Questions like will thee be a loss or not? If there be a loss how large will it be? And other many problems confront a person and he/she possibly chooses to pass the risk over to an insurer. Once an insurer accepts such risks from the insured, it finds itself posed to similar many problems which confronted, the insured. The difference between the two is the insurer has some sense of protection in the sense that it has taken a large number of similar risks and knows that they will not all involve losses. However, insurers are not immune to the possibility of larger than expected losses or more losses than anticipated. They have to charge a premium at the start of the insurance year, without the benefit of hind sight and must live with that premium regardless of actual results.
This clearly demonstrates that the insurers themselves are exposed to risk. Thus, it is not a surprise if they themselves seek insurance protection., In other words the insurers insure the risk again. This is called reinsurance. In simple terms reinsurance is insurance of insurers.
4.2 Natures and Importance of Reinsurance
4.2.1 Nature and Characteristics of Reinsurance
Re-insurance is a method created to divide the task of handling risk among several insurance. Often this task is accomplished through cooperative arrangements called treaties that specify the way in which risks will be shared by members of the group. Reinsurance is also accomplished by using the services of specific companies and agents organized for that purpose. Reinsurance may be considered as the shifting by a primary insurer, called the ceding company, of the part of the risk it assumes to another company called the reinsurer.
That portion of the risk kept by the ceding company is known as the line or retention and varies with the financial position of the insurer and the other portion of risk is passed on to another reinsurer, the process is known as retrocession. An insurer transfers a part of his risk on a particular insurance by insuring it with another insurer or other insurers. Every insurer has a limit to the risk that he can bear. If at any time a profitable venture comes his way, he may insure it even if the risk involved is beyond his capacity, which is his retention limit. In such cases, in order to safe guard his interest he may reinsure the same risk for an amount in excess of his retention limit with other insurers, so that the loss due to risk is spread over many insurers.
4.2.2 Importance and Contribution of Reinsurance
One may wonder why an insurer that has gone to all the expenses and difficulty of security business would voluntarily transfer some of it to third party. There are several reasons for this, the main one being that the primary insurer is often asked to assume liability for loss in excess of the amount that its financial capacity would permit. Instead of accepting only a portion of the risk and thus causing inconvenience and even ill will of its customer, the company accepts all the risk, knowing that it can pass on to the reinsurer the part that it does not care to bear. The policyholder is thus shared the necessity of negotiating with many companies and can place insurance with little delay. Using a single insurer with a single premium also simplifies insurance management procedures. The policy coverage is not only more uniform and easier to comprehend, but the added guaranty of reinsurer also makes it much safer.
From the viewpoint of the insurer, reinsurance not only distributes risk, but also has other uses and advantages. Stabilized profit and loss rations are an important advantage in the use of reinsurance. It is true that good business often must be shared with others, but in return some bad business is also shared. In the long run it is usually considered more desirable to have a somewhat lower but stable level of profits and underwriting losses than to have a higher but unstable level.
This is not to imply that reinsurance arrangements necessarily reduce average profit levels, but they do smooth out fluctuations that would normally occur. Furthermore, reinsurance does not always mean the loss of premium volume for one of the results of reinsurance is the procurement of a new business. As a member of group of ceding companies organized to share mutual risks, one ceding company must usually accept the business of their insurers.
Reinsurance is also used to allow for a reduction in the level of unearned premium reserve requirements. For new, small companies especially, one of the limiting factors in the rate of growth is the legal requirement that the company set aside premiums received as unearned premium reserves for policyholders. Since no allowance is made in these requirements for expenses incurred, the insurer must pay for producers' commissions and for other expenses out of surplus. As the premiums are earned over the life of the policy these amounts are restored to surplus. Finally, reinsurance may be used to retire from business or to terminate the underwriting on a given type of insurance. If a firm wishes to liquidate its business, it could conceivably cancel all its policies that are subject to cancellation and return the unearned premiums to the policyholders. However, this would be quite unusual in actual practice because of the necessity of sacrificing the profit that would normally be earned on such businesses. It would probably be impossible to recover in full the amount of expense that had been incurred in putting the business on the books.
Through reinsurance, however, the liabilities for existing insurance can be transferred and the policyholders' coverage's remain undisturbed, if an insurer desires to retire its life insurance business and to cease underwriting this line, it may do so through reinsurance. Since the life insurance policy is non-cancelable, the policyholder has the right to continue protection. If it were not for reinsurance, the insurer would find it difficult, if not impossible, to achieve its objective of relieving itself from the obligation of seeing that the insurer's coverage is continued
4.3 Types of Reinsurance Agreements
Organizations for reinsurance are found in many form. It ranges from individual contractual arrangements with reinsurers to pools whereby a number of primary insurers agree to accept certain types of insurance on some pre-arranged basis.
4.3.1 Facultative Reinsurance
The simplest type of reinsurance is an informal facultative agreement, or specific reinsurance on an optional basis. Under this arrangement a primary insurer, in considering the acceptance of a certain risk, shops around for reinsurance on it, attempting to negotiable coverage, specifically on this particular contract.
The reinsurance agreement does not affect the insured in any way. Informal facultative reinsurance is usually satisfactory when reinsurance is of unusual nature for when it is negotiated only occasionally. Such an arrangement becomes cumbersome and unsatisfactory, however, if reinsurance agreements must be negotiated regularly.
Occasionally, an insurer will have an agreement whereby the reinsurer is bound to take certain types of risks if offered by the ceding company, but the decision of whether or not to reinsure remains with the ceding company. Such an arrangement is called a formal facultative contract or obligatory facultative treaty. It is used where the ceding company is often bound on certain types of risks by its agents before it has an opportunity to examine the applications. If the exposure is such that reinsurance is not needed or desired, the ceding company may retain the entire liability. In other cases it will submit the business to the reinsurer, who is bound to take it. Such reinsurance agreements are often unsatisfactory for the reinsurer because of the tendency for the ceding company to keep better business for itself and pass on the more questionable lines to the reinsurer.
4.3.2 Automatic Treaty
To protect all parties concerned from the tendency described above, to speed up transaction, and to eliminate the expense and uncertainties of individual negotiations, reinsurance may be provided where the ceding company is required to cede some certain amounts of business and the reinsurer is required to accept them. Such an agreement is described as automatic. The amount that the ceding company keeps for its own account is known as retention, and the amount ceded to others is known as cession.
Two basic types of treaties have been recognized
- Prorata treaties, under such treaties which premiums and losses are shared in some proportion, and
- Excess of loss treaties, under such treaties losses are paid by the reinsurer in excess of some predetermined deductible or retention. In excess of loss treaties there is no directly proportional relationship between the original premium and the amount of lose assumed by the reinsurer. There are many varieties of prorata treaties, but perhaps the two most common are the surplus treaty and the quota share treaty.
Surplus treaties cover only specific exposure policies covering individual or business firms while quota share treaties cover a percentage of an insurer's business, either its entire business or some definite portion.
Under an excess line, or first surplus treaty, the ceding company decides what its net retention will be for each class of business. The reinsurer does not participate unless the policy amount exceeds this net retention. The larger the net retention the more the other members of the treaty will be willing to accept.
Thus, if the ceding company will retain Birr.10,000 on each dwelling fire exposure, the agreement may call for cession of up to "five lines" or 50,000 for reinsurance. The primary insurer could then take a fire risk of Birr. 60,000. On the other hand, if the primary company is willing to retain only Birr.5,000 on a residential fire exposure, it may have only four lines acceptable for reinsurance, and could not take more than 25,000 of fire insurance on a single residence.
First surplus treaties call for the sharing of losses and premiums up to a stated limit in proportion to the liabilities assumed. Sometimes a second surplus, or even a third surplus, treaty is arranged to take over business that is beyond the limits set by the first surplus treaty. The surplus treaty is probably the most common type of reinsurance in use today.
Under quota share treaties, each insurer takes a proportionate share of all losses and premiums of a line of business. An illustration of the quota share treaty is the reinsurance pool or exchange. Pools are usually formed to provide reinsurance in given classes of business, such as cotton, lumber, or oil, where hazards are of a special nature and where the mutual use of engineering or inspection facilities provides an economy for participating members. Each member of the pool agrees to place all described businesses into the pool, but it shares some agreed proportion like 10% or 16.67 percent of the total premiums and losses. Quota share treaties are especially suitable for new small firms whose underwriting capacity is limited, and who would be unable to get started without such an arrangement because of the unearned premium reserve requirements.
It is not uncommon for a primary insurer to find that while it is willing to accept up to Birr.10,000 on each exposure insured in a given class, it is unable to stand an accumulation of losses that exceeds Birr.50,000. To impose a limit on such losses, the excess of loss treaty has been developed where the reinsurer agrees to be liable for all losses exceeding a certain amount on a given class of business during a specific period. Such a contract is simple to administer because the reinsurers are liable only after the ceding company has actually suffered the agreed amount of loss. Since the probability of large losses is small, premiums for reinsurance are like wise also small.
A variation of the excess of loss type of reinsurance is the spread of loss treaty under which the primary insurer decides what loss ratio it is prepared to stand on a given kind of insurance, and agrees with a reinsurer to bear any loss that would raise the loss ratio above the agreed level over a period of, say five years. Thus, the ceding company has spread its loss over a reasonable time period and, in effect, has guaranteed an underwriting margin through reinsurance. In this way an unusually high loss ratio in a poor underwriting year is averaged in with other years.
4.4 Ways of Administering Re-insurance
Most re-insurance is administered by professional re-insurers who specialized in re-insuring the portfolios of other insurers. However the re-insurer may be another insurer whose major business interest also is dealing with the public. Some insurers of this type have re-insurance department or subsidiaries that aggressively seek business from other insurers but most of them are re-insures only because many reinsurance agreements obligates the ceding insurer to re-insure some of the liability assumed by the re-insurer under this direct business. The other way is a polo that may or may not include the ceding insurer. Re-insurance arrangement may distribute the insurance and the loss in many different ways. Some of the distribution methods are:
- Under a quota share split, the insurance and the loss are shared according to some prearranged percentage. For example if a Birr 100,000 policy is written and the agreed split is 50-50, then the re-insurer assumes half of the liability and the remaining half loss will be assumed by the insurer.
- Under a surplus share agreement the re-insurer accepts that amount of the insurance in each of a stated amount and the loss is prorated according to the amount of the insurance assumed. For example, if a Birr 100,000 is the stated amount, the re-insurance's liability under a Birr. 200,000-policy amount would be (200,000 -100,000).
- Under an excess loss arrangement, the re-insurer agrees to pay that portion of the loss incurred under an individual contract in excess of some specified amount such as 100,000 Birr.
- Catastrophe re-insurance - like excess loss, but in this insurance the losses are those incurred by the insurer as a result of a single event under all contracts covered under the agreement. For example, the re-insurer might be obligated to pay that portion in excess of birr 100,000 of the losses incurred.
Reinsurance is an insurance purchased by an insurer to protect itself against losses on polices it has written that it does not wish to bear the entire exposure by itself.
- Considerations in setting the retention amount
The maximum loss an insurer can safely retain is affected by the following variables:
- the size of the insurance company
- its financial conditions
- the insurer’s management philosophy
- the characteristics of the exposure under consideration
- Parties in the insurance business
- the primary (ceding) insurer
- the re-insurer
- Distribution methods of reinsurers
- A quota share split arrangement: in this method parties to the agreement will share the loss based on some prearranged percentage.
- A surplus share arrangement: the reinsurer accepts the amount of the loss and insurance in excess of stated amount and the loss is prorated according to the amount of insurance assumed.
- Excess loss arrangement: in this type of arrangement the reinsurer will agree to pay a portion of the loss incurred in excess of some specified amount