Just about all insurers, whether they are companies, Lloyd’s syndicates or mutual associations, need reinsurance. It protects the insurer’s capital base against the adverse effects of large individual losses or irregular loss patterns such as may be caused by natural catastrophes. Another way of looking at it is that reinsurance supplies the insurer with a form of capital that can be called upon in case of a large loss or losses that would otherwise deplete the insurer’s own capital.
Without reinsurance, an insurer would need to avoid exposing its capital to large variations in the claims experience by accepting much less on individual risks or accumulations. By using reinsurance, these fluctuations are smoothed out, enabling the insurer to accept larger risks, generating a greater premium and therefore make more efficient use of its own capital.
How is Reinsurance Capacity Purchased?
The simplest way is to purchase facultative reinsurance. An insurer issues an individual policy or accepts a share of a policy giving it a maximum exposure of £100,000,000 in the event of a total loss. The insurer has determined that it cannot afford to lose more than £10,000,000 on any one policy it accepts, so must buy some reinsurance to cover the other £90,000,000.
It can do this by placing either 90% of the policy under a facultative reinsurance contract which is usually in respect of a single risk, for example by placing an excess of loss reinsurance contract for £90,000,000 excess of £10,000,000 where the reinsurer will only pay the amount of any claim under that policy over and above £10,000,000.
These reinsurance contracts are referred to as facultative because they are tailor made in that the insurer is free to decide whether to reinsure, how much cover to purchase and from whom to purchase it (the reinsurers).
Insurers often “bundle” large numbers of similar policies and reinsure them all together under a reinsurance treaty, where reinsurers agree to accept a fixed share of all policies that come within the treaty’s scope. For example, a treaty might cover all of the insurer’s fire policies up to a limit of £20,000,000 each policy. The reinsurers might take 50% of all of those policies under a Quota Share Treaty.
What happens when the insurer issues a fire policy with a value of £100,000,000? The Quota Share treaty would take 50% of £20,000,000 and the insurer would take the other 50% (the insurer’s retention). That leaves the other £80,000,000 which is surplus to the Quota Share + retention capacity. There are three possibilities for dealing with this surplus.
- The insurer could simply retain it. The retention becomes £90,000,000 part of £100,000,000 or 90% of the policy. That would not be desirable from the insurer’s viewpoint.
- The insurer could place facultative reinsurance for 80% of the policy.
- If there are sufficient numbers of policies that exceed £20,000,000 the insurer could arrange a surplus treaty that would accept amounts that are surplus to the capacity provided by the retention and Quota Share treaty combined.
In many cases, an insurer will not have a Quota Share treaty and will simply have surplus treaties that operate once the retention has been filled. Think of a Quota Share treaty as giving away a part of the insurer’s retention.
The advantages of proportional treaties are:
- They increase an insurer’s acceptance capacity by providing automatic cover.
- They are relatively simple to administer.
- The reinsurers generally give a better discount, in the form of commission, than they would allow under facultative placements.
Excess of Loss Treaties
Just as facultative reinsurance can be split into proportional and excess of loss, so too can treaty reinsurance. Many insurers have reinsurance programmes that are made up entirely of excess of loss treaties, while others rely on a mixture of proportional and excess of loss.
Excess of Loss treaties will be looked at further in a future post.
This post was originally published March 14, 2013.