Investing Talk #18: Reinsurance Business
Reinsurance is insurance for insurance companies.
Definition:
Reinsurance is a financial arrangement where an insurance company (the ceding company or primary insurer) transfers some of its risk to another insurance company (the reinsurer). This helps insurers manage risk, stabilize their finances, and protect themselves from large losses—like natural disasters or unusually high claim volumes.
Why Reinsurance Matters:
- Risk Management: Insurers limit their exposure to large claims.
- Capital Relief: Frees up capital for insurers to write more policies.
- Stability: Helps insurers remain solvent during catastrophic events.
- Expertise Sharing: Reinsurers often provide technical support and risk analysis.
Types of Reinsurance:
- Facultative Reinsurance:
- Reinsurance for a single policy or risk.
- Case-by-case basis.
- Used for high-value or unusual risks.
- Treaty Reinsurance:
- A pre-agreed arrangement covering a portfolio of policies.
- Automatically covers all policies within the agreed scope.
- More common for large, ongoing reinsurance relationships.
Reinsurance Structures:
- Proportional (Pro Rata):
- The insurer and reinsurer share premiums and losses in a fixed proportion.
- Types: Quota Share and Surplus Share.
- Non-Proportional (Excess of Loss):
- The reinsurer only pays when losses exceed a certain threshold (the "retention" or "attachment point").
- Good for catastrophic loss protection.
Example:
Imagine an insurance company covers a $100 million building. They might only want to keep $10 million of that risk themselves. So, they reinsure the other $90 million with one or more reinsurers. If the building is destroyed, the reinsurers will pay their share of the loss.
Key Players in Reinsurance
- Primary Insurers: The original insurance companies.
- Reinsurers: Take on risks (e.g. Swiss Re, Munich Re, Hannover Re, SCOR, Berkshire Hathaway Re).
- Retrocessionaires: Reinsurers that buy reinsurance themselves.
- Reinsurance Brokers: Intermediaries who help structure and place reinsurance deals (e.g. Aon, Guy Carpenter, Willis Towers Watson).
Benefits of Reinsurance
| For Primary Insurers | For Reinsurers |
|---|---|
| Reduces exposure to big losses | Diversifies their global portfolio |
| Stabilizes earnings | Gains access to premium from cedents |
| Increases underwriting capacity | Profits from taking on selected risks |
| Helps manage capital and solvency | Builds long-term relationships |
| Aids regulatory compliance | Leverages specialized underwriting |
Real-World Example
Catastrophe Reinsurance for Natural Disasters
Imagine a Caribbean island insurer covers many properties at risk of hurricane damage. A Category 5 hurricane causes $600 million in claims.
- Insurer’s Retention: $50 million
- First Excess Layer: $50M–$150M (covered by Reinsurer A)
- Second Excess Layer: $150M–$400M (Reinsurer B)
- Cat Layer: $400M–$600M (Reinsurer C)
So:
- Insurer pays first $50M.
- Reinsurer A pays next $100M.
- Reinsurer B pays next $250M.
- Reinsurer C pays the final $200M.
The insurer avoids insolvency and continues operating.
Reinsurance in Regulation & Accounting
Regulation
- Insurers must maintain solvency ratios.
- Reinsurance can reduce required capital under solvency regimes like Solvency II (EU) or Risk-Based Capital (RBC) in the U.S.
Accounting
- Premiums ceded to reinsurers are recorded as ceded premiums.
- Reinsurance recoverables: Amounts expected back from reinsurers for claims.
- Reinsurance contracts must meet risk transfer criteria to be treated as insurance under IFRS or GAAP.