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Jack Phiyong Mo

Reinsurance is an arrangement under which an insurance company (i.e., reinsurer) agrees to assume the specified risks of another insurance company (i.e., ceding company). In essence, reinsurance is insurance for insurance companies. Depending on the arrangement, the reinsurer may assume all or a portion of the insurance risks underwritten by the ceding company. In exchange, the reinsurer receives some or all of the premium and, in certain cases, investment income derived from the assets supporting the reserves of the reinsured policies.

Why Do Companies Use Reinsurance?

Ceding companies participate in reinsurance for several reasons, including 1) risk transfer; 2) financial or surplus relief; 3) to decrease earnings volatility; 4) to increase business production capacity; and 5) to exit certain business lines.

While all of these are valuable benefits to an insurer, the primary use of reinsurance relates to the first two items. More specifically, direct writers often want to limit their mortality loss exposure on any one life (an example would be to retain up to $1 million of loss on a $3 million policy). By outsourcing a portion of the mortality risk, the ceding company can effectively control its maximum exposure. This also helps to decrease earnings volatility from large claims as they emerge. In addition to risk transfer, an insurer will also use reinsurance to improve its financial position (e.g., solvency ratios, profitability ratios). In essence, this provides direct writers relief from conservative capital and reserving requirements set forth by regulators. In other words, the cedant transfers the underlying risk on the reinsured business, which relinquishes it from having to hold additional capital. Ultimately, an insurer is able to increase new production capacity while ceding off the portion it cannot or chooses not to maintain.

Types of Reinsurance

Reinsurance contracts, also known as treaties, are generally written on either an automatic or facultative basis, with the former being significantly more prevalent in the market.

• Automatic Reinsurance: An automatic reinsurance treaty specifies that the ceding company be contractually obligated to cede risks to a reinsurer on specified blocks of policies where the risks meet the ceding company’s underwriting criteria and provisions of the reinsurance agreement. In essence, an automatic reinsurance treaty does not require approval from the reinsurer for each policy underwritten (only at the onset of the contract). This business is primarily related to the reinsurance of term insurance. Ceding companies generally seek to establish automatic reinsurance with three to five participants to diversify counterparty risk.

• Facultative Reinsurance: Facultative reinsurance is underwritten by the reinsurer for each policy reinsured and is generally purchased by ceding companies for medically impaired lives, unusual risks, or liabilities in excess of the binding limits specified in their automatic reinsurance treaties. Unlike automatic reinsurance, facultative reinsurance is optional (not a contractual obligation) and allows a reinsurer the opportunity to analyze and separately underwrite a risk before agreeing to accept it. In addition, the reinsurer may specify its own ratings and terms for the reinsurance arrangement.

References

Bear Stearns International (European Reinsurance: Life Reinsurance Demystified)