Reinsurance is often described as insurance for insurance companies. It’s a way for insurance companies to transfer some of the financial risk they assume when issuing insurance policies. They do this by ceding some of their risk to another insurance company, the reinsurer. This protects traditional insurers against circumstances where they don’t have enough money to pay out all of the claims owed.
By law, insurance must have enough capital to be able to pay out potential future claims on all policies written. As the Insurance Information Institute explains: “If the insurer can reduce its responsibility, or liability, for these claims by transferring a part of the liability to another insurer, it can lower the amount of capital it must maintain to satisfy regulators that it is in good financial health and will be able to pay the claims of its policyholders.”
There are two basic types of reinsurance arrangements: facultative reinsurance and treaty reinsurance. Facultative reinsurance is designed to cover single risks or defined packages of risks, whereas treaty reinsurance covers a ceding company’s entire book of business, for example a primary insurer’s homeowners’ insurance book.
With facultative reinsurance transactions, the ceding company can offer an individual risk or a defined package of risks to a reinsurer. The reinsurer retains the right to accept or reject the risk, just like the primary insurer has the right to decide whether to insure a policyholder. Under a facultative arrangement, the reinsurer will perform its own underwriting for some or all of the policies to be reinsured, and each policy is considered a single transaction.
Facultative reinsurance is typically used for high-value or hazardous risks because the policies can be tailored to specific circumstances. It can sometimes be less attractive to the ceding company, because the reinsurer may insist the ceding company retains some of the liability on the riskiest policies. In those scenarios, the ceding company may have to approach multiple different reinsurers to transfer any remaining liability.
In treaty reinsurance transactions, the ceding company transfers all risks within a book of business to the reinsurer. For example, a primary insurer might transfer its entire book of commercial auto or all of its homeowners’ risk. The two parties will enter into an agreement, known as the treaty, in which the reinsurer is obliged to accept all covered business.
Treaty reinsurance arrangements are typically long-term, and they will accept policies that the ceding company has not yet written, as long as they fit in with the treaty’s pre-agreed risk class. The reinsurer typically expects to make a profit, but these expectations are measured and adjusted over time.
In contrast to facultative arrangements, reinsurers do not carry out individual underwriting on the risks assumed via treaty arrangements. That responsibility is left to the ceding company, which is why reinsurers will do lots of due diligence to ensure the ceding company is practicing adequate underwriting processes before entering a treaty.
‘Pro rata’ versus ‘excess of loss’
Both facultative and treaty reinsurance arrangements can be written on either a pro rata or an excess of loss basis.
Global reinsurer Munich Re describes ‘pro rata’ as: “A term describing all forms of quota share and surplus share reinsurance in which the reinsurer shares the same proportion of the premium and losses of the ceding company. Pro rata reinsurance is also known as ‘proportional reinsurance’. Along with sharing proportionally in premium and losses, the reinsurer typically pays a ceding commission to the ceding company to reimburse for expenses associated with issuing the underlying policy.”
Pro rata reinsurance is typically quite easy to administer, and it offers good protection against frequency and severity.
In an excess of loss agreement, also known as ‘non-proportional reinsurance,’ the ceding insurer will retain a certain amount of liability for losses. It will pay a fee to the reinsurance company for coverage above that retention, and that coverage is generally subject to a fixed upper limit. Excess of loss arrangements are often more economical in terms of reinsurance premium and cost of administration.