Reinsurance | III

summary

Reinsurance is insurance for insurance companies. it is a way of transferring part of the financial risk that insurance companies take when insuring cars, homes, and businesses to another insurance company, the reinsurer.

When an insurance company issues an insurance policy, a car insurance policy, for example, it assumes the responsibility to pay the cost of any accident that occurs, within the parameters established in the policy. By law, an insurer must have enough capital to ensure that it will be able to pay all possible future claims related to the policies it issues. this requirement protects consumers but limits the amount of business an insurer can take on. however, if the insurer can reduce its liability, or liability, for these claims by transferring a portion of the liability to another insurer, it may reduce the amount of capital it must hold to satisfy regulators that it is in good financial health and will be able to pay the claims of its policyholders. the capital released in this way can support more or larger insurance policies. The company that initially issues the policy is known as the primary insurer. The company that assumes the liability of the primary insurer is known as a reinsurer. primary companies are said to “give” the business to a reinsurer.

Reading: What are the two types of reinsurance life insurance

The reinsurance business is evolving. Traditionally, reinsurance transactions were between two insurance entities: the primary insurer that sold the original insurance policies and the reinsurer. most still are. Primary insurers and reinsurers may share both premiums and losses, or reinsurers may bear the primary company’s losses above a certain dollar limit for a fee. however, risks of various kinds, particularly natural disaster risks, are now being sold by insurers and reinsurers to institutional investors in the form of catastrophe bonds and other alternative risk-sharing mechanisms. Increasingly, new products reflect a gradual mix of reinsurance and investment banking.

types of reinsurance

Reinsurance can be divided into two basic categories: treaty and facultative. Treaties are agreements that cover broad groups of policies, such as the entire auto business of a primary insurer. facultative covers specific individual risks, usually high value or dangerous, such as a hospital, that would not be accepted under a treaty.

In most treaty agreements, once the terms of the contract have been established, including the categories of risks covered, all policies that fall within those terms (in many cases, both new and existing business) are covered, usually automatically, until the agreement is cancelled.

With facultative reinsurance, the reinsurer must underwrite the individual “risk”, say a hospital, just as a major company would, looking at all aspects of the operation and the hospital’s attitude and safety record. furthermore, the reinsurer would also consider the attitude and management of the primary insurer seeking reinsurance coverage. This type of reinsurance is called facultative reinsurance because the reinsurer has the power or “faculty” to accept or reject all or part of any policy offered to it, as opposed to treaty reinsurance, under which it must accept all applicable policies. once the agreement is signed.

Facultative and treaty reinsurance arrangements can be structured on a “pro rata” (proportional) or “excess of loss” (non-proportional) basis, depending on the arrangement by which losses are shared between the two insurers.

In a prorated arrangement, which is most often applied to property coverages, the reinsurer and the parent company share both the policyholder’s premium and potential losses.

In an excess of loss settlement, the principal company retains a certain amount of liability for losses (known as the ceding company’s retention) and pays a fee to the reinsurer for coverage above that amount, usually subject to a fixed upper limit. excess loss settlements can apply to individual policies, to an event such as a hurricane that affects many policyholders, or to the primary insurer’s aggregate losses above a certain amount, per policy or per year.

A parent company’s reinsurance program can be very complex. In a nutshell, if diagrammed, it could look like a pyramid with ascending dollar levels of coverage for increasingly remote events, divided among several reinsurance companies, each taking a cut. would include proportional loss and excess treaty layers and possibly a facultative excess loss layer on top.

regulation

As an industry, reinsurance is less regulated than insurance for individual consumers because reinsurance buyers, mostly primary companies that sell auto, home and commercial insurance, are considered sophisticated buyers. however, by the early 1980s, state insurance officials became increasingly concerned about the reliability of reinsurance contracts (the ability of the reinsurer to meet its contractual obligations) and the use of reinsurance contracts. a parent company. Following the June 1982 annual meeting of the National Association of Insurance Commissioners (NAIC) in Philadelphia, an advisory committee was formed to review the regulation of reinsurance transactions and the parties to those transactions. In 1984, a model credit law for reinsurance was adopted.

All insurers submit financial statements to regulators who monitor their financial health. Financial health includes not taking on more risk or liability for future claims than is prudent, given the amount of capital available to support it, that is, to pay claims. The principal value of reinsurance to a ceding company (the reinsurance buyer) for regulatory purposes is the recognition in the ceding company’s financial statement of a reduction in its liabilities in terms of two accounts: its unearned premium reserve and its for losses. the unearned premium reserve is the amount of premiums equal to the unexpired portion of the insurance policies, i.e. the insurance protection that is still “owed” to the policyholder and for which the funds would have to be repaid to the policyholder if the policyholder cancels the policy before it expires. The claims reserve is made up of funds set aside to pay future claims. Transferring part of the business from the insurance company to the reinsurer reduces your liability for future claims and for the return of the unexpired portion of the policy. the reduction in these two accounts is proportional to the payments that can be recovered from reinsurers, known as recoverables.

The insurer’s financial statement recognizes as an asset on the balance sheet all payments owed by the reinsurer for coverage paid by the ceding company.

By statute or administrative practice, all states (but with considerable variation) recognize and give credit on the financial statement for the reduced financial liability provided by reinsurance transactions. When reinsurers are not licensed in the United States (known as “foreign” or offshore companies) they must post collateral (such as trust funds, letters of credit, held funds) to secure the transaction. A foreign company can also participate in the United States. market by obtaining a license in the states where you want to do business.

For many years, few people outside the insurance industry knew that a mechanism like reinsurance existed. Reinsurance was first introduced to the public in the mid-1980s, during what is now known as the liability crisis. a shortage of reinsurance was widely reported to be one of the contributing factors to the availability problems and high price of various types of liability insurance. A few years later, in 1989, the reinsurance business again became a topic of interest outside the insurance industry when Congress investigated the insolvency of several large P&C insurers.

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These investigations culminated in a widely read report, “Broken Promises: Insurance Company Insolvencies,” published in February 1990. The publicity surrounding the investigations and the poor financial condition of several major life insurance companies They prompted proposals for some federal oversight of the insurance industry, particularly insurers and reinsurers headquartered outside the United States. however, no federal law was enacted.

While much of the insurance industry opposes federal regulatory oversight, many in the us. uu. reinsurers and large commercial insurers view compliance with a single federal law as preferable to compliance with the laws of 51 state jurisdictions.

A critical tool for assessing solvency is the annual “convention” statement, the detailed financial statement submitted by all insurance companies to the NAIC. In 1984, for the first time, the annual statement required insurers ceding liability to unauthorized reinsurers (those not licensed or approved in a designated jurisdiction) to include the amount of incurred but not reported (IBNR) losses in addition to losses. known and reported. (IBNR losses are losses associated with events that have already occurred where the full cost will not be known or reported to the insurer until a later date.) this requirement reflects regulators’ concern that all liabilities be identified and actuarially determined, including ibnr losses, and that ibnr losses be insured by the reinsurer with additional funds or a larger letter of credit than is stated. would have required otherwise.

Related to solvency is the issue of “recoverable” reinsurance, payments owed by the reinsurer. , due to insolvency or other problems (when interest rates are high, some insurance/reinsurance companies seek to increase market share in order to have more premiums to invest. Those that do not pay attention to the risk of the business they are underwriting may end up charging less for coverage and, as a result, go bankrupt). Consequently, some of the insurers that reinsured their business with these now-defunct companies were unable to recover the money owed to them on their reinsurance contracts.

To enable regulators, policyholders and investors to assess a company’s financial condition more accurately, the NAIC now requires insurance companies to deduct 20 per cent of recoverable anticipated reinsurance from their surplus. insured in their financial statements; the surplus is roughly equivalent to capital. when the amounts are more than 90 days past due. The rule helps regulators identify problematic reinsurers for regulatory action and encourages insurers to buy reinsurance from companies that are willing and able to pay reinsured losses promptly.

Concern over recoverable reinsurance led to other changes to the annual financial statement filed with state regulators, including changes that improve the quality and quantity of reinsurance data available to improve regulatory oversight of the reinsurance business.

after hurricane andrew hit south florida in 1992, causing $15.5 billion in insured losses at the time, it became clear that the u.s. insurers had seriously underestimated the extent of their liability for property losses in a mega-disaster. Until Hurricane Andrew, the industry had thought that $8 billion was the largest possible catastrophic loss. reinsurers subsequently reassessed their position, which in turn caused major carriers to reconsider their catastrophe reinsurance needs.

When reinsurance prices were high and capacity was scarce due to the high risk of natural disasters, some primary companies turned to the capital markets for innovative financing deals.

cat bonds and other alternative risk financing tools

The scarcity and high cost of traditional catastrophe reinsurance precipitated by Hurricane Andrew and declining interest rates, causing investors to seek higher yields, sparked interest in securitization of insurance risk. Among the forerunners of so-called real securitization were contingency financing bonds, such as those issued to the Florida Windstorm Association in 1996, which provided cash in the event of a catastrophe but had to be repaid afterward. a loss, and contingent surplus note, an arrangement with a bank or other lender that, in the event of a mega-disaster that would significantly reduce policyholder surplus, the funds would be available at a predetermined price. funds to pay for the transaction in case money is needed are held in US dollars. treasures surplus notes are not considered debt, therefore they do not impede an insurer’s ability to underwrite additional insurance. in addition, there were stock options, through which an insurer would receive a sum of money in the event of a catastrophic loss in exchange for stock or other options.

A catastrophe bond is a specialized security that enhances insurers’ ability to provide insurance protection by transferring risk to bond investors. Commercial banks and other lenders have been securitizing mortgages for years, freeing up capital to expand their mortgage business. Insurers and reinsurers issue catastrophe bonds to the stock market through an issuer known as a special purpose reinsurance vehicle (SPRV) created specifically for this purpose. These bonds have complicated structures and are typically created abroad, where tax and regulatory treatment may be more favorable. sprvs collects the premium from the insurance or reinsurance company and the principal from the investors and holds them in a trust in the form of u.s. Treasury bonds or other highly rated assets, using the investment income to pay interest on the principal. Catastrophe bonds pay high interest rates, but if the triggering event occurs, investors lose the interest and sometimes the principal, depending on the structure of the bond, which can be used to cover the insurer’s disaster losses . bonds can be issued for a term of one year or several years, often three.

Increasingly, catastrophe bonds are being developed for residual market government entities and state-backed wind funds. Capitalizing on the growing popularity of catastrophe bonds as investments, the Florida Citizens Property Insurance Corporation. issued bonds through the special purpose vehicle, everglades re. The bonds were issued by the Massachusetts Property Insurance Underwriting Association, two North Carolina groups (the Fair Plan and the Beach Plan), and the Alabama Wind Group. In addition, the California State Workers’ Compensation Insurance Fund issued a bond to cover workers’ compensation losses in the event of a catastrophic earthquake. Other bonds have been created to cover extreme mortality and medical benefit claim levels.

The catastrophe bond market, which was largely promoted by reinsurers, has begun to change. in 2009, for the first time, the major insurance companies sponsored the majority of bond issues, about 60 percent. Industry watchers say primary companies are increasingly integrating CAT bonds into their main reinsurance programs as a way to diversify and increase flexibility. While traditional reinsurance is purchased primarily on an annual basis, cat bonds typically provide multi-year coverage and can be structured in tranches maturing in successive years.

Of the many new ways of financing catastrophe risk that have developed over the last decade or two, catastrophe bonds are the best known outside the insurance industry. A lesser-known alternative is the Industry Loss Guarantee (ILW) contract. Unlike traditional reinsurance, where the reinsurer pays a portion of the parent company’s losses according to an agreed-upon formula, ILW is triggered by an industry-agreed loss. the contract “guarantees” that the reinsurer will pay up to $100 million for the buyer’s losses if the industry suffers a predetermined amount of loss, say $5 billion or more.

Another recent innovation is the sidecar. These are relatively simple agreements that allow a reinsurer to transfer to another reinsurer or group of investors, such as hedge funds, a limited and specific risk, such as the risk of an earthquake or hurricane in a certain geographic area during a specific period of time. Secondary deals are much smaller and less complex than catastrophe bonds and are typically privately placed rather than marketable securities. In sidecars, investors share in the profits or losses that the business produces together with the reinsurer. While a catastrophe bond could be considered an excess of loss reinsurance, assuming the highest levels of loss for a rare but potentially highly destructive event, sidecars are similar to reinsurance treaties in that the reinsurer and the primary insurer share the results.

An insurance company’s willingness to offer disaster coverage is often determined by the availability of reinsurance. When catastrophe bonds were first issued after Hurricane Andrew, they were expected to gain industry-wide acceptance as an alternative to traditional catastrophe reinsurance, which was then in short supply but still accounted for a small but growing portion of the market. global catastrophe reinsurance

Several of the first true securitization attempts were withdrawn due to time constraints (for example, hurricane season had begun before work on the transaction could be completed) and a lack of sufficient interest from investors. investors. the first operations were completed in december 1996, one by u.s. reinsurer, st paul re, and the second by winterthur, a swiss insurer that issued convertible bonds to pay auto damage claims resulting from hail storms. this was the first major transaction in which insurance risk was sold to public markets. The company said it did not need to finance hail damage in this way, but instead sold the bonds to test the insurance risk securitization market. six months later there was strong investor interest in a bond offering that provided the us with uu. catastrophe reinsurance to pay for homeowners’ losses arising from a single hurricane in eastern coastal states, demonstrating for the first time that insurance risk could be sold to institutional investors on a large scale. .

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The field has gradually evolved to the point where some insurance company investors and issuers are starting to get comfortable with the concept, with some returning to the capital markets every year. In addition to the high interest rates paid by catastrophe bonds, their appeal to investors is that they diversify the risk of the investment portfolio, thus reducing the volatility of returns. returns on most other securities are tied to economic activity and not natural disasters.

the national association of insurance commissioners (naic), which oversees insurance company investments and sets the rules that influence insurers’ investment strategies, classifies these new types of catastrophe risk securities as bonds instead of actions. Stocks are considered riskier under formulas that dictate how much capital must be set aside to back various obligations. In addition, at its June 1999 meeting, the NAIC approved a model law called the “protected cell” that facilitates conducting transactions in the United States. Until then, most securitization operations had been carried out abroad through special entities created for this purpose. Protected cells, separate units within an insurance company, protect investors from losses suffered by the insurer.

In addition to cat bonds, cat options were developed, but the market for these options never really took off. Another alternative is risk trading where individual companies in different parts of the world trade a certain amount of losses. the payment is triggered by the occurrence of an agreed event at a certain level of magnitude.

disaster recovery bonds and regional funds

Disaster recovery bonds serve the same purpose as a business income insurance policy, helping the policyholder/government entity recover after a catastrophic event.

In developing countries, insurance penetration is low, which means that few people and businesses have insurance, so the burden of recovering from a disaster falls almost entirely on the government. Traditionally, developing countries have relied on post-disaster financing to fund recovery efforts, including donations from developed countries, international emergency aid, and humanitarian aid organizations. A faster and more reliable way to finance recovery is pre-financing in the form of reinsurance, catastrophe bonds or other alternative risk transfer mechanisms.

An example of pre-financing is the Caribbean Catastrophe Risk Insurance Facility, the first regional insurance fund. ccrif provides hurricane and earthquake catastrophe coverage to its member countries so that after a disaster they can quickly fund immediate recovery needs and continue to provide essential services.

In 2004, hurricanes severely damaged the economy of several small Caribbean islands, causing losses of more than $4 billion. this led caribbean governments to seek help from the world bank to facilitate access to catastrophe insurance. CCRIF began operations in June 2007, after two years of planning.

CCRIF acts as a mutual insurance company, allowing member countries to pool their risks into a diversified portfolio and purchase reinsurance or other risk transfer products on international financial markets at savings of up to 50 percent. cent on what each one would cost. country if they purchased catastrophe protection individually. Furthermore, since a hurricane or earthquake affects only one or three Caribbean countries on average in a given year, each country contributes less to the pool of reserves than would be required if each had its own reserves.

Initially, CCRIF was capitalized by its members with the help of donor partners: developed countries, the World Bank and the Caribbean Development Bank. its members pay premiums based on their likely use of the pool’s funds. As countries raise building standards to better protect against disasters, premiums will decline.

Because CCRIF uses what is known as parametric insurance to calculate claims payments, claims are paid quickly. under a parametric system, claim payments are triggered by the occurrence of a specific event that can be objectively verified, such as a hurricane reaching a certain wind speed or an earthquake reaching a certain ground shaking threshold, rather than actual losses measured by an adjuster, a process that can take months to complete.

payment amounts are derived from models that estimate the financial impact of the disaster. As a form of deductible that encourages risk mitigation, participating governments can only purchase coverage up to 20 percent of their estimated losses, an amount considered sufficient to cover initial needs.

additional resources

reinsurance association of america

reinsurance page of the national association of insurance commissioners

the essential guide to reinsurance: solutions to the challenges of the 21st century. swiss re, 2012. a guide to reinsurance concepts and their contributions to the economy and society.

“Reinsurance: Fundamentals and New Challenges”, Insurance Information Institute, 2004.

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