Tuesday, May 12, 2020

Purpose of Reinsurance

Reinsurance serves many purposes. Its main purpose is a means used by an insurance company or an underwriter to reduce the financial consequences resulting from the perils that it has accepted as an insurer.

An insurer acting as a buyer of risk cover is principally known as a “reinsured”, but it may also be called a “cedant” or a “ceding company.” With reinsurance: the losses are not reduced, but the reinsured benefits from the smoothing effect that the transfer of risk has on the material consequences of the loss.

Purpose of Reinsurance

A. Spreads of Risk

Insurance was developed to cover people for a risk that they could not avoid, to protect them from the financial consequences of that risk and to put them in the same position immediately before the loss.

Losses can arise in different ways. Those which an insurer would wish to avoid or minimise by the use of reinsurance may be of catastrophic proportions where the financial resources of an insurer without reinsurance would be stretched to breaking point. Reinsurance acts as a pillow to protect insurers against such possibility.

We have established that insurance is a mechanism that allows the impact of loss to be spread. Reinsurance serves the same purpose but at a micro-level – it is how insurers can spread their losses by transfer of risk to reinsurers. Insurers may not want a centralisation of liability for one type of class of risk, business, geographical area or other classification. By affecting reinsurance as part of a risk management strategy, the potential impact of future loss is spread.

B. Increase Capacity

A capacity of insurance company is its ability to provide a limit of cover in the policy issued to its insured. The insurance company is providing a promise to pay when an insured meet claims , so it will aim to have a gross capacity, before the application of any reinsurance, which is big enough for it to write most of the business it found or is offered. Its net capacity is the amount it retains for itself after it has laid off part of its liability to a reinsurer. In addition to the capacity it can provide  on a single risk, the insurance company also should consider the extent to which it takes on aggregations of liability from writing several risks which are all attached to the same potential loss.

Using reinsurance enables an insurance company to offer greater gross capacity than it considers prudent to retain for its net account by paying a reinsurer to take on the difference. In determining its capacity, the insurance company has to calculate how much of its capital is prepared to put at risk.

With various classes of business, reinsurance provides a method of increasing a ceding company's capacity to compete against other insurance companies in a market where an ability to accept large risks is vital, for example, aviation or space risks. The size of a ceding company attracts clients or brokers to place business with it if that insurance company can cover the entire risk.

An insurance company might be limited in its overall capacity to accept business by its regulator's determination of how much it can underwrite based on its available assets. Government regulation regarding the limitation of capacity applies to the overall amount of premium income written as well as underwriting limits.

The advent of government regulations regarding risk-based capital has assisted in growing the use of reinsurance. Risk-based capital is a common method developed by insurance body or regulators to set  the minimum amount of capital that an insurance company needs to support its business operations. It is used to determine capital requirements based on the size and degree of risk taken by the insurer. By entrusting to reinsurance companies, the cedants reduce their capital requirements.

C. Provides Security

Another reason for purchasing reinsurance is that the insurance company wants to be free of some of the uncertainty of loss. This can be achieved by the purchase of reinsurance, although it is important of course that the reinsurer can fulfil its commitment to pay in the event of a loss occurring that is recoverable under the terms and conditions of the reinsurance contract between the reinsurer and insurer.

D. Increases Stability in Results

The insurer can also avoid fluctuation in claims levels from year to year and within a year by the purchase of reinsurance. Again, the similarity can be drawn here between the motives that persuaded the insured to buy insurance in the first place.

E. Increase Confidence

Reinsurance is not the only mechanism open to a ceding company that wants to protect its business position whilst seizing opportunities to expand its business into new products and markets, but at the same time accelerating its core business. Opportunities may be found to transfer risk into financial markets and investors can invest with confidence. This can create a 'virtuous circle' for insurers by boosting share price and attracting more investment. That said, insurers are generally prudent concerning the choice of risk transfer vehicles and may nevertheless maintain a certain amount of their risk management in traditional reinsurance carriers.

In more recent times, with declining returns from financial markets, there has been a return to the more traditional forms of reinsurance, despite price increases. This is because, in a period of uncertainty, insurance companies looking for the comfort of known products with a guaranteed return; which is to say that the insurance company is guaranteed indemnity if its loss falls under the reinsurance protection.

F. Portfolio and Asset Management

An insurance company's portfolio is the entire range of risks that it underwriters and can include motor, bloodstock, household, commercial and professional indemnity among many other classes. Insurance underwriters are usually being judged by their gross underwriting results, aiming at gaining a gross profit without reinsurance being in place, and using reinsurance to protect the exposure of their account against any unfavorable fluctuation.

There is also the question of whether an insurance company protects its all portfolio, or choose to consider individual classes of business. Whereas insurance underwriters within an insurance company usually purchase reinsurance for their separate classes of business, purchasing of reinsurance is now becoming more concentrated with the trend towards cross-class portfolio protection if available.

In many insurance companies, the responsibility for the purchase of reinsurance has moved away from the underwriter to account managers so that more emphasis is given to solvency margins holistically. Reinsurance is a financial tool to manage the insurance risks, so central control is often exercised at Board level to maximise the group financial strength in the most cost-effective way. Where risk can be retained safely within the group, account managers would see this as better use of the group resource compared to purchasing unnecessary reinsurance.

G. Taxation Advantages

Insurance companies are taxed on their technical underwriting results: that is, their final position after taking into account:

  • all the premium received;
  • losses and loss settlement costs;
  • administration costs; and
  • reinsurance premiums paid.

Therefore, unlike taxable equity returns, reinsurance premiums are included within the underwriting result and such are tax-deductible. This is a consideration for ceding companies planning how to provide their company for any unusual losses that might arise from their portfolio.

H. Cash Flow Advantages

Effectively, an insurer has to maintain a balance of readily realisable assets to pay its claims liabilities to policyholders as they become due for settlement and longer-term investments to maximise growth opportunities. It would, therefore, consider the reinsurance cost against the potential profit to be realised from the investments. It would also have to consider the type of reinsurance provided as to whether, and to what extent, it would have to spend its premium as reinsurance premium and when it could expect to receive claim payment from the reinsurer.

In the form of proportional treaty, it is common for payments between a ceding company and its reinsurer to be made by half-yearly or a quarterly technical account has been given, with the balance of account being settled by the debtor. Treaties of this type usually contain a provision for the reinsured to receive rapid reimbursement from the reinsurer when a substantial claim occurs, to avoid an adverse effect on the reinsured's long-term investments. In the form of non-proportional reinsurance, claims are payable by the reinsurance company upon submission of the claim by the ceding company.

I. Corporate strategy

The extent to which a company will risk its assets will have been decided, but priorities have to be established as to the amount of risk it is prepared to entertain and in which sectors of its portfolio. New companies may discover themselves risking more than they would choose, and would probably look for comfort from the arrangement of reinsurance. A new company may be caught between the need, besides that, to attract potential customers and find its place in the insurance markets at large to establish its business, and on the other hand, by the practical limitations on the extent of reinsurance which can be regulated. This extent depends upon operating margins, or profit, which will be low in the early days. It is also subject to other limitations because of the need to comply with the demands of the supervisory authorities.

Similarly, an existing insurance company may wish to develop a new product, for example, a motor insurer might want to expand into household business, or a non-insurance financial service company might want to offer insurance products. As a case in point, several retail firms have branched out into selling financial service in the UK, either directly or in partnership with an existing insurance company. To realise it without affecting their global results they may look for reinsurance protection.

Some large multinational insurance companies create their internal reinsurance vehicles for subsidiary units to ensure that these units are not too adversely affected by large catastrophe losses in their market. These internal arrangements maintain part of the potential reinsurance premium within the company.

Michael Spice BA, FCII, Cert PFS. 2009. Reinsurance. The Chartered Insurance Institute.

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