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