the above examples concern reinsurance contracts that cover more than one policy (treaty). However, reinsurance can also be purchased on a per policy basis, in which case it is known as facultative reinsurance.

Market
Many reinsurances are not placed with a single reinsurer but are shared between a number of reinsurers. (for example a $30,000,000 xs of $20,000,000 layer may be shared by 30 reinsurers with a $1,000,000 participation each) The reinsurer who sets the terms (premium and contract conditions) for the reinsurance contract is called the lead reinsurer; the other companies subscribing to the contract are called following reinsurers. (They follow the lead)

About half of all reinsurance is placed by reinsurance brokers, who then place business with Reinsurance companies. The other half is with "Direct Writing" Reinsurers who reinsure Insurance companies directly.

Comments
Reinsurance companies themselves also purchase reinsurance and this is typically known as retrocessional cover.

It is important to note that the Insurance Company is obligated to indemnify their policyholder for the loss under the insurance policy whether or not the Reinsurer actually reimburses the Insurer. Many insurance companies have gotten into trouble by purchasing reinsurance from reinsurance companies that did not pay their share of the loss. In a 50% quota share the Insurance Company could then be left with half the premium and the entire loss! This is a genuine concern when purchasing reinsurance from a reinsurer that is not domiciled in the same country as the insurer. Many Reinsurance Companies in Australia and the UK did indeed go out of business in the late 90's and did not pay their losses. Remember that losses come after premium, and for certain lines of casualty business (asbestos or pollution) the losses can come many many years later.

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