Reinsurance

It is not a surprise that reinsurance is a topic of continuing and continual interest within SCCA. Few captives or other insurers, for that matter, can effectively operate without it. Yet, in many ways, reinsurance remains an enigma with a frequently esoteric language, a chameleon-like ability to change structure and, at least according to an occasional regulator, a Medusan talent to turn otherwise viable mar­kets to stone.

However, at its most basic level, reinsurance is a simple concept. This is indeed fortunate since many of us who have practiced this arcane art share at least one thing in common with A.A. Milne's Winnie-the-Pooh: we are bears of very little brain. That being the case, allow me to share the basics of what I have learned during three decades as a reinsur­ance underwriter and broker.

I will try to avoid the words “often, sometimes, frequently, usually, etc.," by referencing what I consider to "standard practice.” Doubtless, others will disagree and you may read their comments in subsequent publications.

Regardless of many efforts to obfuscate the issues, there are really only two methods by which reinsurance can provided: treaty and facultative. In addition, reinsurance essentially fulfils only four fundamental functions: financing, stabilization, capacity and catastrophe protection. Lastly, these functions of reinsurance are provided in only two basic flavors: proportional and non-proportional. While there are relative advantages and disadvantages of various combinations of methods, functions and flavors, that discussion will be postponed to later articles whenever possible.

Before I launch into wordy description of the methods, functions and flavors, it is only fair to note that the basic build blocks of reinsurance can assembled into many different patterns. It is not unusual for the needs of a captive to be met through a combination of types of reinsurance, some of which are named after their "creators”. Others are relabelled entirely, e.g., "finite" reinsurance which focuses on the basic reinsurance function of financing. However, I promised "basic" and, despite having introduced terms such as “facultative," we can safely save the discussion of combinations and permutations to subsequent articles.

The two methods by which reinsurance is provided to captives are treaty and facultative. Treaty reinsurance is a formal written contract between a reinsurer and captive insurer that describes the terms and conditions under which the reinsurance is provided, treaty agreements are binding on both parties. Once negotiated, the insurer must insure all the specified risks with the reinsurer and the reinsurer must provide the insurance on all risks in accordance with the treaty's parameters. Risks that are reinsured are said to be "ceded" or transferred from the insurer to the reinsurer.

The alternative to treaty reinsurance is facultative (fac) reinsurance, in which both insurer and reinsurer have the "faculty," the ability, option or prerogative to transfer risk - or not - as they choose. It is the opposite of treaty. The insurer is not required to submit a risk to the reinsurer and the reinsurer is not obligated to accept the risk from the insurer. Of course, as an industry, we appear incapable of leaving well enough alone, so occasionally the terms "facultative obligatory" or "semi-obligatory treaty" is bandied about. The reader may ignore these terms as they wish.

As mentioned, the four basic functions or tasks of insurance are financing, stabilization, capacity and catastrophe protection, financing originally referred solely to unearned premium reserve relief." Just as an army travels on its stomach, an insurance company grows based on its surplus, the amount by which its assets are greater than its liabilities.

Similar to a widget manu­facturer borrowing against its inventory to finance growth, an insurance company can borrow against the equity in its unearned premium reserve fund. The insurance company has equity because accounting rules require it to book the expense portion of its written premium imme­diately. However, the com­pany is only allowed, by the same rules, to recover those "pre-paid" expenses as the premium is "earned" over the course of the policy period. So, from day one, there is a mismatch between insurance company assets (earned pre­mium) and liabilities (pre­paid expense). This mismatch reduces the compa­ny's surplus, which, in turn, limits the amount of business it is allowed to write. One solution is to structure a reinsurance agreement, which provides for sharing of risk by transferring a portion of the unearned premium reserve in exchange for a commission, which covers all or part of the pre-paid expense. The insurance company is therefore able to increase its surplus and finance its growth.

The stabilization task per­formed by reinsurance arises from the inherent volatility associated with the business of insurance. Given a large enough sample of similar risks subject to similar fre­quency and severity of loss, actuaries and other pricing specialists can provide well-defined estimates of loss. However, much of the insur­ance business is subject to the "Law of Small Numbers," where the mix of business is complex and ever changing from year to year, risk to risk and territory to territory among other factors. With fewer similar exposures, loss prediction becomes less cer­tain and fortuity is apt to rear its ugly head. Despite its best intentions, the results of an insurance company almost inevitably show swings in results from measuring peri­od to measuring period.

One way to address this volatility and "smooth out" the results of an insurer over time is to structure a program in which a "bank" is estab­lished with the reinsurer when the business is unex­pectedly profitable. This fund can then be drawn down in periods when the insurance company's results are worse than anticipated. Stabiliza­tion can be performed on a carrier's entire book or on a single line of business, terri­tory, state, etc. While some stabilization plans have been criticized in recent years, the criticism is properly levelled only when the carrier's intention is to deceive third par­ties to the contract.

The third basic service potentially performed by reinsurance is provision of capacity. Regardless of the extent of an insurance company's assets, there are risks of sufficient size and complexity that the carrier does not have the resources to write the poli­cy limits on its own. In a different era or market, the required capacity might have been provided through a subscription pol­icy, with a number of insurers each taking a share of the policy. However, where the carrier wants to provide the capacity on its own "paper," reinsurance can be structured to provide the desired limits. Capacity reinsurance can level the playing field, allowing smaller companies to com­pete with larger carriers.

Catastrophe reinsurance is a basic function of reinsur­ance very much in the fore­front of discussion over the past several years. While Andrew / Katrina / Rita, etc. highlight the necessity of pro­tecting against a dispropor­tionate accumulation of prop­erty losses, the events of September 11th were a draconian reminder of the fre­quency and severity of loss which has become possible, if, hopefully, not probable in his century. Catastrophes are perhaps the most dramatic example of the Law of Small lumbers in action. Despite our best efforts at prediction, protection, remediation and evacuation, events that produce loss of catastrophic proportions will always occur. Catastrophe reinsurance is, therefore, an essential part of carrier's program.

I deliberately chose to discuss the two flavors or forms of reinsurance, proportional versus non-proportional, last. If I had introduced it prior to our discussion on the basic services theoretically performed by reinsurance, there was a significant chance that section would bog down in multiple examples of how the various functions of reinsurance can be provided by various combinations and permutations of proportional and non-proportional covers. It is difficult enough to try to separate the relative contributions of financing, capacity, stabilization and catastrophe protection without further complicating the issue with how much of each is or can be provided by which type of proportional and / or non- proportional program, suffice to say that there are several types of each while simply describing the covers in broad strokes.

Proportional reinsurance is also called Pro Rata reinsurance. At its most basic, a carrier places a specified portion (percent) of a risk with a reinsurer together with the same portion of the original premium and collects the same portion of loss from the reinsurer. The reinsurer typically allows the ceding com­pany an expense commission on the premium ceded.

Essentially, there are two types of pro-rata reinsurance: quota share and surplus share. The principal differ­ence between the two is that all of the insurance compa­ny's subject business is ceded proportionately in a quota share program, while a sur­plus share agreement only reinsures risks above a specif­ic size (surplus of a specified attachment point), but col­lects proportionally for losses on all risks ceded.

Non-proportional reinsur­ance is called Excess of Loss, some times-abbreviated XOL. In XOL programs, the carrier places a specified dol­lar or percentage amount excess of (above) an agreed retention for a negotiated premium and collects losses on the same basis from the reinsurer. Excess of loss con­tracts pay excess losses on the basis of some combina­tion of risk, occurrence, acci­dent or aggregate. On an "each risk" basis, the carrier recovers losses excess of a deductible that applies to each risk involved in the same occurrence. For exam­ple, each property damaged or destroyed in Hurricane Katrina in Mississippi would be assessed a separate deductible under a per risk contract.

In an "each accident" or "each occurrence" contract, loss recoveries are based on the total of losses above a specified deductible or reten­tion applying to the accident or occurrence, regardless of the number of risks involved in the accident or occur­rence. For example, only one retention would apply if a dozen of the insurance com­pany's insured trucks were to be involved in the same acci­dent. Aggregate XOL, as the name implies, provides rein­surance recovery when the total of subject losses exceeds a predetermined cumulative amount. A number of permu­tations on the theme of XOL reinsurance are possible.

In summary, despite the best efforts of reinsurers and intermediaries to make the subject appear arcane and indecipherable to all but a select few, the basics of rein­surance are quite simple. Reinsurance is provided through one of two mecha­nisms: treaty and facultative. There are four tasks accom­plished by reinsurance: financing, capacity, stabiliza­tion and catastrophe protec­tion. Finally, there are two types of reinsurance: propor­tional and non-proportional.

Jim Warters is Vice President and North East Regional Manager for Preferred Reinsurance Intermediaries of Columbia, SC. The company provides insurance and reinsurance brokerage and consulting services to clients throughout North America and can be reached at The Preferred Group, 14 Monckton Blvd, Columbia, SC 29206 Tel (toll free) 800-738-4800.

This article first appeared in the Palmetto Captive Insurance Journal 1st Qtr 2007 which is published by the South Carolina Captive Insurance Association (SCCIA). Details of SCCIA can be found at www.sccia.org.