What is Reinsurance and Who Does it Reassure?
Have you ever wondered how insurance companies fund paying out claims? When you buy an insurance policy, you basically tell the insurance company you trust it. You continue blithely along in life assuming that if anything bad happens called a named peril that whether it is a hurricane or tornado or house fire the company will pay your claim.
Of course, in the case of something huge like a tornado or a hurricane, your neighbors will probably also have to file a claim. So will neighboring towns. That means your insurance company and the other insurance companies will likely pay out many claims and this could potentially exhaust their funding. It could deplete their assets.
Typically, an insurance firm owns some tangible assets and it builds a savings account from the premiums. That would not be prudent. The insurance companies all turn to the same source for additional funding – each other.
Reinsurance 101: What Is It and How Does It Work?
The larger insurance companies provide insurance to smaller companies to share the risk. The largest companies co-insure each other. The idea is that if a smaller company gets inundated with claims, the risk-sharing will save them from exhausting their holdings completely. This process usually works.
You might not have thought about it, but even insurance companies need insurance. They do not self-insure. Instead, they buy insurance from another company. That is called reinsurance and it provides them with a way to mitigate risk.
Reinsurance caps the loss limit an insurer could suffer. This protects them when a catastrophic event occurs that results in a number of their insured filing claims. Insurance companies need insurance, too.
Reinsurance Explained
Variety exists within reinsurance policies. The two main types are facultative and treaty.
Facultative Coverage
This type of policy covers the insurance company against a specific risk factor. The company discovers this during its internal risk analysis and obtains insurance to protect against potential loss. The underwriter for the reinsurance issuers evaluates the individual risk factor. The reinsurance company writes the policy based upon its underwriter’s research.
Proportional Reinsurance
Also referred to as pro rata reinsurance, this type of policy requires the reinsurer to pay a portion of the losses. When it does this, it gets a prorated portion of the insurer's premiums. A typical proportional reinsurance policy requires the reinsurer pay 50 percent of the losses.
Treaty Coverage
This type of policy covers the insurance company against all or any of the insurer's risk factors. Similar to a term life insurance policy, a treaty policy remains effective for a finite time period, i.e. 10 years.
Any type of reinsurance policy can be non-proportional or proportional. This refers to whether the insured company bears a portion of the potential loss or the insurance company writing the reinsurance policy would pay it all.
Non-Proportional Reinsurance
Also referred to as excess of loss reinsurance, this type of policy requires co-payment or shared burden payments only when the insurer's losses exceed a pre-determined amount. The company issuing reinsurance would only pay once the insured company paid what amounts to a deductible on an auto policy. In these cases, though, a company’s deductible might be $100,000, $1 million, or $1 billion.
Historical Perspective
Far from an imaginary scenario, many companies have had to deal with this exact problem in the past.
In 1992, the damage from Hurricane Andrew topped $15.5 billion. Those billions of dollars of losses resulted in so many insurance claims that it put seven US insurance companies out of business. They became completely insolvent and could not pay all of the claims filed.
Common Reisurance Scenario
A small insurance company specializes in auto insurance. It collects about $10,000 in premiums annually. Its owner recognizes that just one serious accident by a customer would result in a payout multiple times that large. The company uses a bit of the premiums to purchase reinsurance. This covers the company against a large loss.
Industry Size
The reinsurance industry, although vital, is tiny. It accounts for just seven percent of the US property and casualty insurance premiums. It reduces the amount of capital the insurer must maintain to self-insure in order to cover claims.
Vital Terminology of the Concept and Practice of Reinsuring
Reinsurance might sound unique and it is. After all, it does represent just seven percent of the casualty and property industry. It should not surprise you to find that reinsurance has its own lingo. Here are the terms you really need to know to follow a discussion or obtain a policy for your own insurance company.
The insurance company purchasing the insurance, referred to as the ceding company, cedes risk to the company that issues the reinsurance.
Cession refers to the amount of risk the insurance company cedes to the company issuing the reinsurance policy.
The retrocession does not harken back to the 1970s. It refers to the insurance policy obtained by the reinsurance agency that it uses to mitigate its risk. (You might think this goes on endlessly, but there typically is only a couple of layers of cession, so just a single layer of retrocession.)
The term retention refers to the risk retained by the ceding company. The ceding company reinsures the balance. What risk the company maintains depends on the firm’s financial strength. This is referred to as the limit which the ceding company may decide to reduce or increase.
The term line refers to the amount of money of the retention and comprises one part of the term of a reinsurance agreement. The ceding company that receives a ten-line reinsurance arrangement, called a treaty, gets to reinsure ten times the retained amount.
The term primary insured/assured refers to the primary insured that originally insures the risk.
The term reciprocity refers to a situation in which the parties desire “satisfaction of mutual interest.” This is a one-hand-washes-the-other concept. Since both insurance companies typically obtain reinsurance at some point, they do so in a reciprocal manner with one another.
The term primitive insurer, also referred to as the direct or original insurer, represents the direct-writing company. It can transfer or cede all or a portion of the risk to another insurance company.
Why You Should Care About Reinsurance
When you start shopping for health insurance companies or looking for affordable home insurance, you need to be aware of the insurance company’s financial situation. You need to check their financial reports and learn who reinsures them and for how much. You need to know that the company can remain solvent in the face of a catastrophe.
Each insurance firm must provide public disclosure. This makes it easy for you to check on their status. Look for a company to reinsure for about half of its potential coverage. You do not want to find a huge imbalance. If a company has taken out reinsurance to cover 70 or 80 percent of its potential claims, it probably has pretty poor management and few assets. The company should not need that much insurance to guarantee that it could pay its own claims.
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Here is another thing to look out for when vetting companies. You need to know if the company had to spread itself thin and obtain reinsurance from multiple sources. It may have obtained more than one insurance policy to ensure it could spread the risk of insuring its customers. This typically throws up a red flag that the company does not own enough assets to self-insure even a small portion of its customers. It may be charging too low of premiums since the premiums usually build the nest egg from which to pay claims.
Sometimes this happens when a direct company takes on too many high-value policyholders. They place themselves under liability by taking on too many and the number may exceed their carrying capacity and safety margins.
Here is where they turn to a reinsurer. The reinsurer also called the cedee, extends the insurance to the ceding company or cedar (no tree jokes).
Now, you are welcome to sing a bit from The Police. A doo doo. Ah dah dah dah. It’s all I want to say to you.
Throw in a few cedees and cedars and you have reinsurance set to music.
How Is This All Legal?
If you have had a business law class, this might start to sound like the companies have gone into business together. They are sharing risk. One indemnifies the other. Hmm… That question has come up before.
While no one will test you and I promise, I won’t pop quiz you either, these two court cases explain how this is legal and why it does not constitute a partnership.
As found in English Insurance v. National Benefit Insurance (1929), A. C. 114, rather than a partnership this type of treaty agreement constitutes a contract of reinsurance.
A later Ohio court expanded upon the definition of a contract of reinsurance. In Stickel v. Excess Insurance Co. of America, the Ohio Supreme Court wrote on Nov. 22, 1939, 23 N. E. (2nd) 839 that reinsurance is “a contract whereby one, for a consideration, agrees to indemnify another wholly or partially against loss or liability by reason of a risk the latter has assumed under a separate and distinct contract as insurer of a third party.”
Examples of When a Company Might Obtain Reinsurance
You can learn pretty quickly when a company might need reinsurance. If instead of purchasing a policy from a company you are getting into the insurance business, you need to review some basic scenarios so you know when you will need to obtain reinsurance.
Life Insurance Example
An actuary predicts the number of people of a given age that will die during a specific time period but cannot predict which of the people. Knowing the number of people provides a number on which the company can forecast how many beneficiaries it would need to pay. It can limit the policies it issues to a certain maximum payout, such as $10,000.
So, let’s say the insurance company insures 100,000 individuals aged 20 years old for $10,000 each. If a 20-year-old approaches them for a policy with a payout of $30,000 and it accepts that, the company throws off its balance of risk. It has incurred an added risk of $20,000. If the 100,001 insured dies, the company owes as if three of the other people died at the same time. It might obtain reinsurance to help cover the increased risk.
Of course, this example oversimplifies the nature of reinsurance, but it does provide a simple enough illustration to convey a real-world situation requiring it. Insurance companies go through this process every day. A high-risk individual might only provide a challenge to the financial stability of a fledgling or a small, independent insurance company.
A large firm though, such as The Hartford, might take on many high-risk or high-income individuals. While their company has ample assets and takes in plenty in premiums, a company that size also regularly takes on large insureds. This requires balancing the risk between multiple insurance companies that reinsurance allows.
Life Insurance Example
Let’s also consider a small insurance company that typically issues property policies. This is a hometown insurer, a true mom and pop business with a carrying capacity of total payout of $100,000 for property insurance claims. If someone moves to town and builds a $300,000 home which they insure with the hometown insurer, the company needs reinsurance to spread the additional $200,000 of risk.
Legal Considerations or Aspects
When it is your company needing the reinsurance policy, you have 10 legal considerations or aspects to examine. These range from business aspects to legal facts.
- 1. Regardless of the reinsurance policy, the direct insurer remains liable for a policyholder’s total loss. The policyholder has no redress with the reinsurer because the original assured/insured is not a party to the contract, as found in Baltica Insurance Co. v. Carr, 330.
- 2. The rules of misrepresentation and non-disclosure apply as with other contracts. This applies to the cedee, cedar and the original assured, as found in loonies v. Pender (1874) L. R. 9 0. B. 531.
- 3. The requirement of insurable interest applies to reinsurance. The insurer has insurable interest against the policy due to their potential financial involvement if the original insured incurs a loss.
- 4. A reinsurance policy indemnifies the direct insurer, in part or whole, against an assumed risk or risks.
- 5. The reinsurance policy creates an obligation on the part of the reinsurer to the ceding company that provides it the power to collect in the event that the original insured suffers a loss and files a claim.
- 5. The reinsurance policy creates an obligation on the part of the reinsurer to the ceding company that provides it the power to collect in the event that the original insured suffers a loss and files a claim.
- 6. Only the written contract between the cedee and cedar stipulates the risk covered. It should not be assumed to be that which the original policy of the original assured covers.
- 7. Reinsurance differs from double insurance and co-insurance. Reinsurance involves different interests and parts.
- 8. Reinsurers and the original insurer carry the same liability. When the cedee makes exgratia payments but does not admit liability under the original policy, it cannot make a recovery claim to the cedar.
- 9. The principle of subrogation applies to reinsurance. If the insurers (cedee/ceding party) make a claim payment, then recover from the liable original insured, the cedar is also entitled to its proportionate share of the recovered amount.
- 10. The principle of contribution also applies to reinsurance. The ceding party cannot recover the full amount of the loss (the claim of the original insured) from each cedar independently.
The Skinny on Reinsurance
While you probably were not planning on studying a legal primer when you sat down to read this article, that is what reinsurance requires to understand it fully. Essentially, your insurance company probably shares its risk with at least one other insurance company. If you start an insurance company, you will do this, too.
Reinsurance comprises a key necessity of the insurance industry to spread risk and mitigate large losses that could wipe out independent offices, small insurers, and even major corporations as has happened when major catastrophes have occurred. You should fully investigate the insurance company from which you obtain insurance as well as its reinsurers. Their financial viability determines whether you will get paid if you need to make a claim.