The Functions of Reinsurance

Reinsurance does not change the basic nature of an insurance coverage. On a long-term basis, it cannot be expected to make bad business good. But it does provide the following direct assistance to the cedant.

Capacity
Having reinsurance coverage, a cedant can write higher policy limits while maintaining a manageable risk level. By ceding shares of all policies or just larger policies, the net retained loss exposure per individual policy or in total can be kept in line with the cedant’s surplus. Thus smaller insurers can compete with larger insurers, and policies beyond the capacity of any single insurer can be written.
The word “capacity” is sometimes also used in relation to aggregate volume of business. This aspect of capacity is best considered below in the general category of financial results management.

Stabilization
Reinsurance can help stabilize the cedant’s underwriting and financial results over time and help protect the cedant’s surplus against shocks from large, unpredictable losses. Reinsurance is usually written so that the cedant retains the smaller, predictable claims, but shares the larger, infrequent claims. It can also be written to provide protection against a larger than predicted accumulation of claims, either from one catastrophic
event or from many. Thus the underwriting and financial effects of large claims or large accumulations of claims can be spread out over many years. This decreases the cedant’s probability of financial ruin.

Financial Results Management
Reinsurance can alter the timing of income, enhance statutory and/or GAAP surplus, and improve various financial ratios by which insurers are judged. An insurance company with a growing book of business whose growth is stressing their surplus can cede part of their liability to a reinsurer to make use of the reinsurer’s
surplus. This is essentially a loan of surplus from the reinsurer to the cedant until the cedant’s surplus is large enough to support the new business. We will see other ways that reinsurance can be used to alter a cedant’s financial numbers. As you might expect in a free market, this aspect of reinsurance
has led to some abuses in its use. As we discuss the various
forms of reinsurance coverage, we will note their financial effects.

Management Advice
Many professional reinsurers have the knowledge and ability
to provide an informal consulting service for their cedants. This
service can include advice and assistance on underwriting, marketing,
pricing, loss prevention, claims handling, reserving, actuarial,
investment, and personnel issues. Enlightened self-interest
induces the reinsurer to critically review the cedant’s operation,
and thus be in a position to offer advice. The reinsurer typically
has more experience in the pricing of high limits policies and
in the handling of large and rare claims. Also, through contact
with many similar cedant companies, the reinsurer may be able
to provide an overview of general issues and trends. Reinsurance
intermediaries may also provide some of these same services for
their clients.

Up next: The Forms of Reinsurance

What is Reinsurance?

Reinsurance is a form of insurance. A reinsurance contract is legally an insurance contract. The reinsurer agrees to indemnify the cedant insurer for a specified share of specified types of insurance claims paid by the cedant for a single insurance policy or for a specified set of policies. The terminology used is that the reinsurer assumes the liability ceded on the subject policies.

The cession, or share of claims to be paid by the reinsurer, may be defined on a proportional share basis (a specified percentage of each claim) or on an excess basis (the part of each claim, or aggregation of claims, above some specified dollar amount).

The nature and purpose of insurance is to reduce the financial cost to individuals, corporations, and other entities arising from the potential occurrence of specified contingent events. An insurance company sells insurance policies guarantying that the insurer will indemnify the policyholders for part of the financial losses stemming from these contingent events. The pooling of liabilities by the insurer makes the total losses more predictable than is the case for each individual insured, thereby reducing the risk relative to the whole. Insurance enables individuals, corporations and other entities to perform riskier operations. This increases innovation, competition, and efficiency in a capitalistic marketplace.

The nature and purpose of reinsurance is to reduce the financial cost to insurance companies arising from the potential occurrence of specified insurance claims, thus further enhancing innovation, competition, and efficiency in the marketplace. The cession of shares of liability spreads risk further throughout the insurance system. Just as an individual or company purchases an insurance policy from an insurer, an insurance company may purchase fairly comprehensive reinsurance from one or more reinsurers.

A reinsurer may also reduce its assumed reinsurance risk by purchasing reinsurance coverage from other reinsurers, both domestic and international; such a cession is called a retrocession.

Reinsurance companies are of two basic types: direct writers, which have their own employed account executives who produce business, and broker companies or brokers, which receive business through reinsurance intermediaries. Some direct writers do receive a part of their business through brokers, and likewise, some broker reinsurers assume some business directly from the ceding companies. It is estimated that more than half of U.S. reinsurance is placed via intermediaries.

The form and wording of reinsurance contracts are not as closely regulated as are insurance contracts, and there is no rate regulation of reinsurance between private companies. A reinsurance contract is often a manuscript contract setting forth the unique agreement between the two parties. Because of the many special cases and exceptions, it is difficult to make correct generalizations about reinsurance.

This heterogeneity of contract wordings also means that whenever you are accumulating, analyzing, and comparing various reinsurance data, you must be careful that the reinsurance coverages producing the data are reasonably similar.

Up next: The Functions of Reinsurance