Unit
- Reinsurance defined: Reinsurance is a contractual arrangement where one insurance company (the ceding insurer) transfers a portion of its risk to another insurer (the reinsurer) in exchange for a premium. This mechanism allows primary carriers to reduce exposure to large losses, stabilize underwriting results, and increase capacity to write new business.
- Risk transfer function: The fundamental purpose of reinsurance is to spread risk across multiple entities, preventing a single catastrophic event from crippling a primary insurer. By ceding risk, the insurer limits its net retained liability and protects its surplus from volatility.
- Capital management tool: Reinsurance serves as a substitute for equity capital. Instead of holding additional capital to cover peak exposures, insurers purchase reinsurance to offload those risks, improving return on equity and freeing capital for growth opportunities.
- Stabilization of results: Reinsurance smooths annual loss ratios by absorbing catastrophic losses and large claims. This predictable earnings pattern enhances stakeholder confidence and supports consistent dividend policies.
- Capacity to underwrite large risks: Through reinsurance, primary insurers can accept policies with high sum insureds that would otherwise exceed their single-risk retention limits. For example, a regional carrier can cover a large commercial property by ceding 80% of the risk to a global reinsurer.
- Expertise and market access: Reinsurers provide valuable underwriting and pricing expertise, especially for complex or new risk classes. They also offer access to global reinsurance markets, enabling primary insurers to diversify their risk portfolios geographically.
- Types of risk transferred: Reinsurance can cover individual policies (facultative) or entire portfolios of policies (treaty). The risk can be proportional or non-proportional, depending on how losses are shared between ceding insurer and reinsurer.
- Financial stability and solvency: Regulators encourage insurers to use reinsurance to maintain solvency margins. By ceding risk, insurers reduce their probable maximum loss and ensure they can meet policyholder obligations even after severe events.
- Ceding commission and profit sharing: Reinsurers typically pay a ceding commission to the primary insurer to cover acquisition costs and administrative expenses. Additionally, profit commission arrangements allow the ceding insurer to share in underwriting profits generated on the ceded business, aligning interests and encouraging prudent underwriting.
- Reinsurance pricing and exposure rating: Reinsurance premiums are determined using actuarial models that assess expected losses, including burning cost and exposure rating methods. Pricing reflects the risk profile of the underlying portfolio, historical loss experience, and the attachment point for non-proportional covers. This ensures the premium adequately compensates the reinsurer for risk transferred.
- Claims settlement and run-off: Reinsurers participate in claims handling and often provide guidance on loss adjustment. For long-tail lines, contracts may include run-off provisions specifying how claims are managed after contract termination. Clear communication and timely documentation are critical to avoid disputes and ensure smooth settlement.
Risk Assessment
LOW RISK
For a well-structured reinsurance program, the residual risk retained by the ceding insurer is low because the contract clearly defines limits, deductibles, and exclusions. However, credit risk of the reinsurer must be evaluated. In this course, we treat reinsurance as a risk mitigation tool that, when properly implemented, significantly reduces the volatility of the ceding insurer's underwriting results.
Quick Revision
- Reinsurance transfers risk from primary insurer to reinsurer in exchange for premium.
- It stabilizes earnings and protects surplus from catastrophic losses.
- Reinsurance provides capital relief and enables underwriting of larger risks.
- Expertise transfer and market access are additional benefits.