Download - Rajesh 100 Marks 6th Semester
-
8/8/2019 Rajesh 100 Marks 6th Semester
1/92
PRINCIPLES & TYPES OF REINSURANCE
Principles of Reinsurance
Table of Contents
Chapter One - Introduction to Reinsurance
Origins of Reinsurance
Reinsurance Types
Facultative Reinsurance
Treaty Reinsurance
Proportional Reinsurance
Quota Share
Surplus Share
Non-Proportional Reinsurance
Chapter Two - Types of Life and Property & Casualty Reinsurance
Proportional Reinsurance for Life Insurance Companies
Yearly Renewable Term
Coinsurance
Modified Coinsurance
Reinsurance for Property & Casualty Companies
Proportional Reinsurance
1
-
8/8/2019 Rajesh 100 Marks 6th Semester
2/92
PRINCIPLES & TYPES OF REINSURANCE
Quota Share
Surplus Share
Non-proportional Reinsurance
Individual
Occurrence
Aggregate
Layering
Non-proportional Reinsurance for Life Insurance Companies
Stop Loss Reinsurance
Catastrophe Reinsurance
Spread Loss Reinsurance
Chapter Three - Purposes of Reinsurance
Assumption Reinsurance
Indemnity Reinsurance
Entering New Lines of Business
Underwriting Impaired Risks
Chapter Four - Reinsurance Agreements
The Facultative Agreement
The Treaty Agreement
2
-
8/8/2019 Rajesh 100 Marks 6th Semester
3/92
PRINCIPLES & TYPES OF REINSURANCE
The Cession Form
Chapter Five - Reinsurance in Operation
Claims
Change in Reinsurance Amounts
Agreement Duration
Experience Rating
Supplemental Coverage
Substandard Reinsurance
Decisional Factors in Setting Retention Limits
Chapter Six - The Reinsurance Environment
Product, Market and Classification Development
New Products
Classification of Life Insurance Risks
Emergence of New Reinsurance Markets
Company Restructuring
Increased Risk
Competition
Interest Rates and Financial Volatility
Chapter Seven - Reinsurance Regulation
Introduction
Disclosure
3
-
8/8/2019 Rajesh 100 Marks 6th Semester
4/92
PRINCIPLES & TYPES OF REINSURANCE
Assessment of Risk Transfer and Accounting
Security
Glossary
4
-
8/8/2019 Rajesh 100 Marks 6th Semester
5/92
PRINCIPLES & TYPES OF REINSURANCE
Chapter One
Introduction to Reinsurance
Origins of Reinsurance
Think about a business in which you have invested all of your assetsyour
savings, your house and everything else of value. In fact, you have invested
more than that because you have borrowed against your future profits in
order to raise the capital to start and run the business. Now, consider the
possibility that all of your assets could be lost because of a storm. If you can
mentally transport yourself back to the 17th century, you may begin to have
an understanding of the business environment in which English and other
ship owners operated in the year 1688, the year that the worlds most famous
reinsurerLloyds of Londonhad its first meeting.
For many ship owners in the 17th century, the example above was a very real
fact of business life. Since few ship owners could afford to bet everything
on a single roll of the diceor on a single voyagethey would seek out
others that would, for a fee, agree to accept a part of the risk. Typically, a
ship owner would write information about the impending voyage on a piece
of paper and solicit investors willing to accept some or all of the risk by
posting the description on or near the wharf.
An investor wishing to accept a part of the risk of the voyage would place
his initials below the line on the notice and would indicate the percentage of
the risk that he would bear. The investors that accepted some or the entire
5
-
8/8/2019 Rajesh 100 Marks 6th Semester
6/92
PRINCIPLES & TYPES OF REINSURANCE
risk incident to the voyage became known as underwriters since they were
writing their name under the description of the risk.
Since each of these underwriters would typically bear only a part of the total
risk rather than the entire risk, the ship owner needed to take the information
about the voyage to multiple underwriters until all of the riskor at least the
portion of the risk that he wouldnt agree to bear himselfwas assumed. As
the number of voyages increased and potential investors grew in number as
they became more familiar and comfortable with the risks, the business of
insuring these voyages became chaotic. In 1688, a group of investors met
for the first time in a central place in order to facilitate these insurance
transactions. That first meeting took place at Lloyds Coffeehousea
location from which Lloyds of London took its name.
It wasnt long before Lloyds Coffeehouse became the center of marine
insurance in England and, subsequently, worldwide. As the marine
insurance industry grew, fewer ship owners had contact with the
underwriters. Instead, ship owners and underwriters used middlemen to
bring the transaction together for a fee. These middlemen, individuals that
came to be known as brokers, negotiated the insurance, and when a claim
was incurred the brokers collected the claim from each underwriter and
made payment to the ship owner.
By the late 18th century, the underwriters that continued to use Lloyds
Coffeehouse moved the insurance operation to the Royal Exchange in the
city London and formed a committee to manage the day-to-day operation of
the organization. About a hundred years after its move to the Royal
6
-
8/8/2019 Rajesh 100 Marks 6th Semester
7/92
PRINCIPLES & TYPES OF REINSURANCE
Exchangelate in the 19th centuryLloyds was incorporated and became
known as the Society of Lloyds.
The bulk of Lloyds of Londons business continues to come from the
transportation sector, where they insure or reinsure airline, shipping and
other risks related to transportation. About one-third of its income is derived
from a type of reinsurance that we will discuss, known as treaty
reinsurance and about 15 percent is the result of facultative reinsurance, a
reinsurance type that we will also consider.
While Lloyds of London still looks to Great Britain for the largest part of its
income, much of its income comes from other parts of the world and from
non-marine type coverages. Now that we have looked at the beginnings of
the worlds best-known reinsurer, lets turn our attention to some of its basic
concepts.
Just the way that any individual may choose to insure a certain riskor part
of a riskand retain other risks, an insurance company may also elect to
insure some of the risk it has assumed. When an insurance company makes
that choice to insure some of its risk, it is known as reinsurance, and the
policy that it negotiates is called a reinsurance treaty.
Although there are certainly some similarities between the individual as
purchaser of insurance and an insurance company as purchaser of
reinsurance, there are many differences. One reinsurance situation may
differ from another in the:
7
-
8/8/2019 Rajesh 100 Marks 6th Semester
8/92
PRINCIPLES & TYPES OF REINSURANCE
Type of reinsurance
and
Use of reinsurance
As we will see, the types and uses of reinsurance can be quite complex.
The concept of risk-sharing is as fundamental to reinsurance as it is to
insurance in general. It involves the spreading of a significant risk over a
number of individuals and, thereby, exchanging the possibility of a
potentially catastrophic financial loss for a certain, but manageable, lossknown as the premium. When insurance companies share their risk through
reinsurance, the amount of the risk that they dont share is known as their
retention; the amount of risk shared is the amount ceded to the reinsurer.
The presence or absence of reinsurance is not generally something of which
the policyowner is aware. Typically, the policyowners interaction has only
been with the primary insurer rather with the reinsurer. And, if the
policyowner has a claim covered under the policy, the primary insurer is
obligated to honor it, irrespective of whether there is any reinsurance
involved. So, the parties to the reinsurance contract are the primary insurer
and the reinsurer; the policyowner is not a party to it.
8
-
8/8/2019 Rajesh 100 Marks 6th Semester
9/92
PRINCIPLES & TYPES OF REINSURANCE
Reinsurance Types
There are two basic types of reinsurance, known as:
Facultative reinsurance
and
Treaty reinsurance
Facultative Reinsurance
The difference between the two types of reinsurance lies in the power of the
primary insurer and the reinsurer to decide whether or not to assume the risk.
In facultative reinsurance the reinsurer retains the power to assume or
decline any risk presented to it. In other words, it retains the faculty to
take on the risk or reject all or part of it. The agreement in facultative
reinsurance is negotiated for each risk. In the property & casualty insurance
industry, facultative reinsurance is employed when the value of the property
is higher or the risk is greater than those risks covered by the reinsurance
treaty. Similarly, the primary insurer can choose whether or not to purchase
reinsurance for a particular risk and from whom.
Treaty Reinsurance
If the facultative type of reinsurance enables both the primary insurer and
the reinsurer to determine whether or not to reinsure each particular risk,
treaty insurance is just the opposite. Once the agreement for treaty insurance
9
-
8/8/2019 Rajesh 100 Marks 6th Semester
10/92
-
8/8/2019 Rajesh 100 Marks 6th Semester
11/92
PRINCIPLES & TYPES OF REINSURANCE
Quota share
and
Surplus share
Quota Share
In quota share reinsurance a fixed percentage of coverage provided under
each policy is retained and the balance is ceded. The percentage of coverage
retainedwhich could be 10%, 25%, 50% or some other percentageisgenerally the same for every policy, regardless of the amount. The
corresponding premium is also paid to the reinsurer. In turn, the primary
insurer receives a commission for the business from the reinsurer.
In the event of a claim under the policy the reinsurer would pay that
percentage of the claim equal to its percentage share of the policy.
For example, suppose a property and casualty insurer entered into treaty
reinsurance with a reinsurer to share risks on a 25% - 75% quota share basis.
Following the establishing of the reinsurance agreement, the primary insurer
entered into the following risks:
Insurance Amount Amount Ceded
11
-
8/8/2019 Rajesh 100 Marks 6th Semester
12/92
PRINCIPLES & TYPES OF REINSURANCE
Amount Retained
$50,000
$150,000
$12,500
$37,500
$37,500
$112,500$500,000 $125,000 $375,000$1,000,000 $250,000 $750,000
As we can see, in the case of a quota share treaty reinsurance agreement,
each and every insurance policy is split between the primary insurer and the
reinsurer according to the quota share percentage stated in the reinsurance
agreement.
Surplus Share
But, as we noted earlier, quota share is not the only type of proportional
reinsurance agreement; a surplus share agreement might be negotiated
instead.
In a surplus share agreement, the primary insurer retains a fixed amount of
the issued coverage. If the liability under the issued policy is less than the
dollar amount retained by the primary insurer, none of the coverage is ceded
to the reinsurer; conversely, if the liability under the issued policy is greater
than the dollar amount retained by the primary insurer, the excess is
reinsured. The premium for each policy reinsured is shared in the ratio ofthe retained liability to ceded liability. If the premium paid by the applicant
was $1,200 and the reinsurer was ceded $40,000 of a $100,000 policy, the
reinsurer would also receive a 40 percent share of the premium, or $480.
12
-
8/8/2019 Rajesh 100 Marks 6th Semester
13/92
PRINCIPLES & TYPES OF REINSURANCE
Looking back at the example of the amounts retained and the amounts ceded
under the quota share agreement, we can see the difference in a surplus share
agreement. Under a surplus share agreement that provides for the primary
insurers retention of the first $50,000 of coverage, the split would look like
the following:
Insurance
Amount
Amount Retained Amount
Ceded
$50,000
$150,000
$50,000
$50,000
$ 0
$100,000$500,000 $50,000 $450,000$1,000,000 $50,000 $950,000
As we can see, the basic difference between quota and surplus share is in
terms of the retention by the primary insurer. Under quota share, it is a fixed
percentage; under surplus share, it is a fixed amount.
So, we have seen that reinsurance may be proportional or non-proportional.
If it is proportional, it is either quota share or surplus share. But, what if it is
non-proportional?
Non-Proportional Reinsurance
Non-proportional reinsurance is also called excess of loss reinsurance. In
this type of reinsurance, the primary insurer, i.e. the ceding company, is
13
-
8/8/2019 Rajesh 100 Marks 6th Semester
14/92
PRINCIPLES & TYPES OF REINSURANCE
indemnified for the portion of a loss that exceeds the ceding companys net
retention. The primary difference between excess of loss reinsurance and
surplus share reinsurance, which it closely resembles, is the premium paid
by the primary company to the reinsurer. In the case of surplus share
reinsurance, the premium paid by the primary insurer to the reinsurer is
based on the proportionate share of the liability borne by each party. In
excess of loss reinsurance, the premium paid by the primary insurer to the
reinsurer bears no proportional relationship to the original premium paid by
the policyowner. Instead, it is a charge based on the potential for loss.
Excess of loss plans may cover policies on an individual basis, but they may
also apply to an occurrencean earthquake, for examplethat would allow
the ceding company to recover losses associated with a single catastrophic
event in excess of a particular amount. They may also be written to cover an
aggregate of losses that are incurred over a period of time. Although that
period is often a year, it may be a period of several years. These latter
reinsurance contracts are often referred to as stop-loss contracts.
14
-
8/8/2019 Rajesh 100 Marks 6th Semester
15/92
PRINCIPLES & TYPES OF REINSURANCE
Chapter Two
Types of Life and Property & Casualty Reinsurance
Proportional Reinsurance for Life Insurance Companies
We have looked at reinsurance in a general fashion and considered the
differences between treaty and facultative, proportional and non-
proportional and between quota share and surplus share. We will turn our
attention now to the application of these types of reinsurance to different
insurance industries, beginning with proportional reinsurance the life
insurance industry.
Proportional Reinsurance
Two basic approaches are taken to the providing of proportional reinsurance
in the life insurance industry:
The yearly renewable term insurance plan
and
The coinsurance plan
Yearly Renewable Term
In the case of proportional reinsurance provided under a yearly renewable
term insurance plan, the primary company purchases term life insurance
from the reinsurance company on a yearly renewable term insurance basis.
15
-
8/8/2019 Rajesh 100 Marks 6th Semester
16/92
PRINCIPLES & TYPES OF REINSURANCE
The amount of yearly renewable term life insurance purchased is equal to
the net amount at risk in the policy that is in excess of the primary life
insurance companys retention limit.
The net amount at risk in a life insurance policy is simply the amount
payable as a death benefit under the policy less the policys terminal reserve.
Although the reserve is technically defined as the difference between the
present value of future benefits (which increase with age) and the present
value of future net premiums (which decrease with age), resulting in a steady
increase in terminal reserve over the years, it approximates a life insurance
policys cash valueand that is sufficient for our purposes.
Net amount at risk
The net amount at risk is generally equal to the difference between the death
benefit of a life insurance policy and its cash value. To the extent that a life
insurance policys cash value increases over time while the death benefits
remain constant, the net amount at risk will decrease as the policy ages. The
net amount at risk is graphically illustrated below:
Death benefit
Cash value
Net amount atrisk16
-
8/8/2019 Rajesh 100 Marks 6th Semester
17/92
PRINCIPLES & TYPES OF REINSURANCE
To illustrate how the yearly renewable approach would work in the case in
which a primary life insurer has a retention limit of $500,000, lets suppose
that the insurers agent sells a whole life insurance policy for $1 million to a
35 year-old applicant. At the end of the first year, the terminal reserve is
about $8,800. The net amount at risk under this policy, according to our
definition, is the difference between the death benefit of $1 million and the
terminal reserve of $8,800. The net amount at risk, therefore, is $991,200.
($1,000,000 - $8,800 = $991,200)
Since the primary insurer purchases one year renewable term life insurance
from the reinsurer in an amount equal to the difference between its retention
limit and the net amount at risk, if greater, it will purchase term insurance
for $491,200 in the first year. ($991,200 - $500,000 = $491,200) What the
primary life insurer has done by purchasing the term insurance is simple; it
has transferred the risk of the insureds death, to the extent that the net
amount at risk exceeds its retention limit, to the reinsurer. Reinsurance often
Death benefit
Cash value
Net amount atrisk
17
-
8/8/2019 Rajesh 100 Marks 6th Semester
18/92
PRINCIPLES & TYPES OF REINSURANCE
remains in effect for many years, so the one year term insurance purchased
by the primary insurer must be renewed from year to year. Lets look at
what happens by year 8.
Since the policy is whole life insurance, it is characterized by a level death
benefit and a constantly increasing cash value that approximates the policys
terminal reserve. Because the policys terminal reserve has increased, the
net amount at risk has decreased commensurately. The policys terminal
reserve at the end of the 8th year would be $77,800, so the net amount at risk
has decreased to $922,200, and the amount of one year term life insurance
purchased from the reinsurer would be reduced to $422,200.
In the case of the yearly renewable term insurance plan of life reinsurance,
the primary insurer purchases liability-reducing coverage for a portion of the
death benefit only. As a result, the reinsurers obligations extend solely to
paying a part of the death benefit upon the insureds death. There are no
reinsurer obligations in the case of the yearly renewable term insurance plan
for any dividends, cash surrender values or nonforfeiture provisions. As we
will shortly see, this is a major difference between the yearly renewable term
insurance plan or reinsurance and the coinsurance plan.
The benefits of the yearly renewable term insurance plan to the primary
insurer are its:
Simplicity
Favorable impact on asset growth
and
18
-
8/8/2019 Rajesh 100 Marks 6th Semester
19/92
PRINCIPLES & TYPES OF REINSURANCE
Ability to choose a reinsurer that is unlicensed in the primary
insurers domiciliary state
Because the yearly renewable term insurance plan is characterized by greater
simplicity, it is considerably easier to administerand that translates into
administrative savings. The more important benefits of this life reinsurance
approach, however, are the remaining two: asset growth impact and
reinsurer choice.
By employing a yearly renewable term insurance plan as a method ofreinsuring, the primary insurer generally retains most of the policyowners
premiums, since it is purchasing the type of life insurance with the lowest
premium, i.e. yearly renewable term insurance. As a result, this reinsurance
arrangement has the smallest adverse impact on the primary insurers asset
growth. Although this characteristic may appeal to any primary insurer, it is
usually of greatest appeal to smaller primary life insurance companies.
A primary life insurance company may choose the yearly renewable term
insurance approach because of its desire to reinsure its risk with a reinsurer
that is not licensed in the primary insurers state of domicile. The reason for
the preference for yearly renewable term insurance rather than another
approach in this case is because the primary insurer cannot deduct the
reinsurers reserves held against the liability from its own reserves if the
reinsurer is not licensed in the primary insurers state. Since it cannot
deduct the reinsurers reserves from its own, it makes much more sense for
the primary insurer to opt for the yearly renewable term insurance approach
in which it holds all of the policy reserves anyway.
19
-
8/8/2019 Rajesh 100 Marks 6th Semester
20/92
PRINCIPLES & TYPES OF REINSURANCE
Coinsurance
The yearly renewable term insurance plan of reinsurance is quite simple and
straightforward. The parties to the reinsurance agreement need not have a
particularly close working arrangement. The second type of life insurance
reinsurance that we will examinethe coinsurance planis quite different
with respect to virtually all the characteristics of the first type.
In the first place, the coinsurance plan is significantly more complex than the
yearly renewable term approach, and that greater complexity arises
principally from the nature of the relationship between the two parties to the
reinsurance agreement. We noted earlier that the relationship between the
two parties to the yearly renewable term plan was a fairly arms-length
arrangement. In the coinsurance plan, the relationship is much closer since
the two insurersprimary and reinsureragree to provide all of the benefits
purchased by the policy owner jointly.
We noted that, in the yearly renewable term insurance plan, the reinsurer
was obligated only to provide its portion of the death benefits if the insured
died during the period of reinsurance. Other than that, the reinsurer has
virtually no obligation to the primary insurer. In the coinsurance plan, to the
contrary, the reinsurer is liable for its proportionate share of the policys:
Death benefits
Cash surrender value
20
-
8/8/2019 Rajesh 100 Marks 6th Semester
21/92
PRINCIPLES & TYPES OF REINSURANCE
Dividends, in the event the insurance is participating
and
Non forfeiture benefits
Clearly, the two insurance companies are bound much closer in the
coinsurance plan of reinsurance than they are in the yearly renewable term
insurance plan. That greater proximity comes at a price.
You will recall that one of the advantages to the primary insurer of the
yearly renewable term plan was its ability to retain the lions share of the premium, and that translated into faster asset growth. In that case, the
reinsurer received a relatively small portion of the total policy premium.
The reinsurers portion of the premium in the coinsurance plan is much
greater.
Lets return to our earlier example of the 35 year-old applicant that
purchased a $1 million whole life insurance policy from the primary insurer
whose retention limit was $500,000. Of the approximately $15,000 annual
premium for the policy, the reinsurer may have received $500 or so in the
first year of the agreement; the primary insurer kept the balance. If the
reinsurance agreement in effect called for coinsurance of 50 percent, the
reinsurer would have received one-half of the total premium, or $7,500.
From a death benefit perspective, the result between the two arrangements
would have been identical.
The remitting of one-half of the total premium to the reinsurer is, however,
not the whole financial story. In the case of the coinsurance plan, the
21
-
8/8/2019 Rajesh 100 Marks 6th Semester
22/92
PRINCIPLES & TYPES OF REINSURANCE
reinsurer pays the primary insurer a commission, known as a ceding
commission that reimburses the primary insurer for the costs incurred by
the company in putting the business on its books. As we will discuss when
we examine the uses of reinsurance, this ceding commission is vital for
many small companies with substantial growth rates and relatively small
surplus positions who may want to use reinsurance to finance their growth.
The ceding commission that is paid by the reinsurer is designed to include:
An allowance for the commissions paid by the primary insurer to itsagent
The premium taxes paid by the primary insurer
and
A part of the primary insurers overhead expenses
The ceding commission is negotiated between the primary insurer and the
reinsurance company and is often greater than the first year premium that is
cededalong with the liabilityto the reinsurer. This approach is
consistent with the primary insurers new business acquisition cash flow in
which the life insurance companys first year costs to acquire new life
insurance business may exceed its first year premium by 50 percent or more.
In more concrete terms, a primary insurer may pay out in first year
commissions, overrides, expense allowances and other acquisition costs a
total of $1,500 to put a life insurance policy with a $1,000 annual premium
on its books. That additional $500 by which the expenses exceed the
22
-
8/8/2019 Rajesh 100 Marks 6th Semester
23/92
PRINCIPLES & TYPES OF REINSURANCE
revenue must generally come from the primary insurers surplus. So, a life
insurance company with limited surplus may look forward to reinsuring
much of its new business as a way of replacing that lost surplus.
As we noted, in addition to this commission arrangement, the coinsurance
plan requires much more from the reinsurer. If the life insurance policy that
was reinsured is a participating policy, the reinsurer must be ready to pay
dividends as declared by the primary insurer. Since participating policy
dividends generally reflect the experience of the company paying the
dividends, and since the primary company and the reinsurance company may
have vastly different experience, this arrangement can cause significant
concerns for the reinsurer.
Assume, for example, that the reinsurers net investment earnings are less
than those of the primary insurer. In such a case, the reinsurers dividend
scale would be lower than the primary companys scale, and yet the
reinsurer must pay dividends according to that higher scale.
Although participating policy dividends tend to be affected more
significantly by investment earnings than by mortality experience, mortality
is still a factor in any companys dividend declaration. However, if the
reinsurers mortality experience is less favorable than that of the primary
company, the reinsurers normal dividend scale will be even further out of
step with the dividend scale of the primary insurer.
To make matters more complicated for the reinsurer, the mortality results
experienced on life insurance business that is reinsured are generally poorer
23
-
8/8/2019 Rajesh 100 Marks 6th Semester
24/92
PRINCIPLES & TYPES OF REINSURANCE
than the mortality experience on business that is written directly and fully
retained. Conventional wisdom suggests that the underwriting standards of
smaller companies that rely most heavily on reinsurance may be somewhat
more liberal than the standards of companies with higher retention limits.
Despite these complications in the relationships between primary insurers
and their reinsurers, there is generally little reason for concern; the
reinsurers actuaries have considered all of the issues in their determining of
the amount of ceding commissions paid to the primary insurer, so that the
differences in dividend scales generally create little difficulty for the
reinsurer.
In addition to dividends, the reinsurer, in the case of coinsurance, is liable
for a part of the policys surrender value if it is surrendered for its cash
value. Alternatively, a terminated policy may be placed under one of the
non forfeiture provisions, such as reduced paid-up or extended term
insurance. If either of those conditions apply, the reinsurer continues to be
liable for its proportionate share of those benefits as well.
Modified Coinsurance
It is possible that for any particular primary insurer, neither the coinsurance
plan nor one year renewable term insurance plan fits particularly well. As a
result of this, reinsurers have developed a reinsurance arrangement known as
modified coinsurance.
24
-
8/8/2019 Rajesh 100 Marks 6th Semester
25/92
PRINCIPLES & TYPES OF REINSURANCE
The benefit to the primary life insurer derived from yearly renewable term
reinsurance, when compared to coinsurance, is that the primary insurer is
able to retain much more of the policy premium. Since retaining a greater
amount of the premium helps the company grow its assets more quickly,
many companies prefer this particular feature. The disadvantage of yearly
renewable term insurance to the primary insurer is that it is responsible for
paying all of its acquisition costs. Because of its payment of these
acquisition costs that often exceed the first year premium, new business
drains the primary insurers surplus and limits its ability to write additional
new life insurance business. So, the yearly renewable term approach has
both important advantages and significant disadvantages.
The coinsurance plan approach to reinsurance resulted in the reinsurers
paying a large portion of the primary insurers acquisition costs through its
payment of a ceding commission. While this commission has a favorable
impact on the primary insurers surplus position, the coinsurance plan also
has certain disadvantages: the primary insurer must pay a portion of each
annual premiumpossibly a substantial portionto the reinsurer. As we
noted, this arrangement helps surplus but negatively affects asset growth.
Primary insurersparticularly those that are most sensitive to the surplus
and asset issuesview the reinsurers accumulation of substantial premium
funds as an unnecessary and undesirable feature of reinsurance. Because of
this concern, an approach to reinsurance was developed that enables the
primary insurer to retain the entire reserve of the reinsured policy. This third
approach is known as the modified coinsurance plan.
25
-
8/8/2019 Rajesh 100 Marks 6th Semester
26/92
PRINCIPLES & TYPES OF REINSURANCE
Under the modified coinsurance plan, the primary insurer pays the
reinsurance company a pro rata portion of the premium for the reinsured
policysimilar to the coinsurance plan. The premium payment made to the
reinsurer is netted by the amount of the ceding commissions that would have
been paid to the primary insurer.
The big difference in the modified coinsurance plan is that at the end of each
policy year the reinsurer pays to the primary insurer an amount that is equal
to the net increase in the policy reserve that year. Although the actual
reserve increase payment calculation is somewhat more complicated than
suggested, this is what occurs.
Under this modified coinsurance arrangement, as a result of this annual
payment back to the primary insurer, the reinsurance company never holds
more of the premium than the amount equal to the gross premium on the
death benefit reinsured for a single year. In simpler terms, the reinsurer has
not been permitted to accumulate significant premium funds.
As we can see, this modified coinsurance plan answers the critics of both the
yearly renewable term plan and the coinsurance plan. By reducing the
amount of premium held by the reinsurer, it helps the primary insurer to
grow its assets more quickly. Furthermore, the recouping of much of the
primary insurers acquisition cost from the reinsurer helps the primary
insurer to maintain a more favorable surplus position. In many respects, the
modified coinsurance plan of reinsurance is the best of both worlds.
26
-
8/8/2019 Rajesh 100 Marks 6th Semester
27/92
PRINCIPLES & TYPES OF REINSURANCE
Reinsurance for Property & Casualty Insurance Companies
The types of reinsurance we examined thus faryearly renewable term,
coinsurance and modified coinsuranceare all proportional reinsurance
types used in the life insurance industry. The same proportional reinsurance,
however, is used in the property and casualty industry. Lets turn our
attention now to how this proportional reinsurance functions in property and
casualty insurance.
The idea behind reinsurance is, of course, identical in the life insurance and
property & casualty industries: a spreading of the risk among two or more
insurance carriers. The language and operation of the reinsurance, however,
are different. Reinsurance in the property & casualty industry tends to be
somewhat less complicated than the reinsurance that we have already
examined.
We noted that there are two basic types of proportional reinsurance plans in
the life insurance industry: yearly renewable term and coinsurance. There
are also two types of proportional reinsurance plans in the property &
casualty insurance industry. These proportional reinsurance plans are called:
Quota share
and
Surplus share
27
-
8/8/2019 Rajesh 100 Marks 6th Semester
28/92
PRINCIPLES & TYPES OF REINSURANCE
Quota Share
Under a quota share agreement, the primary insurer cedes a fixed percentage
of each policy it issues in a particular line or class of business.
In a quota share reinsurance arrangement, a primary insurer might agree to
reinsure 70 percent of every policy that it issues and retain the remaining 30
percent. Just as we noted in the coinsurance arrangement in the life
insurance industry, the reinsurer pays a ceding commission to the primary
insurer.
Once the percentage to be ceded has been agreed upon, the premium and
loss division that occurs after that is completely automatic. In the 70 percent
quota share arrangement, the primary insurer retains 30 percent of the
premium and liability, and 70 percent of the premium and liability is
assumed by the reinsurer. The arrangement is quite simple and
uncomplicated and applies to all policies issued by the primary insurer in the
class of policies reinsured, regardless of the policy size.
28
-
8/8/2019 Rajesh 100 Marks 6th Semester
29/92
PRINCIPLES & TYPES OF REINSURANCE
Example -Quota share reinsurance arrangement
A quota share reinsurance arrangement would produce the following
revenue and claims liability for the primary insurer and the reinsurer,
assuming the limit of the policy in question is $100,000:
Insurance policy limit $100,000
Primary insurance company retention 30%
Primary insurers coverage share
Reinsurers coverage share
Total insurance coverage
30,000
70,000
100,000
Total annual policy premium $1,200
Primary insurers premium shareReinsurers premium share
Total insurance premium
360840
1,200
Hypothetical claim $75,000
Primary insurers claim share
Reinsurers claim shareTotal claim
22,500
52,50075,000
29
-
8/8/2019 Rajesh 100 Marks 6th Semester
30/92
PRINCIPLES & TYPES OF REINSURANCE
Surplus Share
The other property & casualty proportional reinsurance arrangement is
known as surplus share. The surplus share approach to reinsurance has
some resemblance to the coinsurance method that is used in the life
insurance industry.
In a surplus share arrangement, the primary insurer retains astated amount,
rather than a stated percentage as in the quota share method. Under this
agreement, the reinsurer does not become involved in any particular risk
until the policy limits exceed the primary insurers retention limit.
However, once the amount of reinsurance is determinedby the amount that
the policy provides in excess of the primary insurers retentionthe
premium is shared in the same proportion. So, if the coverage is shared on a
50%-50% basis between the primary insurer and the reinsurer, each receives
one-half of the premiums. It is entirely possible that the reinsurance
outcomein terms of liability and premiumscould be the same under a
quota share and surplus share reinsurance approach.
Example -Surplus share reinsurance arrangement
30
-
8/8/2019 Rajesh 100 Marks 6th Semester
31/92
PRINCIPLES & TYPES OF REINSURANCE
A surplus share reinsurance arrangement would produce the following
revenue and claims liability for the primary insurer and the reinsurer,
assuming the limit of the policy in question is $100,000:
Insurance policy limit $100,000
Primary insurance company retention $30,000
Primary insurers coverage share
Reinsurers coverage shareTotal insurance coverage
30,000
70,000100,000
Total annual policy premium $1,200
Primary insurers premium share
Reinsurers premium share
Total insurance premium
360
840
1,200
Hypothetical claim $75,000
Primary insurers claim share
Reinsurers claim share
Total claim
22,500
52,500
75,000
To summarize the proportional approach to reinsurance in the property &
casualty industry, the difference between the surplus share and quota share
arrangements is only in terms of how the primary insurers retention is
stated. In the case of quota share, it is stated as a percentage of every policy,
31
-
8/8/2019 Rajesh 100 Marks 6th Semester
32/92
PRINCIPLES & TYPES OF REINSURANCE
regardless of its size; in the case of surplus share, it is stated as a dollar
amount.
As a result of this difference in approach, the percentage of liability assumed
by the reinsurer under quota share is the same irrespective of the policy size.
However, under a surplus share arrangement, the reinsurers liability
percentage increases as any policys limits increase in excess of the primary
insurers retention limit.
Individual
We noted at the outset of our discussion of reinsurance that it may be either
proportional or non-proportional. Thus far, we have examined only the
proportional type. Lets turn our attention, now, to this second type: non-
proportional reinsurance. We will begin with its application in the property
& casualty industry.
When we talk about non-proportional reinsurance in the property & casualty
industry, we really mean coverage better known as excess of loss
reinsurance. This reinsurance coverage is so-called because it protects the
primary insurer against losses in excess of a particular deductible. In this
case, the ceding company is indemnified for any losses that exceed a
specified amount that is the primary insurers retention.
Similar to yearly renewable term reinsurance in the life insurance industry,
the premium paid for excess of loss reinsurance by the primary insurer bears
no proportional relationship to the policyowners premium. Rather, the
32
-
8/8/2019 Rajesh 100 Marks 6th Semester
33/92
PRINCIPLES & TYPES OF REINSURANCE
reinsurance premium is based solely on the likelihood of loss. In a sense,
the primary insurer is purchasing coverage, like renewable term insurance,
from the reinsurance company.
There are three forms that excess of loss reinsurance takes in the property &
casualty industry:
1. Individual
2. Occurrence
and
3. Aggregate
Lets examine each of these approaches.
Individual
In the case of individual excess of loss reinsurance coverage, the reinsurer
pays any claim on an individual policy to the extent it exceeds the retention
limit of the primary insurer. For example, if the primary insurers retention
limit is $25,000 and an individual claim is received for $30,000, the $5,000
excess amount would be paid by the reinsurer.
Occurrence
33
-
8/8/2019 Rajesh 100 Marks 6th Semester
34/92
PRINCIPLES & TYPES OF REINSURANCE
The occurrence approach to excess of loss reinsurance coverage is equally
straightforward. In that case, a loss resulting from a catastrophic eventan
earthquake, tornado or hurricane, for examplethat exceeds an agreed-upon
total is paid by the reinsurer. The primary insurer may feel that its financial
status would not be severely affected until and unless it was required to pay
losses for a specific event exceeding $10 million. So, it would establish
occurrence reinsurance for any amount over the $10 million.
Aggregate
Aggregate reinsurance simply provides protection for a primary insurer
against any losses that exceed a specified amount over a period of time or
for a particular policy. This type of reinsurance is also called:
Stop-loss coverage
and
Excess of loss ratio reinsurance
The aggregate reinsurance coverage limits a primary insurers liability to a
specified amount under a particular policy or for a specified period. The
period is usually one year, but it may be several years, depending on the
needs of the primary insurer and the reinsurance agreement. It is not
unusual for this type of coverage to reinsure losses that exceed $100 million
in a calendar year.
34
-
8/8/2019 Rajesh 100 Marks 6th Semester
35/92
PRINCIPLES & TYPES OF REINSURANCE
We can represent the relationship of these coverages graphically as shown
below:
Excess of loss reinsurance
Excess of Loss
Non-proportional coverage for losses in excess of primary insurers retention
Individual
Coverage on an
individual policy
basis
Occurrence
Coverage for an
occurrence, such as
an earthquake
Aggregate
Coverage for
losses in excess of
a total amount, or
per policy, or per
year
Layering
The insurance industry is creative in its use of reinsurance to enable
companies to meet customer requirements. An example of that creativity
can be seen in the use of various reinsurance agreements to produce a
layering effect.
A customer that needs $20 million of coverage may apply for it from a
primary insurer that chooses to limit its own exposure to $50,000. Clearly,
35
-
8/8/2019 Rajesh 100 Marks 6th Semester
36/92
PRINCIPLES & TYPES OF REINSURANCE
in such a case there is a substantial need for large amounts of reinsurance.
Often, the reinsurance needed exceeds even the reinsurers limits, so
multiple reinsurers are enlisted to provide coverage. In the example shown
below, two automatic reinsurance arrangements apply in the case of
reinsurers 1 and 2.
Layering of reinsurance coverage
Primary
Insurer
Reinsurer
1
Reinsurer
2
Reinsurer
3
$20,000,
000
$15,000,000
Facultative
reinsurance
(excess of
loss)
$5,000,0
00
$4,500,000
Treatyreinsurance
(excess of
loss)
$500,00
0 Treaty
reinsurance
(surplus
share)
$50,000
Primary
insurer
36
-
8/8/2019 Rajesh 100 Marks 6th Semester
37/92
PRINCIPLES & TYPES OF REINSURANCE
retention
limit
Primary
insurerexposed to
$50,000
limit under
retention
schedule
Reinsurer 1
exposed torisk of
$450,000
after first
$50,000
assumed by
primary
insurer
Reinsurer 2
has $4.5million
exposure
after first
$500,000 of
loss
Reinsurer 3
has $15million
exposure
after first $5
million of
loss
As we can see in the example above, the primary insurer has several
reinsurance arrangements. It has a surplus share agreement with Reinsurer 1
under which all business above its $50,000 retention limit is reinsured.
However, since Reinsurer 1s limit is only $500,000, additional reinsurersare needed. In this case, two additional reinsurers are pressed into service.
Reinsurer 2 has a limit of $5 million, so that a third reinsurer is needed to
cover the entire liability up to the $20 million that is needed by the
customer.
Layering like this is not uncommon in the property & casualty industry,
especially among insurers that provide very large coverage for their
customers. While the illustrated coverage is, of course, hypothetical, such
arrangements are not particularly rare.
37
-
8/8/2019 Rajesh 100 Marks 6th Semester
38/92
PRINCIPLES & TYPES OF REINSURANCE
Non-Proportional Reinsurance for Life Insurance Companies
Unlike the property & casualty industry, in which much of the reinsurance is
non-proportional, reinsurance in the life insurance industry has traditionally
been accomplished on the proportional basis that we examined initially.
However, in the recent past, increasing interest has been shown in a
reinsurance approach in which the life insurance reinsurers liability is
related to the primary insurers mortality experience on all of its book of
business instead of on an individual policy.
This kind of non-proportional arrangement is used widely in the property &
casualty business. In the life insurance business, non-proportional
reinsurance may be:
Stop loss reinsurance
Catastrophic reinsurance
or
Spread loss reinsurance
Stop Loss Reinsurance
Stop loss reinsurance is used in the life insurance industry principally as a
supplement to proportional reinsurance. It is designed to ensure that the
primary insurer is not placed in financial jeopardy due to abnormally-high
38
-
8/8/2019 Rajesh 100 Marks 6th Semester
39/92
PRINCIPLES & TYPES OF REINSURANCE
mortality in a prescribed period. That period is usually one calendar year.
Typical stop loss reinsurance arrangements provide that the reinsurer must
reimburse the primary insurer to the extent that claims exceed 10 percent of
its normal mortality.
Reimbursement payments from the reinsurer may be equal to 100 percent of
the amount in excess of the primary insurers limit or may only be a portion
of the excess. In order to ensure that the primary insurer has a vested
financial interest in properly underwriting even reinsured business,
reinsurers are tending to reimburse only a portion of the excess mortality.
The result is that the primary insurers are likely to underwrite these risks
more carefully.
The stop loss reinsurance arrangement is a very flexible one. The reinsurer
may agree to cover:
selected portions of the primary insurers book of business
varying levels of mortality
or
periods of varying duration
The appeal of stop loss reinsurance to primary insurers is its providing of
protection against unexpected swings in mortality. These swings might arise
out of an unexpectedly large number of small claims of an increase in the
individual claims average size. Regardless of the cause, these swings can
39
-
8/8/2019 Rajesh 100 Marks 6th Semester
40/92
PRINCIPLES & TYPES OF REINSURANCE
wreak havoc on a companys financial results, especially in smaller
companies.
Another advantage of stop loss reinsurance is its relatively low cost.
Primary insurers may choose to reduce their total reinsurance outlay by
increasing their retention limits under proportional agreements and
reinsuring any retained amounts under stop loss agreements. Its final appeal
lies in the fact that, because it is so uncomplicated, it is easy and inexpensive
to administer.
Catastrophe Reinsurance
Catastrophe reinsurance is the second type of non-proportional reinsurance
employed in the life insurance industry. Catastrophe reinsurance generally
calls for the reinsurer to reimburse a fixed percentage of the primary
insurers:
aggregate losses
in excess of the primary insurers conventional
reinsurance
which exceed a prescribed limit
and
which result from a single catastrophic event
40
-
8/8/2019 Rajesh 100 Marks 6th Semester
41/92
PRINCIPLES & TYPES OF REINSURANCE
The reinsurance agreement normally requires the reinsurer to reimburse 90
percent to 100 percent of these excess aggregate losses.
The limit of coverage may be expressed in an aggregate dollar amount or in
terms of the number of lives lost. It normally covers a one-year period and
limits the reinsurance companys liability to that prescribed period.
Catastrophe reinsurance is a prime example of coverage that is designed to
protect the primary insurer from a risk that has very low probability of
occurring but, if it does occur, it has an enormous liability attached to it. For
example, although the likelihood of another San Francisco earthquake is
fairly small, an insurers resulting liability could be astronomical.
Spread Loss
Spread loss is the final type of non-proportional reinsurance used in the life
insurance industry that we will consider. Although reinsurance tends to be
somewhat complicated, especially when it is being put to creative use,
spread loss reinsurance is probably the least complicated. This reinsurance
coverage has a single function: to spread an abnormally large loss incurred
in a single year over several years.
Spread loss reinsurance typically works as follows. In any calendar year in
which the primary insurers aggregate death claims exceed a specified
amount, the reinsurer steps in and assumes the claim payment liability.
Having paid these excess claims, the reinsurer adjusts the reinsurance
41
-
8/8/2019 Rajesh 100 Marks 6th Semester
42/92
PRINCIPLES & TYPES OF REINSURANCE
premium so that the amount of claims paid in that year plus 20 percent is
collected from the primary insurer over the ensuing five years. The net
result has been to spread these abnormally high claims over several years.
We can summarize these three types of non-proportional reinsurance as
shown in the graphic representation below:
Non-proportional reinsurance
Non-proportional reinsurance used in the life insurance industry generally
assumes three forms: stop-loss, catastrophe and spread loss.
Life Insurance Non-Proportional Reinsurance
Stop Loss
Supplemental
Losses exceeding
normal mortality
Catastrophe
Stop loss for
accidental death
Extraordinary
losses fromsingle cause, e.g.
a plane crash
Spread Loss
Spreads
large one year
losses over a
longer period
42
-
8/8/2019 Rajesh 100 Marks 6th Semester
43/92
PRINCIPLES & TYPES OF REINSURANCE
Chapter Three
Purposes of Reinsurance
Why Insurers Choose to Reinsure
To this point we have considered how the various types of reinsurance
arrangements operate to meet the objectives of primary insurers, both life
insurance and property & casualty insurance companies. What we havent
yet done is considerwhy an insurer would choose to reinsure, other than for
the obvious reason of risk reduction.
As we continue our examination of reinsurance, we will see that reinsurance
is generally used by a primary insurer for one of two reasons:
To transfer to another company some or all of a
primary insurers liabilities; or
To accomplish one or more broad managerial
objectives
When reinsurance is used for the first purpose, it is generally referred to as
portfolio or assumption reinsurance; when used for the second purpose, it is
called indemnity reinsurance.
43
-
8/8/2019 Rajesh 100 Marks 6th Semester
44/92
PRINCIPLES & TYPES OF REINSURANCE
Assumption Reinsurance
Through assumption reinsurance, a primary insurer transfers some or all of
its liabilities to a reinsurer. This type of reinsurance is always tailored to the
particular requirements of the situation and its parties. For that reason,
assumption reinsurance does not lend itself to broad generalizations.
However, it is a fairly simple matter to identify several uses to which
assumption reinsurance has been put.
The traditional uses of assumption reinsurance include:
Assisting insurance companies during a period of financial
distress
Financing mergers between and acquisitions of insurance
companies
and
Facilitating restructuring
A traditional method of bailing out troubled insurers has been through the
use of assumption reinsurance. A number of life insurance companies have
found themselves forced to liquidate because they encountered severe
financial problems, including such companies as:
Executive Life
Confederation Life
and
44
-
8/8/2019 Rajesh 100 Marks 6th Semester
45/92
PRINCIPLES & TYPES OF REINSURANCE
Mutual Benefit Life
In each of these cases, it mighthave been possible for the insurer to avoid
liquidation by reinsuring, if a reinsurance company was willing to assume
the risks involved.
It is not unusual in cases like these for two companies to implement a plan
whereby a solvent insurer will agree to assume the liabilities of the
distressed company. Not unexpectedly, the white knight will also gain
something in the transaction. In return for assuming the distressed insurersliabilities, the reinsurer will generally obtain the assets underlying the
liabilities as well as the right to receive future premiums under the policies.
Sometimes, of course, the assets are insufficient to offset the liabilities. In
fact, this is a fairly likely scenario in a financially failing insurer. In such a
case, the reinsurer will normally place a lien against the cash values of the
ceded policies until the deficiency can be liquidated through the companys
earnings on the policies. When a lien is placed on the failing insurers
policies, policyowners are restricted in their access to cash in their policies
a situation that Executive Life policyowners encountered.
Many other dynamics are occurring in the life insurance industry that call for
the likely use of assumption reinsurance. Some of those changes are:
Demutualization
Mutual holding company formation
45
-
8/8/2019 Rajesh 100 Marks 6th Semester
46/92
PRINCIPLES & TYPES OF REINSURANCE
and
Mergers and acquisitions
Insurance companies face significant challenges. Among those challenges
are the enormous costs involved in maintaining cutting-edge technology and
sustaining new product development initiatives. As insurers address the
important issues of identifying and returning to core competencies and
establishing critical mass levels, many of them have identified their ability to
raise capital as essential to their survival.
At one time, most of the insurance giants were mutual companies, owned by
and operated for the benefit of their policyowners. They had no
stockholders and were largely unable to raise capital. Because of that
inability, many of those companies considered demutualizing, forming
mutual holding companies, entering into strategic alliances and merging
with or acquiring other companies. Each of these alternatives that are
designed to help insurers raise capital involves a change in organizational
structure.
When insurers restructure, they often employ reinsurance to enable them to
cede business that isnt core to their business strategy. For example, an
acquiring company will often cede much of the business of an acquired
insurer in order to divest itself of less profitable policies. Additionally,
restructuring insurers will often attempt to carve out mortality risks during
the demutualization process or during the formation of a mutual holding
company.
46
-
8/8/2019 Rajesh 100 Marks 6th Semester
47/92
PRINCIPLES & TYPES OF REINSURANCE
Sometimes, when mergers and acquisitions are being contemplated,
reinsurers may be asked to assume a portion of the transaction in order to
provide a certain amount of financing. Depending on the cost to borrow
money, financing through reinsurers may be less expensive.
Assumption reinsurance may involve only a portion of a ceding companys
book of business. A prime example of that can be found in the home service
side of the life insurance business. Some of the largest life insurers in the
United States were initially in the home servicealso known as the debit
business, a business involving the sale of relatively small policies by an
agent who operates within an assigned geographical area selling and
servicing policies. While these companies may owe their current stature to
this type of business, many companies are leaving the debit business in
pursuit of more upscale clientele capable of purchasing larger policies. In so
doing, they may choose to identify such business as marginally profitable
and cede all of itthrough assumption reinsuranceto another company.
In other situations, assumption reinsurance may be employed to enable an
insurer to withdraw from a particular state or region. Rather than being
required to continue to service insurance contracts in areas from which it had
withdrawn, an insurer may choose to cede the business to another insurer
that has continued to operate in the area. In such a case, everybodys
interestthe policyowners, the ceding insurers and the reinsurersis
usually served through the reinsuring of this business.
47
-
8/8/2019 Rajesh 100 Marks 6th Semester
48/92
PRINCIPLES & TYPES OF REINSURANCE
As we can readily see, assumption reinsurance must be individually
designed for each situation in order that the primary reinsurers objective can
be met.
Indemnity Reinsurance
Indemnity reinsurance is generally used by a primary insurer to transfer its
liability with respect to individual policies to its reinsurer. The transfer of
liability may involve all of the primary insurers liability under the life
insurance policy, or it may be a transfer of only a portion of it.
The use of indemnity reinsurance is widespread, and a primary insurer may
choose to use it for many reasons. Among the primary reasons for the use of
indemnity reinsurance are:
Limiting the amount of insurance held on a single life
Stabilizing the primary insurers mortality experience
Reducing the insurers drain on surplus
Gaining access to the reinsurers product development and
underwriting expertise
and
Transferring liability under substandard insurance contracts
Of all the important reasons given for the use of indemnity reinsurance, its
most prevalent use is to enable the primary insurer to avoid too heavy a
48
-
8/8/2019 Rajesh 100 Marks 6th Semester
49/92
PRINCIPLES & TYPES OF REINSURANCE
concentration of risk on the life of a single policyowner. Almost all
companies choose to limit the amount of life insurance that they will retain
on the life of a policyowner. The amount limit is generally referred to as the
insurers retention limit. Although the actual amount may differ from
insurer to insurer, life insurance companies generally limit their retention to
no more than 1 percent of capital and surplus. It should come as no surprise,
therefore, that insurers with larger assets will generally have greater net
retention limits.
In addition to the amount of surplus that impacts an insurers retention level,
it will also be affected by the amount of insurance that the company has in
force and managements confidence level in the companys underwriting
ability. As a result of these considerations, a companys retention limit may
be as low as $10,000 for a small, relatively young company to $30 million or
more for one of the giants.
Insurance companies may also have retention limits that differ based on
several factors. Some of the factors that might affect a companys retention
for a particular risk are:
The life insurance productwhether term insurance or
permanent insurance is being applied for
The proposed insureds age
and
The proposed insureds underwriting classification
49
-
8/8/2019 Rajesh 100 Marks 6th Semester
50/92
PRINCIPLES & TYPES OF REINSURANCE
Normally, those products that entail a higher degree of mortality risk, such
as term life insurance or insurance that is issued on a rated or substandard
basis, will have lower retention limits that apply. Additionally, many
companies will retain lower amounts for very young and very old insureds.
There is little question but that it is generally in an insurers interest to retain
as much of its business as it can prudently manage. As a result of that
general principle, insurers usually increase their retention limits as their
book of in-force business increases and their surplus funds grow.
In addition to limiting an insurers exposure to significant liability on a
single life, indemnity reinsurance is often used to stabilize the insurers
mortality experience. Typically, insurers will use stop-loss, catastrophe and
spread-loss arrangements to reduce their exposure to unwanted risk
concentrations as a means of stabilizing experience. It is these first two uses
of reinsurance that are most obvious. However, there are other reasons for
reinsurance that may be equally as important but far less obvious: surplus
management and reinsurer expertise.
Surplus in a life insurance company can be equated to retained earnings in
any other corporation. And, it is through its retained earnings that most
companies fuel their growth. Surplus serves the same purpose in a life
insurance company.
Surplus and the management of surplus are important issues in all life
insurance companies. In the small and medium size life insurance company,
it is critical. The reasons for that importance are:
50
-
8/8/2019 Rajesh 100 Marks 6th Semester
51/92
-
8/8/2019 Rajesh 100 Marks 6th Semester
52/92
PRINCIPLES & TYPES OF REINSURANCE
Although gain from operations is the principal source of surplus for
insurance companies, a second source of surplus comes from traditional
capital markets. In other words, insurance companies that are organized as
stock companies can issue stock.
Since generating surplus through the issuing of stock is an alternative
available only to insurance companies that are organized as stock
companies, mutual companies are at a significant disadvantage. Over the
last decade, this mutual company disadvantage has led many of the largest
mutual life insurance companies to elect to change their organizational
structure from a mutual company to a stock company; in other words, to
demutualize.
It is easy to see the beneficial results of demutualization in terms of surplus
creation by looking at the first financially healthy mutual insurance company
to demutualize in the United States. In 1986, a company then known as
Union Mutual changed its organizational structure to a stock company and
raised $580 million in its initial public offering of stock. It also doubled its
surplus.
We have looked at gain from operations and demutualization as ways in
which surplus can be created for an insurer, and we have left a major source
of surplus to the last: reinsurance. Reinsurance can serve as a major capital
source in the insurance industry. In a certain sense, a primary insurer that
purchases reinsurance can be seen as borrowing the reinsurers capital.
52
-
8/8/2019 Rajesh 100 Marks 6th Semester
53/92
PRINCIPLES & TYPES OF REINSURANCE
When the use of proportional reinsurance was examined in the life insurance
industry, we considered two major forms: coinsurance and modified
coinsurance. In both cases, a reinsurer paid the primary insurer a ceding
commission based on the amount of reinsured life insurance. That ceding
commission included an allowance for:
Commissions paid by the primary insurer to its agent
Premium taxes and
A portion of the primary insurers overhead expenses
The reinsurer, by paying the primary insurer a ceding commission that may
be greater than an annual premium is, in fact, financing the primary insurers
ability to put additional business on its books. Through its commission
payment, the reinsurer is reducing the primary insurers surplus drain that
was caused by the writing of new insurance business.
Although the financial aspect of reinsurance is critical to many primary
insurers, it isnt only the financial aspect of reinsurance that plays an
important role. Another important reinsurance use concerns the primary
insurers borrowing of the reinsurers expertise. This reinsurer expertise is
often used by primary insurers in two areas:
Entering new lines of business
and
Underwriting substandard risks
53
-
8/8/2019 Rajesh 100 Marks 6th Semester
54/92
PRINCIPLES & TYPES OF REINSURANCE
Lets briefly consider each of these uses.
Entering New Lines of Business
It shouldnt be surprising that when a primary insurernormally a
particularly conservative organizationdecides to add to its product line
there is a felt need to tap into available experience. That experience often
comes from reinsurers.
Consider, for example, the movement of a number of smaller life insurance
companies in the late 1970s and early 1980s to enter or expand their
marketing efforts in the disability income insurance line of business. While
offering what appeared to be a substantial source of profit, disability
coverageat least in terms of its new forms and cutting edge featureswas
new ground and needed to be developed and marketed cautiously.
A concern shared by many of these companies was that a noncancellable,
guaranteed renewable disability income policy with an own occupation
definition of disability could result in many millions of dollars in claims
over its life. For that reason, they turned to reinsurers that had a wealth of
54
-
8/8/2019 Rajesh 100 Marks 6th Semester
55/92
PRINCIPLES & TYPES OF REINSURANCE
accumulated disability income knowledge and experience in underwriting
disability income insurance.
Through the efforts of these reinsurers, many smaller life insurance
companies successfully entered the disability income business at a level that
would enable them to compete with other primary insurers having far greater
disability underwriting experience. Although many of these primary
insurers have since returned to marketing only their core life insurance
products and have sold their book of disability business to other companies,
they were able to enter the disability business only because of these
reinsurance companies.
Underwriting Impaired Risks
Another area in which primary insurers use the expertise of reinsurance
companies to significant advantage is in the area of impaired risks. Many of
these impairments are seen by underwriters on such an infrequent basis that
even the largest primary insurers have little experience in underwriting them.
Not unexpectedly, an underwriter faced with an impairment that may be
encountered once or twice in an entire career is justifiably concerned about
his or her ability to properly underwrite the risk.
In such a case, underwriters for primary insurers are likely to look for a
reinsurer that possesses the needed expertise. This type of knowledgehow
best to select impaired risksis a special service that reinsurers offer to their
primary insurer customers.
55
-
8/8/2019 Rajesh 100 Marks 6th Semester
56/92
PRINCIPLES & TYPES OF REINSURANCE
Even though a particular impairment may be fairly common, primary insurer
underwriters will typically submit the risk to one or more reinsurers with
whom they have agreements. While they may want to solicit the best offer
from the reinsurer, primary insurers also have another objective in sending
the case to several reinsurance companies: it demonstrates to the soliciting
agent that everything has been done to ensure that his or her client has
received the most favorable underwriting decision.
Sometimes a primary insurer will want to transfer all of its substandard
policies to a reinsurer. This type of transfer occurs most frequently in those
situations in which a primary insurer writes no substandard business on any
basis. However, in order to provide a more complete range of products and
services to its agents, the primary insurer may arrange to channel all of its
substandard risk applications to a reinsurer with both the interest in writing
the business and an expertise in doing so.
As an alternative to the complete transfer of all substandard risks to a
reinsurer, a primary insurer may elect to transfer only those substandard
risks that represent a particular multiple of standard mortality or morbidity.
For example, a primary insurer might want to reinsure any application for
life insurance in which the proposed insured falls into a mortality class that
is 150 percent or more than standard mortality.
At this point, it should be clear that the uses of reinsurance are far broader
than the simple risk spreading would seem to suggest. As we have seen, it is
often used to attain management objectives that have little to do with
underwriting any particular risk.
56
-
8/8/2019 Rajesh 100 Marks 6th Semester
57/92
PRINCIPLES & TYPES OF REINSURANCE
Chapter Four
Reinsurance Agreements
Reinsurance Agreements
Since primary insurers may reinsurer their business to achieve a wide range
of objectives, it ought not to be surprising that there are various types of
agreements. We noted at the outset of this course that there are two basic
types of reinsurance agreements and that these agreements are known as:
Facultative agreements
and
Treaty agreements
Thus far, the basic types of reinsurance have been examined along with their
uses. It is time to consider the agreements under which primary insurers and
reinsurers are bound.
The Facultative Agreement
In a facultative agreement, the reinsurer has the facultyanother word for
the powerto accept or reject any risk that is brought to it by the primary
insurer. As a result of this reinsurer ability to select risks on a case-by-case
basis, the agreement must establish a procedure that the primary insurer uses
to offer risks to the reinsurer.
57
-
8/8/2019 Rajesh 100 Marks 6th Semester
58/92
PRINCIPLES & TYPES OF REINSURANCE
The fundamental characteristic of a facultative reinsurance agreement is that
neither the reinsurer nor the primary insurer is required to offer or accept any
particular risk. Both insurers have complete freedom of action to consider
the risks on their own merits.
In a reinsurance arrangement using a facultative agreement, a primary
insurer will submit a copy of the application for the risk that it is interested
in reinsuring. In addition, it will normally include all of the supporting
documents that it has received from its agent, such as:
Attending physicians statements
A heart chart
Avocation forms
and
Financial statements
and any other material that bears on the appropriate underwriting of the
particular risk.
Additionally, the primary insurer will also submit a form to the reinsurer on
which it specifies the basis on which it is requesting reinsurance and the
amount of the risk that it proposes to retain. It is this form that is the offer
for reinsurance. As the offer, the form and its attachments supply all of the
information concerning the risk in the possession of the primary insurer and
typically requests that the reinsurer telephone, e-mail, fax or telegram
notification of its acceptance or rejection of the risk.
58
-
8/8/2019 Rajesh 100 Marks 6th Semester
59/92
PRINCIPLES & TYPES OF REINSURANCE
Whether the risk is a property & casualty risk or a life insurance risk,
facultative reinsurance is normally used in those cases where:
The value to be insured is unusually high
or
The risk is deemed to be substantially greater than normal
The Treaty Agreement
While the facultative reinsurance agreement provides the maximum freedom
to both the primary insurer and reinsurer to undertake any particular risk, the
treaty agreement severely limits that freedom. Unlike the arrangement in a
facultative reinsurance agreement, the treaty agreementremember, it is
also known as automatic reinsurancerequires that the primary insurer
offer to reinsure every risk that falls within the provisions of the reinsurance
agreement. Furthermore, the reinsurance company must accept every risk
that is envisioned in the agreement.
The treaty agreement contains a schedule of retention limits that apply to the
primary insurer. Whenever the primary insurer issues a policy exceeding the
limits, the excess amounts must be automatically reinsured. Since the
reinsurance applies automatically, the procedure used in the facultative
agreement wouldnt make much sense. Because of its automatic application,
the primary insurer typically sends no copies of the application or supporting
documents to the reinsurer under a treaty agreement.
59
-
8/8/2019 Rajesh 100 Marks 6th Semester
60/92
PRINCIPLES & TYPES OF REINSURANCE
The amount of reinsurance to which the reinsurer agrees to be bounda
subject covered in the treaty agreementgenerally depends upon the
reinsurers assessment of the primary insurers underwriting ability. Based
on the reinsurers level of confidence in the expertise of the primary
insurers underwriting staff and the primary insurers retention limits, it is
not uncommon for the reinsurer to agree to its automatic risk acceptance of
up to four or five times the primary insurers retention limits. For a primary
insurer with retention limits of $250,000, a reinsurer may agree to
automatically accept an additional $1.25 million in risk.
Of course, if the primary insurers retention limits are unusually high, a
reinsurer may reduce its automatic acceptance of risks so that it will only
accept risks no greater than an amount equal to the primary insurers
retention. For example, a primary insurer with a retention limit of $10
million may find it difficult to find a reinsurer that will agree to treaty
reinsurance at a level of greater than an additional $10 million.
The reinsurer under an automatic or treaty agreement must be able to rely
completely on the underwriting of the primary insurer. To be able to
confidently rely on that underwriting expertise, a reinsurer may require that
the primary insurer retain an amount of risk equal to its retention limit. If
the primary insurer seeks to remove itself from the risk by reinsuring its
portion of the liability under the risk through facultative reinsurance, the
automatic reinsurer is relieved of its obligation to accept the risk on an
automatic basis. In such a case, the entire risk is typically handled on a
facultative reinsurance basis.
60
-
8/8/2019 Rajesh 100 Marks 6th Semester
61/92
PRINCIPLES & TYPES OF REINSURANCE
Even under treaty agreements, there are certain cases in which the reinsurer
is not required to automatically assume liability. This special handling
normally applies to jumbo cases, defined as cases in which the total
insurance amount on the proposed insureds life in all companies, including
the amount applied for, is greater than the amount recited in the reinsurance
agreement. When situations like that occur, the automatic agreement no
longer applies, and the case is handled completely on a facultative basis.
The Cession Form
The contract between the primary insurer and the reinsurer is known as the
cession form. Irrespective of whether the agreement under which a primary
insurer and reinsurer are operating is of the facultative or treaty variety, it
provides that the primary insurer must prepare a formal cession of
reinsurance. This occurs only after the primary insurers agent has delivered
the policy to the policyowner and collected the first policy premium.
The cession form, in addition to incorporating the reinsurance agreement by
reference, contains several important elements, including:
The details of the risk
A schedule of reinsurance premiums
and
A schedule of ceding commissions, if any
61
-
8/8/2019 Rajesh 100 Marks 6th Semester
62/92
PRINCIPLES & TYPES OF REINSURANCE
A copy of the cession form is sent to the reinsurer, and a duplicate copy is
retained by the primary insurer. It will describe the reinsurance arrangement
and whether it is of the yearly renewable term insurance, coinsurance or
modified coinsurance type. It also makes provision for premium payments
from the primary insurer to the reinsurer and for ceding commissions to be
paid by the reinsurer if a coinsurance or modified coinsurance arrangement
is in force.
Reinsurance premiums paid by the primary insurer are normally on an
annual basis. Usually, the reinsurer will bill the primary insurer on a
monthly basis for the annual premium for all reinsured policies with
anniversaries on that month.
As each of the forms of reinsurance has been discussed, reference was made
to the portion of the risk for which the primary insurer is responsible and the
portion for which the reinsurer is responsible. Although that language is
sufficiently descriptive to apportion liability between the parties to the
agreement, it may be somewhat misleading.
It is important to remember that the primary insurer is responsible to the
policyowner for meeting all of the policys terms and providing all of its
benefits, irrespective of any reinsurance agreement. The reinsurance
agreement does not make the reinsurer responsible to the policyowner.
Instead, the parties to the reinsurance agreement are only the primary insurer
and the reinsurer, so that the reinsurance agreement makes the reinsurer
62
-
8/8/2019 Rajesh 100 Marks 6th Semester
63/92
PRINCIPLES & TYPES OF REINSURANCE
liable to the primary insurer only. The policyowner is not a party to the
agreement.
63
-
8/8/2019 Rajesh 100 Marks 6th Semester
64/92
PRINCIPLES & TYPES OF REINSURANCE
Chapter Five
Reinsurance in Operation
Claims
Insurance is generally purchased because of the policyowners need to be
assured that a payment will be made if and when a claim is presented. So,
this is a reasonable place to begin a discussion of how reinsurance works in
the primary insurers day-to-day operations.
We observed, earlier, that a policyowner is not a party to a reinsurance
agreement. Often, the policyowner isnt even aware that reinsurance is in
effect on his or her policy. Instead, the policyowner looks to the insurer that
issued the policy, i.e. the primary insurer, to pay any benefits due under it.
Because the policyowner expects claims payment from the primary insurer,
the reinsurance agreement provides that any settlement of the claim made by
the primary insurer is binding on the reinsurance company. That provision
applies irrespective of the type of reinsurance agreement in force. Even
though a primary insurer can bind its reinsurer to its claim decisions,
primary insurers often consult with reinsurers in situations involving
doubtful claims.
In settling policy claims, the reinsurer can be seen as an extension of the
primary insurer. To the extent that a claim is settled for less, the reinsurer
participates in the savings. Or, if legal costs are incurred in order to contest
a claim, the reinsurer must bear its part.
64
-
8/8/2019 Rajesh 100 Marks 6th Semester
65/92
PRINCIPLES & TYPES OF REINSURANCE
Normally, when a policy has been reinsured, the reinsurer is legally
obligated for the life of the policy. However, there are two exceptions to the
general rule:
When the amount of coverage in force has declined
and
When the primary insurer increases its retention limits
Change in Reinsurance Amounts
The total amount of coverage in force may decline because certain coverage
has expired according to the policys terms. For example, a non-renewable,
non-convertible term insurance policy might expire because the insured
lived to the end of the specified term. Or, the policyowner may have lapsed
a policy by not paying its premiums when due.
Regardless of the cause of the decline in coverage, the amount reinsured
changes. There are generally two approaches for making the reduction in
the amount reinsured:
An off the top reduction in reinsurance
or
A pro rata reduction
65
-
8/8/2019 Rajesh 100 Marks 6th Semester
66/92
PRINCIPLES & TYPES OF REINSURANCE
In the case of a reinsurance agreement that calls for an off the top reduction
in reinsurance, the total amount of the reduction in coverage comes solely
out of the sum reinsured, up to the total sum reinsured. For example,
suppose that the primary insurer retained $1 million of coverage in a total $5
million insurance portfolio. In an off the top arrangement, a reduction in
coverage of $500,000 would leave the retained amount unaffected but would
reduce the reinsured amount from $4 million to $3.5 million.
In a reinsurance agreement that provides for a pro rata reduction, the amount
retained and the amount reinsured would be reduced as a result of the
coverage reduction. In the example above of a $5 million insurance
portfolio that was reduced by $500,000, a reinsurance agreement calling for
a pro rata reduction would reduce the $1 million retained by $100,000 and
the $4 million reinsured by $400,000. The result would be a retention of
$900,000 and a reinsured amount of $3.6 million.
The other exception to the general rule of the reinsurer being at risk for the
duration of the coverage applies when the primary insurer increases its
retention limits. This increase in retention limits normally occurs as a
reinsurers small client insurers grow their assets and increase their
insurance in force. Often, in such a case, they will choose to increase their
retention and hold onto more of their risk exposure and their premiums.
In such a case, reinsurance agreements normally permit a recapturing of
the primary insurers reinsured business. Under the recapture provision of
many reinsurance agreements, a primary insurer that increases its retention
66
-
8/8/2019 Rajesh 100 Marks 6t