Understanding Reinsurance and Its Transaction Types

The worldwide insurance industry is vast and interconnected. Calamities in distant places of the world can have an impact on the availability of insurance and the amount of premium you pay at home. Natural catastrophes such as major hurricanes in the southeast United States, earthquakes in Asia, Tsunamis, etc. can all have an impact in the global insurance industry that, if severe enough, may result in higher premiums being charged or insurance coverage becoming unavailable. Man-made disasters such as terrorism, industrial accidents, etc. also cause similar impacts in the insurance marketplace and their effects have become more and more significant. How can natural and man-made disasters that occur in faraway places impact you? The answer to that question lies in the interconnectedness of the insurance industry. Insurance is a global industry where insurance companies share risk amongst each other in a process known as reinsurance.

Reinsurance in its simplest definition means insurance for insurance companies. What that means is that an insurance company will transfer risk(s) it assumes from its insured(s) (insurance company clients), in whole or in part, to another insurance company with the goal of reducing its exposure to loss and protecting its solvency (i.e. ability to meet future obligations). The insurance company that writes the risks originally and transfers them to another entity is known as the ceding company and the insurer who accepts the risks on behalf of the ceding company is known as the reinsurer. Reinsurance is considered an insurer to insurer transaction and [insurance] companies can operate exclusively in the reinsurance space if they wish to do so, solely accepting risks written by ceding companies.

A ceding company’s goal, if it was acting solely on its best interests, would be to retain profitable business in its portfolio and cede (give up) unprofitable business to reinsurers. While that may sound like a great strategy, it is important to keep in mind that a reinsurer’s interests are in much ways reversed. The reinsurer would ideally hope to receive profitable business from the ceding company while not being called upon to participate in unprofitable business. The interplay between the interests of the ceding company, the interests of the reinsurer and risk (which involves uncertainty of future outcomes) all come together to form the reinsurance sector where ceding companies cede risk and reinsurers accept them in ways deemed beneficial to both parties and for the insurance industry overall.

Types of reinsurance

Reinsurance may be written in a proportional or non-proportional basis. Proportional reinsurance is also known as pro rata reinsurance and non-proportional reinsurance is also known as excess of loss reinsurance. In proportional reinsurance, the insurer and reinsurer will participate in the reinsurance contract according to predefined proportions by which all premiums, losses and expenses are split between them, according to the defined percentages. The reinsurer will provide a commission to the ceding company to cover the acquisition expenses for the business being written. In non-proportional reinsurance, the reinsurer agrees to indemnify (compensate) the ceding company for all losses that exceed a predetermined amount. A threshold is established below which the ceding company bears full responsibility for the losses incurred, known as the ceding company’s retention. After the threshold is breached and losses exceed the ceding company’s retention, the reinsurer steps in and indemnifies the ceding company for the losses above the retention level.

How reinsurance is transacted

The transaction of reinsurance falls within two broad categories. Reinsurance business may be transacted on a treaty or on a facultative basis. Transacting reinsurance via treaty means that the ceding company is obligated to cede risks that fall within the scope of the treaty to the reinsurer and the reinsurer is obligated to accept those risks being ceded.

Transacting reinsurance business under a treaty allows the reinsurer to participate in all the risks [within the scope of the treaty] being written by the ceding company. Treaty reinsurance ensures that the reinsurer participates in profitable accounts while also accepting the unprofitable ones. The ceding company is also protected in that the reinsurer is obligated to accept the unprofitable accounts while the ceding company also cedes profitable business. The goal is for both the insurer and reinsurer to write business profitably in the aggregate. Treaty reinsurance is very useful when dealing with large volumes of homogenous risks such as auto or homeowners insurance. The automatic offering and acceptance of said risks within the treaty prevents the need for the analysis of individual risks by the parties to the reinsurance contract which can be very expensive when dealing with large volumes of business.

Facultative reinsurance is different from treaty reinsurance in that it is optional (non-obligatory). The ceding company has the right to decide which risks to retain and which to cede and the reinsurer has the right to decide which risks to accept and which to reject. Facultative reinsurance is used for reinsuring risks that do not fall within the scope of a treaty or in instances that treaty reinsurance is not purchased by the ceding company. Facultative reinsurance is useful when dealing with risks that are either unique, large or specialized in nature and require individual underwriting (analysis). Lines of business such as aviation and construction bear potentially catastrophic consequences should a loss occur. Under facultative reinsurance the reinsurer will analyze the risk prior to accepting it, and it will ensure that adequate premium is charged for them to participate, according to the exposure being accepted. The reinsurer also has the option of rejecting the risk.

Reinsurance is an important component of the insurance industry and it works behind the scenes to ensure that insurance companies bear a level of risk that they can accept (while providing them with a mechanism to cede risk to other insurers). The type of reinsurance written and the way that it’s transacted are important components to consider when structuring a reinsurance contract. Different results can be achieved based on how a reinsurance program is structured. Thanks to reinsurance, catastrophic losses such as those described in the beginning of this article, are capable of being absorbed by the insurance industry globally instead of having the regions that suffered the loss disproportionately affected and unable to recover for years into the future.

There are many benefits to transacting reinsurance beyond the ability to transfer and share risks amongst insurance companies. The benefits of reinsurance shall be discussed in future postings.