Insurance, Reinsurance and the Transfer of Risk in the (Re)Insurance Industry

Much happens behind the scenes after an insurance policy is purchased by an insured. A written risk may be transferred from one insurer to another. Many different companies may have interests in the original insurance contract (and its continued success) beyond the original insured and insurer. In insurance, an individual or business purchases a policy from an insurer to protect their assets against loss. Should a covered loss occur, the insurance contract will indemnify the insured, subject to the terms and conditions of the policy. Insurers are also able to purchase insurance coverage of their own, known as reinsurance, to protect their assets and be indemnified should they be called to pay for a covered loss on behalf of their insureds. A risk may take several different paths as it gets transferred from one (re)insurance company to another. Ultimately, many different insurers may have varying degrees of exposure for a risk which all put together are meant to protect the insured and the insurers involved in the transaction(s).

An insurance policy will involve an individual or business (known as insured) who cedes risk to an insurance company who then accepts the risk on their behalf. The insurance company can keep the risk in its books for the entire duration of the contract or it may transfer the risk, in whole or in part, to another insurer by means of a reinsurance contract. The insurer transferring the risk is known as the ceding company (or reinsured) and the company accepting the risk is known as the reinsurer. A reinsurer also has the choice of accepting the risk and retaining it for the duration of the reinsurance contract or transferring the risk to another reinsurer by using a retrocession contract. The reinsurer transferring the risk is known as the retrocedent and the company accepting the risk is known as the retrocessionaire. A retrocession contract is the name used for the transfer of risk beyond reinsurance. Insurers and reinsurers may also transfer risk to financial markets through ‘alternative risk transfer’ methods whereby investors accept risks on behalf of insurers in the hopes of achieving a return on their investment and (re)insurers receive funds from said investors should a covered loss occur, or if certain other conditions are met. Alternative risk transfer is an evolving area of insurance. A diagram of the different entities involved in the transfer of risk within the insurance industry can be found hereunder.

What an insured, reinsured and retrocedent is purchasing when they buy a (re)insurance policy is a promise to be indemnified for covered losses as per the terms and conditions of the applicable contract. What an insurer, reinsurer and retrocessionaire is selling is a promise to pay, as per the terms and conditions of the contract, if a covered loss occurs. The transaction between insured and insurer in an insurance contract is to ensure that funds will be available to indemnify the insured following a covered loss with the hopes of returning the insured to the condition they enjoyed before the loss. The transactions between insurers, reinsurers and retrocessionaires ensure that the companies that accept risk have avenues to maintain their exposure at desired levels whether it be for an individual risk or for a portfolio of business.

The volume of risk transferred as it travels from the original insured to a retrocessionaire gets progressively larger. An insured transferring the property loss exposures of his home will purchase a homeowner’s policy from his insurer. That insurer may in turn transfer his entire portfolio of homeowner’s policies, covering thousands of homes, to a reinsurer by purchasing reinsurance. The reinsurer may in turn transfer his portfolio of homeowners, automobile and personal accident (re)insurance to a retrocessionaire. The example explained above is one of many ways by which the transfer of risk is achieved between insurers.

There are benefits to companies acting as reinsurers and retrocessionaires. One such benefit is that the cost to acquire individual risks to build up a portfolio of written business are borne by the primary insurer who interacts directly with the insureds. Reinsurers will grant a ceding commission to the insurer to aid them with their business acquisition costs. Another benefit for reinsurers is that they can diversify their exposures since they can participate in reinsurance transactions covering different lines of business e.g. homeowners and automobile insurance, or wider geographic areas such as the United States, Latin America, Europe, etc. From an insurer’s perspective, transferring risk and purchasing reinsurance is beneficial because it can keep their exposure to manageable levels. A well-prepared reinsurance program can help an insurer remain solvent following great catastrophes such as earthquakes and hurricanes.

There are also drawbacks to acting as a reinsurer or retrocessionaire. One drawback is that, as the transaction gets further from the original policy, less premium is available to be earned. This is in part due to ceding commissions paid to underlying insurers and any brokers and intermediaries that may be involved in the transactions. An insurer may hire the services of an insurance broker to obtain insurance coverage, the broker will need to be compensated. The insurer may hire a reinsurance broker to acquire reinsurance coverage, both the insurer and the insurance broker will also look to be compensated for any premium ceded. Once the risk is finally accepted by the final reinsurer/retrocessionaire, the premium will be reduced by all the transactions that have taken place. Another disadvantage is that reinsurers and retrocessionaires are far removed from the original underwriting (analysis) of the risks that make their way to the insurer’s portfolio, therefore their fortune relies in part on the primary insurer’s ability to write profitable business. A disadvantage for the insurer in purchasing reinsurance is that they may in fact be ceding away profitable business to reinsurers that they themselves would wish to retain.

The insurance industry is vast and much happens behind the scenes without an insured’s knowledge. Risk is transferred from one insurer to another. The insurance consumer ultimately benefits as risk is spread and managed according to each insurer’s best capabilities. Many insurance companies may be involved in any risks and each will follow the fortunes of the original insured and insurer. However; regardless of how many reinsurance arrangements and retrocession contracts apply, the insurer is ultimately responsible for indemnifying the insured for any covered losses. The insurer’s responsibility to their insured is not reduced by any failure of their reinsurers to perform.

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