Reinsurance – a mechanism in mitigating Risk

Risk

What is Risk?  Risk describes the uncertainty of the future outcome of a current decision or situation.  We have learned to cope with this uncertainty through different means.  There are certain risks for which market offers no insurance cover.  A risk is only insurable if:

  • the loss is accidental
  • the law of large numbers applies
  • there is no moral hazard
  • the cover is allowed by law

however, this circumstance is only temporary.  In this atomic age we see unobtainable risks are being covered, which were once unimaginable.  This was made possible due to Reinsurance.

Need for Reinsurance

Reinsurance is about transferring risk from a primary insurer to a reinsurer. Reinsurance which is contractual arrangement that transfers some or all of the potential costs of insured losses from policies written by one insurer to another insurer. The insurer that transfers the loss exposures is the primary insurer and the insurer that accepts the loss exposures is the reinsurer. Some reinsurers are companies or organizations that specialize in the reinsurance business. Other reinsurers are also primary insurers that enter into reinsurance arrangements with other insurers.

A primary insurer might buy reinsurance for a variety of reasons. One of the most important reasons is that reinsurance permits the primary insurer to share its exposures with the reinsurer. For example, an insurer that writes a large amount of property insurance in the seismic prone area can use reinsurance to reduce its exposure to claims from its insured arising from earthquake damage to their property.

Reinsurance also enables a small insurer to provide insurance for large accounts, whose insurance needs would otherwise exceed the insurer’s capacity. For example, suppose a primary insurer writes a commercial liability policy for a large company that manufactures hazardous chemicals. Since the potential for heavy liability losses resulting from injuries caused by leakage of this chemical is great, the primary insurer might arrange with a reinsurer to cover all of its liability losses for this insured over a certain amount, such as INR 1 million. Therefore, the primary insurer and the reinsurer are sharing the liability loss exposures for this insured.

Purpose of Reinsurance

  • A mechanism of spreading losses
  • Increasing capacity to handle larger risks
  • Stabilizing operating results from year to year with reinsurer absorbing larger / catastrophic losses
  • Increasing the chances of making profit by reinforcing the underwriters attempts to establish an account which is homogenous in both size and quality of risk
  • Ability to write untested and new risk exposures

So, broadly, Reinsurance aims at increased Capacity, financial Stability, stabilizing Claim Ratios, protection against Class effect, Protection of Solvency Margins and many more.  Dr. F. L. Tuma has said “Reinsurance does not reduce losses, but it makes it easier for insurance to carry the material consequences’’.

Arranging Reinsurance

With reinsurance the reinsurer receives a portion of the premiums from the primary insurers’ policies and assumes some of the losses on those policies. The primary insurer usually retains portion of the premium and pays that insured losses on reinsured policies and is then reimbursed by the reinsurer for losses for which the reinsurer is contractually responsible. If reinsurance is readily available, insurance companies can increase the number of new policies they write by transferring some of the premium and loss exposures to reinsurers. Thus, the availability of reinsurance can affect an insurance company’s capacity to write business.

There are two broad categories of reinsurance: treaty reinsurance and facultative reinsurance:

Treaty reinsurance is an arrangement whereby a reinsurer agrees to reinsure automatically a portion of all eligible insurance of the primary insurer. It is blind – risk wise details not revealed.  The treaty is a contract that defines the eligible insurance. The primary insurer is required to reinsure, and the reinsurer must accept, all business covered by the treaty. There is no individual selection of policies.

Primary insurers and reinsurers periodically renegotiate the agreement on which treaty reinsurance is based. Before entering into a treaty and agreeing on pricing arrangements, the reinsurer carefully evaluates the primary insurer’s past performance and expected future underwriting results. Because the treaty is based on all eligible insurance written by the primary insurer, the reinsurer is more concerned with the group of insured as a whole that with individual accounts that compose that group.

Facultative reinsurance is not automatic but involves a separate transition for each reinsured policy. That is, the reinsurer evaluates each policy it is asked to reinsure. Underwriters for the primary insurer decide which policies to submit for reinsurance, and underwriters for the reinsurance company decide which policies to reinsure.  Pricing terms and condition of each policy are individually negotiated.

Proportional & Non-Proportion Treaty

  • Proportional Treaties are based on sharing of risks which is defined either in ‘%’ or ‘lines”. Proportional treaties protect risk exposure.  Premiums and losses are shared in the proportion that the reinsured’s retention and the reinsurer’s share bear to the sum insured of the risk.
  • Quota Share Treaty is an automatic reinsurance whereby the reinsured cedes a fixed percentage of every risk.
  • Surplus Treaty is an automatic reinsurance whereby the reinsured cedes the surplus over and above its retention on every risk and limit of cession to the treaty as number of ‘lines’.
  • Non-proportional Treaties are based on sharing of losses. Non-proportional treaties protect loss exposure as incurred by reinsured. Insurer does not cede risks, but seeks protection against actual losses on risks as and when they may occur.  Reinsured agrees to retain a loss up to a certain amount and the Reinsurer agrees to pay the excess loss, up to a certain specified amount.  Types of non–proportional arrangements are Risk Excess of Loss, Event Excess of Loss (CAT Losses), Stop Loss.

Implementation of claims handling procedures

What do well-designed claims handling procedure look like?

No matters that sort of claim we are considering, there are certain features that all claims handling operations must incorporate. They must be able to:

  • Accepts claim notifications;
  • Verify policy liability
  • Record claims details on the insurer’s IT system;
  • Accurately reserve in respect of claims notifications;
  • Pay valid claims quickly; and
  • Pursue recoveries (including reinsurance recoveries)

At the same time, they must comply with local laws and any relevant regulatory requirement.

Reinsurance Claims procedures

Reinsurance Claims Procedure should include a process incorporating communication with reinsurance underwriters.

It is essential that reinsurance claims are handled efficiently and adequately in order to:

  • Restrict claim payments to those that are properly due under the terms and condition of the particular reinsurance contract at issue and any relevant legal requirements
  • Confine claim payment to those which are correctly presented, such as technical accuracy, adequate loss detail, and any required supporting evidence.
  • Maintain accurate and representative statistical records of the losses advised settled and reserved in order to meet internal and external reporting requirements, and
  • Ensure that all possible recoveries are made from the appropriate retrocessional protections.

A reinsurance company’s claims experience is likely to vary significantly from that of a direct insurance company. In essence, two main methods as discussed earlier, of placing reinsurance: proportional and non-proportional (and for each of these, there are two main bases of cover: facultative and treaty).

In addition, the level of loss information provided to a reinsurance company is likely to vary significantly from that provided to a direct insurance to a direct insurance company. This is particularly true of treaty business. Facultative reinsurance is more akin to direct insurance.  A facultative reinsurer generally has intimate knowledge of the risk covered and of any losses arising, usually being provided with a copy of any loss adjuster’s report and being involved with loss control and handing.

Proportional and non-proportional treaties are structured differently, which is reflected in the quality and level of loss information required when a claim is made under them. In the case of proportional treaties, such as quota share, the information is limited, whereas a non-proportional or excess of loss treaty generates loss information that is more specific and informative.

A proportional treaty provides protection against all losses affecting a ceding company’s account in respect of a particular class of business. Thus, the provision of specific loss information would result in an unduly heavy administrative burden on the cedant, particularly as many of the losses may be relatively small in value. In the case of non-proportional treaties, a claim must generally exceed a stipulated minimum level before impacting on the treaty. Consequently, the frequency of losses is reduced and more specific information can be provided.

Reinsurer’s Claims department

The claims department receives its daily claim advices either from a broker or directly from the cedant. A quarterly account is generally used to advise of losses arising from a proportional treaty. As noted above, the nature of a proportional treaty means that if a reinsurer was to pay its share of every loss at the time of settlement with the original insured, the administrative burden of the treaty would be too great. However, certain larger losses, which exceed contractually stipulated amounts, and which reinsurers are generally requested to settle immediately, are notified to reinsurers outside of normal quarterly reporting procedures. The minimum value of a cash loss should be set at a level that avoids the need for reinsurers to make a large number of individual payments, but is not so high as to cause the financial strain for the ceding company. The quarterly account also provides outstanding loss information.

Non-proportional or excess of loss treaties generally provide for all losses to be payable by the reinsurers upon receipt of a statement of the settlement of the original loss or within a specified period thereafter. The information provided is of a more specific nature, including individual loss information with applicable outstanding losses.

In general terms, the primary responsibility for the handling of losses rests with the ceding company. Reinsurers need prompt advice of losses that may involve them in a significant liability. With regard to proportional treaties, they require sufficient information to enable them to:

  • understand the nature of the loss and form a view of liability
  • assess the probable cost and
  • keep their own retrocessionaires informed about large losses.

Reinsurance often audits the claims processes employed by their cedants to ensure good quality claims handling from the cedant.

Generally, proportional treaties stipulate that the reinsurer be notified of the occurrence of large losses, usually as soon as reasonably practicable. With regard to non-proportional treaties, it is generally a requirement for the reinsured to inform the reinsurer immediately of any loss to which it may be liable to contribute, or which is of a category listed in the contract, regardless of size.

A further factor to be borne in mind concerns the treatment of expenses incurred by the ceding company in commencing or defending any legal proceedings in connection with a claim. Under non-proportional treaties such costs, plus the costs of a successful claimant, are included in the calculation of ultimate net loss. Under proportional treaties, the ceding company and the reinsurer share proportionately the costs and benefits of litigation. There is not the same mutuality of interest under non-proportional treaties as there is under proportional treaties: in the former, the benefit of a successful defence will accrue solely to the ceding company if the amount of the disputed claim is within the treaty retention. If the case is lost, however, the reinsurer may become liable for some of the extra costs incurred. Some contracts contain a clause enabling a reinsurer to participate in the decision to litigate.

Reinsurers writing business on an excess of loss basis may have to wait several years before large claims, which may be subject to litigation, are settled. Consequently, such reinsurers wish to be made aware, as quickly as possible, not only of claims estimated to exceed the retention, but also of those estimated to settle near the retention.

As a general rule, the onus is on the cedant to notify the reinsurer of any claim, incident, event, or circumstance that may give rise to a claim under the terms of the reinsurance policy.

Conclusion

Reinsurance is not merely getting rid of the portion of risk that cannot be retained, rather it is optimization of retention and designing of reinsurance programme, aligning it with the available best practices of the market is a challenge.  Reinsurance helps primary insurers in many diversified ways viz., transferring of risks, protection of the balance sheet, underwriting complex and untested risks, providing additional underwriting capacity and many more.


Author

RAVINDRANATH M NAYAK

Faculty & Research Associate
National Insurance Academy, Pune