What is Reinsurance?
Reinsurance is a tool for the insurance companies to reduce their claim liability by getting some of it insured by another company, thereby preventing insurance companies from insolvency; therefore, the company so insuring the claims is called the ‘Reinsurer’ and the company getting insured is called the ‘Ceding company.’
Reinsurance has a long history with references going back to even 15th-century European laws. Over the years, the mode of reinsuring has evolved, and several alternative instruments have come up, one such being catastrophe bonds, sidecar, ILW, which help insurance companies in transferring the risk of occurrence of a natural catastrophe.
Type of Reinsurance
Reinsurance is mainly an indemnity contract or a reimbursement contract, wherein the reinsurer reimburses the loss actually paid by the ceding company, and such loss should be covered by the reinsurance contract or of any other policy which falls within the scope of such contract.
The following categorization has been published by the federal insurance office, us department of treasury. Let’s discuss types of reinsurance.
#1 – Treaty Reinsurance
This is like umbrella reinsurance wherein the nature of policies to be covered are defined in the reinsurance contract i.e., no specific policy is mentioned, only the qualifying criteria are specified, and all the policies which meet such a criterion become automatically reinsured. This works only when the reinsurer and the ceding are high on the trust factor. There are following two categories within this type:
A – Pro-Rata Reinsurance
This agreement has a predefined ratio of the division of risks and premiums. The Cedant gives this proportion of premium to the Reinsurer and the Reinsurer, in turn, bears the proportional risk. In its simple form, this arrangement is known as a Quota share; however, if the Cedant has to retain a fixed amount of loss occurring due to a claim, and the sharing of risk begins beyond this threshold, then such an arrangement implies a ‘surplus share.’ Therefore the percentage of loss sharing cannot be predetermined and varies as the amount of total loss varies.
B – Excess of Loss Reinsurance
This reinsures the losses above a predetermined level and can be of three kinds.
- Per Occurrence: This protects multiple policies that get affected by the occurrence of a single event.
- Aggregate: This protects for all the losses occurring during a certain time period.
- Per Risk: This protects against individual risk classes.
#2 – Facultative Reinsurance
Here the reinsures insure specific risks or policies instead of ensuring all the policies that fall under a particular specification. In comparison to the treaty agreement, this is costly as every time there is a claim, both the parties undergo a due diligence process to conclude whether or not the claim is covered by the reinsurance agreement.
Purpose of Reinsurance
To draw an analogy, we should think of the reinsurer as the central bank and the ceding companies as commercial banks. The reinsurer determines the actions of the ceding companies related to how much risk they can assume and how much supporting capital they can acquire from the reinsurers. The following are the purpose of reinsurance.
- #1 – Limiting Potential Losses – Generally, insurance claimsInsurance ClaimsAn insurance claim refers to the demand by the policyholder to the insurance provider for compensating losses incurred due to an event covered by the policy. The company either validates or denies the claim based on their assessment and nature of the incurred losses. are unknown, while the premiums that the insurance companies receive are determined at the time of the policy signing. Therefore the claims can exceed what the insurers can amass from investing the premiums, and therefore, they may not be able to satisfy the claims completely. Therefore insurance companies use reinsurance to limit the losses, just like a derivative instrument used for hedging.
- #2 – Meeting Regulatory Requirements – As per the laws and regulations of the Insurance Industry, the insurance companies may be limited by the number of policies they can issue pertaining to a specific risk. This implies that if they cross this threshold, they are not in line with the regulations; therefore, they seek reinsurance, which transfers some of this risk to the reinsurer thereby opening up the room for issuing more policies.
- #3 – Restructuring Balance-Sheet – Like companies create a special purpose vehicleSpecial Purpose VehicleA Special Purpose Vehicle (SPV) is a separate legal entity created by a company for a single, well-defined, and specific lawful purpose. It also serves as the main parent company's bankruptcy-remote and has its own assets and liabilities. to remove some of their liabilities from their balance sheet to strengthen the same, insurance companies transfer some of their liabilities to the reinsurer so that its balance sheet looks better, and it can take up more business.
- #4 – Enter or Exit Risk Domain – At times, the insurance companies prefer to reduce exposures to a certain kind of risk; therefore, they make use of reinsurance to do the same. This leads to a desired risk diversification or concentration.
Regulations under Reinsurance
- In the US, the Regulation of the Reinsurance industry is highly decentralized, whereby the states in which the reinsurance company is located governs the activity of the same by analyzing the balance sheet of the reinsurance company.
- Even if there are multiple subsidiaries located in various states, each state has its autonomy to come up with a report on the health of the reinsurance company. Even if these subsidiaries are located in different states, they are also governed by the states in which they are licensed to act.
- Regulation takes two forms in the US. Direct Regulation impacts those companies which are located or licensed to act in any of the US states; however, at times, insurance companies may seek reinsurance from the companies which are neither located nor licensed in any US state, and therefore, these are not directly but indirectly regulated. These provisions have been taken to prevent excessive reinsuring with mala-fide intent.
Examples of Reinsurance Companies
Following are a few well-known companies in the reinsurance business in the world:
- Munich Reinsurance Company
- Swiss Re Ltd.
- General Insurance Corporation of India
- African Reinsurance Corporation
Reinsurance is a method of risk transfer for the insurance agencies, which helps them in taking on greater risk or more business and also reducing their claim liability; however, the industry is highly regulated for investor protection and to avoid taking on unnecessary risks.
Alternative means of reinsurance have also evolved lately and, at times, are preferred by insurance companies as they have lenient terms governing them or they deal with specific kinds of risk; however, this is a trade-off between investor protection and flexibility.
This has been a guide to what is reinsurance and its meaning. Here we discuss the top 2 types of reinsurance ( Treaty and Facultative) along with its purpose, regulations, and trends. You can more about finance from the following articles –