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W. Jean Kwon, Ph.D., CPCUSchool of Risk Management, St. John’s University

101 Murray StreetNew York, NY 10007, USAPhone: +1 (212) 277-5196

E-mail: Kwonw@stjohns.edu

Risk Management and Insurance: Perspectives in a Global Economy

23. Reinsurance

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3

Correction – Figure 23

One in each category of this column has to be non-proportional!

4

Study Points

Worldwide risk sharing

Reinsurance demand

Reinsurance fundamentals and operations

Reinsurance markets

Reinsurance regulation

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Worldwide Risk Sharing Through Reinsurance

6

Fundamentals

Insurance vs. reinsurance vs. retrocession

Retention vs. cession

Privity of contract vs. cut-through provision

Reciprocal agreement

Refer also to Chapter 1 for the basic concepts.

7

Worldwide Risk Sharing (Figure 23.1)

Insured Insured Insured Insured

Primary Insurer(Canada)

Insured Insured Insured Insured

Primary Insurer(China)

Reinsurer(U.S)

Reinsurer(Germany)

Reinsurer(Japan)

Reinsurer/Retrocessionaire

(France)

Retrocessionaire(Italy)

Retrocessionaire(Bermuda)

Reinsurer(Singapore)

Reinsurer(Mexico)

Retrocessionaire(U.S.)

Retrocessionaire(Korea)

Retrocessionaire(Brazil)

Another version in next page

8

Worldwide Risk Sharing (Figure 23.1)

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Rationales for Reinsurance Demand

Ownership structure

Cost of financial distress

Capital market imperfections

Real service efficiency

Reduction of tax liability

Volatility control

Regulatory constraints

Refer to “Insurance Demand” in Chapters 2 and 19.

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Reinsurance Fundamentals

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Reinsurance is...,

Risk financing arrangements between insurance firms; e.g.,• Between direct insurer and reinsurer

Transfer of part of the risks that the direct insurer assumes by way of insurance contract to another insurance carrier (the reinsurer) which has no direct contractual relationship with the insured.

12

Key Terms and Concepts

Cedant, reinsured, primary insurer, ceding company

Reinsurer, assuming company

Retrocessionaire

Retention• The amount of risk retained by

cedant

Cession• Alternative term to “reinsurance”• The amount of risk transferred

Retrocession

13

Suppliers of Reinsurance

Professional reinsurers• Munich Re, Swiss Re, Berkshire Hathaway…,• Mega-mergers and acquisitions internationally

Reinsurance departments (of insurance companies)• Directly• Through underwriting agents

14

Suppliers of Reinsurance

Pools• For national/regional cover of large risks (e.g., nuclear power or

space shuttle projects)• For nonstandard risk pooling in automobile and workers’

compensation insurance

Lloyd’s associations

Captives• For holding company and sister companies• May function as either insurer or reinsurer• Little or no provision of insurance to others

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Reinsurance Distributions

Direct writing reinsurer

Reinsurance brokerage firm

Slip

Lead (leading underwriter)

Broker’s cover

Characteristics• Represent the client (cedant, not

reinsurer)• Act as consultant to the client• Spread the risk using multiple

reinsurers to ensure security for the client

Other services/business• Captive management services• Alternative risk transfer

arrangement

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Types and Nature of Reinsurance Contracts

Facultative vs. treaty reinsurance• Facultative-obligatory (fac-oblig) reinsurance

Proportional (pro-rata) vs. non-proportional (excess-of-loss or XL) reinsurance

Financial reinsurance

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Facultative vs. Treaty

Facultative Placement in the reinsurance

market “on or after” writing risk

Per risk or policy

Treaty Placement via re existing

contract

Bulk contract for all risks falling into (e.g., property risks < $1 million in Manhattan

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Proportional vs. Non-proportional (Excess-of-Loss)

Proportional Equal share of risk, premium and

loss

Excess-of-Loss (XL) Sharing of loss not in proportion

to sharing of premium

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How to Utilize Reinsurance

Single reinsurance contract

Reinsurance program• For a line• For a group of lines umbrella• For all businesses of the insurer whole account

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Classification of Reinsurance Contracts (Figure 23.2)

Facultative

The contract is on individual risk basis; that is, there is no pre-existing reinsurance contract. The insurer decides whether to cover a risk alone, or cede part of it to a reinsurer. When offered, the reinsurer may accept it, decline it or counteroffer the insurer.

Treaty

The contract commonly is annual on a line of business and territory basis. The insurer and the reinsurer are bound to a contract that dictates what risks are to be shared and how they are shared. Therefore, the insurer must transfer all risks subject to the agreement and the reinsurer must accept all ceded risks.

Facultative-Obligatory (Fac-Oblig)

Commonly used as the top layer of a treaty reinsurance program, this type of contract gives the insurer an option to retain a risk fully or cede part of it to the reinsurer. When ceded (a facultative element), the reinsurer must assume the risk (an obligatory element).

Rein

sura

nce

Cont

ract

Proportional

Non-proportional

Proportional

Non-proportional

Source: Kwon (1999)

21

Forms of Reinsurance (Figure 23.3)

Proportional (Pro-rata)Sharing the amount of insurance, premium and loss on a proportional basis

• Quota Share• Surplus

• Facultative-Obligatory

Excess-of-loss (Non-proportional)Reinsurance coverage only when loss exceeds the retained loss at lower layer(s)

• Facultative Excess• Risk (working) Excess

• Catastrophic (Cat) Excess• Stop Loss

• Umbrella Excess. . . . .

Financial

• Retrospective Financial Reinsurance• Prospective Financial Reinsurance

Form

s of R

eins

uran

ce

Source: Kwon (1999)

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Proportional Reinsurance – Quota Share (Table 23.1)

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Proportional Reinsurance – Surplus (Table 23.2)

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Illustrative Proportional Treaty (Figure 23.4)

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Non-proportional (Excess-of-Loss) Reinsurance

Facultative XL Risk (working) XL Common account XL Per occurrence XL

• Hours clause Stop loss XL Aggregate XL Umbrella XL Whole account XL

Reinstatement provision (page 608)

26

Excess-of-loss Reinsurance (Figure 23.5)

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Reinsurance Program Design

Factors to consider in designing a program• Risk and loss portfolios over several years• Types of reinsurance contracts• Apportionment of risks or losses by layer• Availability of reinsurers specializing in each type of reinsurance and

their ancillary services• Prevailing conditions in the reinsurance market and in the economy• Profitability (including the size of ceding and other commissions from

reinsurers)• The insurer’s own capacity to retain losses

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Reinsurance Program Design

Commissions• Types

• Ceding commissions• Profit commissions

• Not all reinsurance contracts offer commissions

You may use the example in pages 609-610 to describe the relief from

ceding commissions.

Ceding commissions differ from reinsurance brokerage fees.

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Financial Reinsurance

Risks involved• Underwriting (pricing) risk• Timing risk• Investment risk

Financial reinsurance explicitly considers the investment and timing risks and may provide little or no pricing risk transfer.

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Financial Reinsurance

Retrospective financial reinsurance

Time and distance contracts

Loss portfolio transfer• Run-off business

Prospective financial reinsurance• The primary focus of financial reinsurance in today’s market

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Prospective Financial Reinsurance

Length of coverage period

Finite term of contract (non-renewability)

Explicit profit sharing agreement

Limit on coverage

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Prospective Financial Reinsurance (Insight 23.1)

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Reinsurance Markets

34

Reinsurance Premiums Globally (2005) (Figure 23.6)

North America50.4%

Europe34.2%

Asia10.3%

Rest of the World5.1%

Source: Datamonitor (2005)

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Reinsurance Global Market Share 1998 vs. 2008

Standard & Poor’s (2009)

36

Cession Rate by Region (1998) (Table 23.3)

No recent updates are found regarding cession distribution.

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Top 20 Global Reinsurers (2007)

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Top 15 Global Reinsurers (2008)

Standard & Poor’s (2009) Total is for Top 40 companies.

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US Reinsurers (2009)

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Top 10 Global Reinsurance Brokers (2006)

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Reinsurance in Emerging Markets

Reinsurance is crucial, as domestic companies tend to have low levels of capitalization and keep low retentions (and a correspondingly high demand for reinsurance).

Insuring industrial infrastructure necessitates technical expertise.• Historically, large global reinsurers have provided risks assessment and

underwriting services

Most insurers in developing countries have proportional treaties as the basis of their reinsurance programs.

Fronting is common in developing countries.

42

Reinsurance in Emerging Markets

Compulsory placement of reinsurance as a means of the local government’s attempt to:• Diversify the pools of risks from individual insurers to the national

reinsurer• Permit more favorable terms and prices when the national reinsurer

retrocedes risks internationally• The global trend is to abandon such practices, as compulsory

cessions usually harm markets relying on them.

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Compulsory Reinsurance Cessions (Table 23.5)

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Reinsurance Regulation

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Reinsurance Regulation

In general, reinsurance subject to less stringent regulation than is direct insurance• Even so, of critical concern because of its importance to the stability

and growth of insurance markets• Further, the market internationally dominated by a relatively small

number of very large reinsurers

Current initiatives largely the domain of advanced economies and intergovernmental organizations

Table 23.6

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Reinsurance Regulation

The IAIS Standard on Supervision of Reinsurers (2003)

• Principle One. Regulation and supervision of reinsurers’ technical provisions (loss reserving), investments and liquidity, capital requirements and policies and procedures to ensure effective corporate governance should reflect the characteristics of its business and be supplemented by systems for exchanging information among supervisors.

• Principle Two. Except as stated in Principle One, regulation and supervision of the legal forms, licensing and the possibility of withdrawing the license, fit-and-proper testing, changes in control, group relations, supervision of the entire business, on-site inspections, sanctions, internal controls and audit, and accounting rules applicable to reinsurers should be the same as those for primary insurers.

47

Reinsurance Regulation

The E.U. Reinsurance Directive (2005)

• Supervisory power

• Single licensing

• Solvency provision

48

Regulatory Developments in Reinsurance (Table 23.6)

49

Reinsurance Issues (new for discussion)

Meaning and application of reinsurance

• Alternative risk transfers, especially insurance-linked securitizations

Taxation issues

50

51

52

53

54

Discussion Questions

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Discussion Question 1

What advantages and disadvantages would an insurance company expect from ceding its risks (a) facultatively or (b) using a treaty?

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Discussion Question 2

Describe how premiums and losses are shared in (a) surplus treaty reinsurance and (b) working XL reinsurance.

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Discussion Question 3

What effect would you expect from continuing consolidation in the reinsurance market? Discuss its impact on competition, capacity and reinsurance market security.

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Discussion Question 4

An author cited in this chapter wrote “reinsurance can be viewed as both a leverage and a risk management mechanism.” Explain.

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Discussion Question 5

What are the reasons that some governments offer for subjecting domestic nonlife insurance companies to compulsory cessions to a national or regional reinsurance company? In those countries, why do you believe the cession commonly applies to treaty reinsurance only?

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Discussion Question 6

In view of the trends in the reinsurance market, what is their likely impact on reinsurance distribution systems.

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Discussion Question 7

Why are the world’s largest reinsurance firms located in Europe?