1.

Definition

Reinsurance is insurance that is purchased by an insurance company (the "ceding

company" or "cedant" or "cedent" under the arrangement) from one or more other
insurance companies (the "reinsurer") as a means of risk management, sometimes in
practice including tax mitigation and other reasons described below. The ceding company
and the reinsurer enter into a reinsurance agreement which details the conditions upon
which the reinsurer would pay a share of the claims incurred by the ceding company. The
reinsurer is paid a "reinsurance premium" by the ceding company, which issues insurance
policies to its own policyholders.
The reinsurer may be either a specialist reinsurance company, which only undertakes
reinsurance business, or another insurance company.
For example, assume an insurer sells 1,000 policies, each with a $1 million policy limit.
Theoretically, the insurer could lose $1 million on each policy totaling up to $1 billion.
It may be better to pass some risk to a reinsurer as this will reduce the ceding company's
exposure to risk.

2. Purpose of reinsurance and its underlying concept

Functions
Almost all insurance companies have a reinsurance program. The ultimate goal of that
program is to reduce their exposure to loss by passing part of the risk of loss to a
reinsurer or a group of reinsurers. In the United States, insurance is regulated at the state
level, which only allows insurers to issue policies with a maximum limit of 10% of their
surplus (net worth), unless those policies are reinsured. In other jurisdictions allowance is
typically made for reinsurance when
Risk transfer
With reinsurance, the insurer can issue policies with higher limits than would otherwise
be allowed, thus being able to take on more risk because some of that risk is now
transferred to the reinsurer. The reason for this is the number of insurers that have
suffered significant losses and become financially impaired. Over the years there has
been a tendency for reinsurance to become a science rather than an art: thus reinsurers
have become much more reliant on actuarial models and on tight review of the companies
they are willing to reinsure. They review their financials closely, examine the experience
of the proposed business to be reinsured, review the underwriters that will write that
business, review their rates, and much more.
Income smoothing
Reinsurance can make an insurance company's results more predictable by absorbing
larger losses and reducing the amount of capital needed to provide coverage. The risks
are diversified, with the reinsurer bearing some of the loss incurred by the insurance
company. The income smoothing comes forward as the losses of the cedant are
essentially limited. This fosters stability in claim payouts and caps indemnification costs.

Surplus relief
An insurance company's writings are limited by its balance sheet (this test is known as
the solvency margin). When that limit is reached, an insurer can do one of the following:
stop writing new business, increase its capital, or (in the United States) buy "surplus
relief".
Arbitrage
The insurance company may be motivated by arbitrage in purchasing reinsurance
coverage at a lower rate than they charge the insured for the underlying risk, whatever the
class of insurance.
In general, the reinsurer may be able to cover the risk at a lower premium than the insurer
because:

Reinsurers may operate under weaker regulation than their clients. This enables them
to use less capital to cover any risk, and to make less prudent assumptions when
valuing the risk.

Reinsurers may operate under a more favorable tax regime than their clients.

Reinsurers will often have better access to underwriting expertise and to claims
experience data, enabling them to assess the risk more accurately and reduce the need
for contingency margins in pricing the risk

Even if the regulatory standards are the same, the reinsurer may be able to hold smaller
actuarial reserves than the cedant if it thinks the premiums charged by the cedant are
excessively prudent.

The reinsurer may have a more diverse portfolio of assets and especially liabilities than
the cedant. This may create opportunities for hedging that the cedant could not exploit
alone. Depending on the regulations imposed on the reinsurer, this may mean they can
hold fewer assets to cover the risk.

The reinsurer may have a greater risk appetite than the insurer.

Reinsurer's expertise
The insurance company may want to avail itself of the expertise of a reinsurer, or the
reinsurer's ability to set an appropriate premium, in regard to a specific (specialised) risk.
The reinsurer will also wish to apply this expertise to the underwriting in order to protect
their own interests.
Creating a manageable and profitable portfolio of insured risks
By choosing a particular type of reinsurance method, the insurance company may be able
to create a more balanced and homogeneous portfolio of insured risks. This would lend
greater predictability to the portfolio results on net basis (after reinsurance) and would be
reflected in income smoothing.

3. Parties involved in the reinsurance

Reinsurance is an agreement between two insurance companies two sophisticated

business enterprise where one company, the reinsurer, assumes an insurance risk from
another insurance company, the ceding company. In essence, reinsurance is the business
equivalent of a consumer purchasing insurance to cover the potential of death. The only
difference is that the entity buying the insurance coverage is an insurance company. Said
differently, the entity shifting risk is an insurance company, rather than a consumer.

In exchange for assuming a defined set of insurance risks from the insurance company
and legally obligating itself to reimburse the insurance company for all or a portion of the
losses incurred by the ceding company on a particular insurance policy or particular
group of insurance policies, the reinsurer receives a premium from the ceding company.
In essence, the premium paid by the ceding company for the insurance provided by the
reinsurer is the business equivalent of the premium paid by a consumer for insurance
coverage. The agreement to spread risk between the ceding companies.

Regardless of the fact that an insurance company may spread its insurance risk to a
reinsurer, the insurance company remains obligated to pay all the benefits due to the
original policyholder or the policyholders beneficiary when an insured event occurs.
There is no relationship between a reinsurer and a consumer, policyholder, and/or
policyholder beneficiary.

Agent

Reinsurance

Brokers

Intermediaries
Transfer of

Risk

Figure 1.0 shows how the Reinsurance work flow

Policy Holders
In insurance, the insurance policy is a contract (generally a standard form contract)
between the insurer and the insured, known as the policyholder, which determines the
claims which the insurer is legally required to pay. In exchange for an initial payment,
known as the premium, the insurer promises to pay for loss caused by perils covered
under the policy language.

Insurance Companies

Insurance is the equitable transfer of the risk of a loss, from one entity to another in
exchange for payment. It is a form of risk management primarily used to hedge against
the risk of a contingent, uncertain loss.

Reinsurance Companies

The practice of insurers transferring portions of risk portfolios to other parties by some
form of agreement in order to reduce the likelihood of having to pay a large obligation
resulting from an insurance claim. The intent of reinsurance is for an insurance company
to reduce the risks associated with underwritten policies by spreading risks across
alternative institutions.

Insurance Brokers

Insurance brokers typically work for the policyholder in the insurance process and act
independently in relation to insurers. Brokers assist clients in the choice of their insurance
by presenting them with alternatives in terms of insurers and products. Acting as agent
for the buyer, brokers usually work with multiple companies to place coverage for their
clients. Brokers obtain quotes from various insurers and guide clients in determining the
adequate policy from a range of products.

Insurance Agents
Insurance agents are, in general, licensed to conduct business on behalf of insurance
companies. Agents represent the insurer in the insurance process and usually operate
under the terms of an agency agreement with the insurer. The insurer-agent relationship
can take a number of different forms. In some markets, agents are independent and
work with more than one insurance company (usually a small number of companies); in
others, agents operate exclusively either representing a single insurance company in one
geographic area or selling a single line of business for each of several companies. Agents
can operate in many different forms independent, exclusive, insurer-employed and selfemployed.

Reinsurance Intermediaries

Insurance intermediaries facilitate the placement and purchase of insurance, and provide
services to insurance companies and consumers that complement the insurance placement
process. Traditionally, insurance intermediaries have been categorized as either insurance
agents or insurance brokers. The distinction between the two relates to the manner in
which they function in the marketplace.

4. Types of reinsurance
4.1 Facultative Coverage
This type of policy protects an insurance provider only for an individual, or a
specified risk, or contract. If there are several risks or contracts that needed to be
reinsured, each one must be negotiated separately. The reinsurer has all the right to
accept or deny a facultative reinsurance proposal.
4.2 Reinsurance Treaty
Unlike a facultative policy, a treaty type of coverage is in effect for a specified
period of time, rather than on a per risk, or contract basis. For the duration of the
contract, the reinsurer agrees to cover all or a portion of the risks that may be
incurred by the insurance company being covered.
4.3 Proportional Reinsurance
Under this type of coverage, the reinsurer will receive a prorated share of the
premiums of all the policies sold by the insurance company being covered.
Consequently, when claims are made, the reinsurer will also bear a portion of the
losses. The proportion of the premiums and losses that will be shared by the
reinsurer will be based on an agreed percentage. In a proportional coverage, the
reinsurance company will also reimburse the insurance company for all processing,
business acquisition and writing costs. Also known as ceding commission, such
costs may be paid to the insurance company upfront.
4.4 Non-proportional Reinsurance
In a non-proportional type of coverage, the reinsurer will only get involved if the
insurance companys losses exceed a specified amount, which is referred to as
priority or retention limit. Hence, the reinsurer does not have a proportional share in
the premiums and losses of the insurance provider. The priority or retention limit
may be based on a single type of risk or an entire business category.
4.5 Excess-of-Loss Reinsurance
This is actually a form of non-proportional coverage. The reinsurer will only cover
the losses that exceed the insurance companys retained limit. However, what makes
this type of contract unique is that it is typically applied to catastrophic events. It
can cover the insurance company either on a per occurrence basis or for all the
cumulative losses within a specified period.

4.6 Risk-Attaching Reinsurance

Under this type of contract, all policy claims that are established during the effective
period of the reinsurance coverage will be covered, regardless of whether the losses
occurred outside the coverage period. Conversely, no coverage will be given on
claims that originate outside the coverage period, even if the losses occurred while
the reinsurance contract is in effect.
4.7 Loss-occurring Coverage
This is a type of treaty coverage where the insurance company can claim all losses
that occur during the reinsurance contract period. The important factor to consider is
when the losses have occurred and not when the claims have been made.

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5. An insurers retention

5.1 For records required to be maintained by an insurer or related entity, the

following retention periods shall apply.

5.1.1

Policy records shall be maintained for the longer of:

5.1.2

five years from the expiration date of the policy, or

5.1.3

until such time as the insurer is no longer required to maintain

a reserve to pay claims under the specific insurance policy.

5.2 Declined applications shall be maintained for at least 1 year.

5.3 Claims records shall be maintained for 2 years from the settlement of
the last claim filed.

5.4 Rate and form filing records must be maintained for at least two years after the
expiration date of any policy which uses the rate or form, for approved filings, and
for six months, for disapproved filings.

5.5 Financial records shall be maintained:

5.5.1

by domestic companies, until they have been subject to an

examination and a report of the examination has been made by the
Department; or

5.5.2

by foreign insurers, as required by the laws of their jurisdiction

of domicile.

5.6 All other records required to be maintained by this regulation shall be

maintained for 5 years.

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5.6.1

In the case of records required to be maintained by producers under

section 4.B of this regulation, records shall be maintained for 3 years after
completion of a personal lines transaction and 5 years after completion of
a commercial lines transaction. For purposes of this regulation,
completion shall occur at the expiration or cancellation of the policy.

5.6.2

Nothing in this regulation is intended to discourage longer retention of

records than required herein. Insurers may find it prudent to use longer
retention periods where statutes of limitations do not correspond to the
time requirements of this regulation.

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Retrocession
Reinsurance companies often also purchase reinsurance, a practice known as retrocession.
They typically purchase this reinsurance from other reinsurance companies, but may also
retrocede to other insurance companies to spread the risk more widely. A company that
accepts such retrocession business is a "retrocessionaire". The reinsurance company that buys
reinsurance is the "retrocedant".
The flow of business and premium is as follows: client insurer reinsurer
retrocessionaire. Other terms used for each of these entities in this flow of business would be:
client cedant retrocedant retrocessionaire.
It is not unusual for a reinsurer to buy reinsurance protection from other reinsurers. For
example, a reinsurer that provides proportional, or pro rata reinsurance capacity to insurance
companies may wish to protect its own exposure to catastrophes by buying excess of loss
protection. Another situation would be that a reinsurer which provides excess of loss
reinsurance protection may wish to protect itself against an accumulation of losses in
different branches of business which may all become affected by the same catastrophe.
Retrocession insurance is common in areas prone to natural disasters like earthquakes and
hurricanes where damage to property, automobiles, boats, aircraft and loss of life are more
likely to occur.
This process can sometimes continue until the original reinsurance company unknowingly
gets some of its own business (and therefore its own liabilities) back. This is known as a
"spiral" and was common in some specialty lines of business such as marine and aviation.
Sophisticated reinsurance companies are aware of this danger and through careful
underwriting attempt to avoid it.
In the 1980s, the London market was badly affected by the creation of reinsurance spirals.
This resulted in the same loss going around the market thereby artificially inflating market
loss figures of big claims (such as the Piper Alpha oil rig). The LMX spiral (as it was called)
has been stopped by excluding retrocessional business from reinsurance covers protecting
direct insurance accounts.

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It is important to note that the original insurance company is obliged to pay due claims
whether or not the reinsurer reimburses the insurer. Many insurance companies have
experienced difficulties by purchasing reinsurance from companies that did not or could not
pay their share of the loss. (These unpaid claims are known as uncollectibles.) This is
particularly important on long-tail lines of business where the claims may arise many years
after the premium is paid.

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