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Reinsurance

Chapter · January 1998

DOI: 10.1007/978-1-4615-6187-3_14

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 REINSURANCE 14

Objective
The transaction between two insurance companies in which one insurance
company issue an insurance contract for an other company is called reinsurance
or reassurance (in life insurance). This chapter examines the purposes and
methods of reinsurance and the functioning of the market.

Introduction
The fundamental requirement for the existence of insurance contracts is the
existence of a large number of similar loss exposures. What makes insurance
feasible is the pooling of many loss exposures, homogeneous and independents,
into classes of risks (Chapter 8). However, even if the probability that an event
will occur is accurately known, the underwriting risk may be too large for an
individual exposure. Similarly, it may be difficult for a single insurance company
to cover catastrophic risks such as earthquakes, flood, or war damage, because it
may affect a large number of insureds at once.
Simply defined, reinsurance is the transfer of liability from a ceding insurer
(the primary insurance company having issued the insurance contract) to another
insurance company (the reinsurance company). The placing of business with a
reinsurer is called a cession. It is commonly said that it is the insurance of
insurance companies. The reinsurer itself may cedes part of the assumed liability
to another reinsurance company. This second transaction is called a retrocession,
and the assuming reinsurer is the retrocessionnaire.
Reinsurance contracts are entered into between insurance (or reinsurance)
companies, whereas insurance contracts are created between insurance companies
and individuals or non-insurance firms. Therefore, a reinsurance contract is only
concerned with the original insured event or loss exposure and the reinsurer is
only liable to the ceding insurance company. The policyholder of an insurance
company have no right of action against the reinsurer. On the other hand, he is
probably the main beneficiary of reinsurance arrangements.
The Demand for Reinsurance
Why is reinsurance of value to primary insurers? Financial theory explains that
reinsurance is redundant in the conditions of capital market equilibrium for
diversified, widely held firms (Doherty and Tinic, 1981). The most obvious
explanation is that insurance companies do not have well-diversified portfolios.
Reinsurance provides an alternative mechanism for further diversification of
the risk but other factors such as the minimization of taxes, the effect of regulatory
constraints and services provided by reinsurers, may also explain the demand for
reinsurance.1
It is estimated that whereas only a small fraction of life insurance business is
reinsured, in property and liability insurance a substantial amount of the covered
risk is transferred to reinsurers. The problem of reinsurance planning at the level
of a company is solved essentially according to the individual requirements of the
company.

Functions of Reinsurance
Not any single insurance company has the financial capacity to produce an
unlimited amount of insurance coverages (contracts) in any line of business.
Similarly, an insurance company is always restricted in the size any single risk it
could safely accepts.
At first, it may be said that if a risk is too large for a single insurance
company, it could be shared among several companies. This process is also called
coinsurance and is still often used by insurance companies.
Reciprocity is the practice of cession between two primary insurers. It is the
exchange of one share of business for another insurer's business of the same type.
The objective of reciprocity is to maintain the same premium volume and at the
same time gain a greater spread of risk.
Reinsurance is more efficient and less costly than having several insurers
underwrite separate portions of a loss exposure. Reinsurance is also a more
efficient way to spread the risk among several companies. But there are other
reasons why an insurer may find useful to buy a reinsurance contract. The
functions or advantages of reinsurance are the following:

1). Financing
2). Capacity
3). Stabilization of loss experience
4). Catastrophe protection
5). Underwriting assistance
6). Ease of entry or exit from a
territory or a class of business
Financing
There is a limit to the amount of premiums an insurer can write which is related
to the size of the surplus.2 We have seen in Chapter 13 that when premiums are
collected in advance, the company must establish an unearned premium reserve.
Reinsurance enables a company to increase its surplus by reducing its unearned
premium reserve. This is particularly useful to a new or growing insurance
company, or even to an established insurance company entering a new field of
underwriting.

Capacity
Capacity in insurance terminology means a company's ability to insure a large
amount of insurance coverage on a single loss exposure ( large line capacity) or
to write a large number of contracts in a line of business ( premium capacity). A
large capacity is necessary for marketing reasons. It would be difficult for an
insurance company to explain to the agents or brokers that they have done a
terrific job but that they now should stop working until the end of the year because
the company as reached its surplus capacity for a particular line of business.
Reinsurance also permits the acceptance of coverage on individual risks in
larger amounts than the capital and surplus position of the company would allow,
or more simply on risks that the management of the company would consider too
hazardous.

Stabilization of Loss Experience

An insurance company, like any other business firm, likes to smooth, as far as
possible, its financial results from one year to another. However, underwriting
results (losses) may fluctuate widely in some lines of business for many reasons
(economic, climatic or others) or because the diversification of business in a class
of business is not adequate.
Reinsurance is an arrangement under which the insurance company reduces
the year to year fluctuations within some limits. Reinsurance is sometimes
compared to a banking operation where the insurer borrows from the reinsurer in
bad years and pays back when its loss experience is good ( Webb et al., 1984, p.
324).

Catastrophe Protection
The impact of a major catastrophe loss from a natural disaster, an industrial
accident, or similar disasters, on a company's normal (or expected) loss
experience may be considered the principal reason for buying reinsurance. A
catastrophe loss may endanger the very existence of the company. In this
particular case, a reinsurance contract is typically the insurance of the insurer.

Underwriting Assistance
Reinsurance companies accumulate a great deal of information and statistical
experience regarding the various types of insurance coverage, the methods of
rating, underwriting and claims adjustment. This experience is quite useful for
the ceding company particularly to enter a new line of business, a new territory,
or to underwrite an uncommon type of risk.

Ease of Entry and Exit from a Territory or Class of Business

Reinsurance facilities can provide extremely valuable services to enter a new
market, but they are also very useful when an insurance company chooses to stop
writing in a particular line of business or a particular geographic region.
If an insurer decides to withdraw from a territory or class of business, it can
legally be done only after all contracts are terminated. The insurer could
technically cancel the contacts and refund the unearned premiums but that process
would be expensive and highly criticized by policyholders, producers and
regulatory authorities. The alternative method is to transfer all the portfolio of
insurance policies to another insurance company or a reinsurer.

Methods and Forms of Reinsurance

Reinsurance is a contractual arrangement between a primary insurance company
and a reinsurance company. The two major categories of reinsurance contracts are
facultative reinsurance contracts and treaty reinsurance.3

In facultative reinsurance (or single risk), the ceding company negotiates a

contract for each insurance policy it wishes to reinsure. It is particularly useful in
reinsuring large risks (i.e., those that the insurance company is either unwilling or
unable to retain for its own accounts) or unusual risks such as satellites, public
free pop music live shows, etc.
There is no prearrangement and the conditions are fixed according to the case.
Because of its flexibility, facultative reinsurance is much employed in security
bondings, in which the risks are not standardized. It is also commonly practiced
in a more regulated manner in life insurance.
Facultative reinsurance, by nature, involves some degree of adverse selection
for the reinsurer and is expensive for the insurance company. It is practical only
when there is a small number of risks. It is also very useful when the primary
insurer has no experience of a particular risk and turn to the reinsurer for
underwriting assistance.
 In treaty reinsurance, the ceding company agrees in advance to the forms,
terms and conditions of reinsurance. Treaty reinsurance provides a more stable
contractual relationship between a primary insurer and a reinsurer. Most insurers
depend heavily on treaty reinsurance because facultative reinsurance is not
practical when dealing with a class or line of business. The reinsurer no longer
examines each risk individually and he has no power to decline a risk within the
treaty. The treaty method is also less expensive and quick to operate.
Although the reinsurer is obligated to accept all cessions of business under
the terms of the treaty, adverse selection is less likely to occur if the insurer wants
to establish a long term business relationship with the reinsurer. In this case, the
reinsurer follows the good or bad results of the ceding company ( the comparison
with a banker) over a longer period of time.
The forms of the reinsurance contracts depend upon the manner in which the
risks are shared between the insurer and the reinsurer. Reinsurance contracts are
divided into proportional and non-proportional contracts as follows:

1). Proportional or Pro-rata contracts:

- Quota share
- Surplus share
2). Non-proportional or Excess contracts
- per risk excess
- per occurrence excess
- Aggregate excess (Stop loss)

Quota Share
Under a quota share contract, the primary insurer cedes a fixed percentage of
every exposure it insures within he class of business subject to the contract. The
reinsurer shares of the premiums written (less a ceding commission) and pays the
same percentage of each loss. The figure 14.1 illustrates the application of a quota
share treaty with a retention of 50% by the primary insurer.
Quota share contracts are very common in property and liability insurance
contracts (with the exception of automobile insurance) because they are simple to
administer and there is no adverse selection for the reinsurer. Higher commissions
and better terms are obtainable as this type of treaty is generally profitable for the
reinsurer.
Quota share is the most effective contract for the small companies to enter
into a new class of business and to reduce their unearned premium reserve. A
quota share is also ideal for reciprocal treaties between insurance companies. For
example, two insurance companies with similar volume of business and
profitability could each reinsure a 50% quota share of the other's business. This
could have substantial diversification effects on each, particularly if they are
involved in different geographical areas.
______________________________________________________
DISCUSSION:
An insurance company has developed, after six months of
business, $ 1,000,000 in unearned premium reserve for a
surplus of $ 500,000.
The balance sheet of the company is the following:

ASSETS LIABILITIES AND SURPLUS

Cash 750,000 Unearned premium reserve 1,000,000
Other 2,250,000 Other Liabilities 1,500,000
Surplus 500,000
__________ _________
Total 3,000,000 Total 3,000,000

To increase its surplus the company purchases 50% quota-share

treaty.
The reinsurer agree to pay 30% commission for 50% of the
actual unearned business and all forthcoming business.

The company pays the reinsurer:

$ 500,000 - $ 150,000 ( 30 % Commission).

The new balance sheet is:

ASSETS LIABILITIES AND SURPLUS

Cash 400,000 Unearned premium reserve 500,000
Other 2,250,000 Other Liabilities 1,500,000
Surplus 650,000
_________ _________
Total 2,650,000 Total 2,650,000

______________________________________________________
 Figure 14.1
Premiums Shared under a Quota Share Treaty

Los s expos ure

500

400

300
Reinsurer
Insurer
200

100

0
1 2 3 4 5 6 7 8
Number of pol ici es

Surplus Share
Surplus share contracts, like quota share contracts, are defined as proportional
reinsurance, but the difference between them is in the manner the retention is
stated. In a surplus share contract, the retention is defined as a monetary amount
rather than a fixed percentage.
As a consequence, in a surplus treaty, the percentage varies with the size of
the loss exposure. Another difference between the two contracts is the limit that
is imposed by the reinsurer on the size. This reinsurance limit is usually defined
as a "n-line surplus treaty," i.e., the reinsurer will accept reinsurance coverage up
to n times the retention amount. The surplus can be divided among several
companies.
Figure 14.2 illustrates the application of a surplus share treaty with a retention
of 50,000 monetary units and a reinsurance limit of 500,000. This would be
referred to as a "ten-line surplus treaty." In this example, the following would
occur:
 Size of loss exposure Cedent's retention Surplus cession
50,000 or less 50,000 nil
80,000 50,000 30,000(37.5%)
160,000 50,000 110,000(68.7%)
400,000 50,000 350,000(87.5%)

The reinsurer would pay its share of the losses in the same proportion as its
share of the premium. The surplus treaty is particularly useful for large
commercial and industrial risks. It is superior to a quota share treaty in providing
large line capacity. It is also preferable to the quota-share because it does not
require the primary insurer to share small exposures that it is able to carry itself.
On the other hand, it does not secure any unearned premium relief that may be
required by small insurers.

Figure 14.2
Premiums Shared under a Surplus Treaty
Los s expos ure
500

400

300
Reinsurer

200 Insurer

100

0
1 2 3 4 5 6 7 8
Number of pol ici es
 In a surplus contract, only the portion of the risk exceeding the company's
retention is reinsured, leaving the company with an homogeneous portfolio. The
ceding company is able to keep more profitable business and the reinsurer
receives a higher share of the less good risks. However, administration costs are
much higher and the rates of commission paid by the reinsurer to the ceding
company are less than under Quota Share treaties.

Reinsurance Commissions
Under a proportional reinsurance treaty, the reinsurer pays to the ceding company
a reinsurance commission to cover the acquisition and administrative costs
incurred through acquiring the business. In some very competitive markets, it has
become common practice for primary insurers to finance an aggressive market
approach, with the important margin gained from the reinsurer. By being
subsidized on the reinsurance commission, the primary insurer has the possibility
to price classes of risks at a reduced rate to obtain the business. The victim in this
process is of course the reinsurer.
A profit commission is a percentage of the profit made by the reinsurer out
of a treaty which is refunded to the ceding company at the end of the year (or at
the close of the treaty). The rate is usually indicated in the treaty as a percent of
the average profit of the preceding 3 years. In a number of treaties, there is no
profit commission but a sliding scale of commission. The rate is inversely related
to the loss ratio. This ensures a reasonable sharing in the experience of the treaty,
leaving a fair rate of return to both parties.

Facultative Obligatory Treaty

It is an agreement whereby the ceding company has the option to cede the risks
(facultative), and the reinsurer is bound to accept it under a treaty arrangement. It
is normally associated with a surplus treaty and gives reinsurance facilities for
risks of specific nature when the capacity of the surplus has been exhausted.

Excess Loss Contracts

Excess loss contracts (or XL) differ from pro-rata contracts in that the ceding
company and the reinsurance company do not share the amount of insurance
coverage, premium and losses in the same proportion. In fact, no insurance
amount is ceded under an excess loss contract. The reinsurer is not directly
concerned about the original rates charged by the ceding company. It only pays
the ceding company when the original loss has exceeded some agreed limit of
retention.
 Generally, the ceding company pays a premium to the reinsurer which is
function of the nature and extent of the coverage assumed by the reinsurer, and
no commission is paid to the ceding company. This system is called the "burning-
cost" system.
The burning-cost is a percentage calculated by dividing the total losses
exceeding the excess point during the period by the premiums for the same period.
A maximum and a minimum rate are applied and a deposit premium is paid. As
in the retrospective premium, the final premium is adjusted at the end of the year.

Per Risk Excess

The retention under a per-risk contract is stated as a monetary amount of loss (not
an amount of loss exposure or coverage). The reinsurer is liable for any amount
of loss in excess of the retention determined in the contract. This amount is often
subject to a limit, for example $200,000 in excess of $50,000. The reinsurer under
this form of treaty pays all losses over a deductible. There may be more than
one excess of loss treaty covering the same book of business as long as they do
not overlap.
For example:
$200,000 in excess of $50,000
$500,000 in excess of $200,000
$1,000,000 in excess of $500,000

In this example, losses would be paid as follows:

Loss amount Cedent's retention Reinsurers

1st Layer 2nd Layer 3rd Layer

50,000 50,000 0 0 0
100,000 50,000 50,000 0 0
300,000 50,000 200,000 50,000 0
900,000 50,000 200,000 500,000 150,000

Per-risk excess treaties are very effective in providing large line capacity,
since they absorb the large losses. They, of course, are also very effective in
stabilizing loss experience. In the short run, a primary insurance company can
even improve the results on an inherently unprofitable book of business through
excess reinsurance. However, the reinsurer will probably refuse to renew his
participation in the future and the primary insurer will certainly have to pay a
higher cost for reinsurance.
Per Occurrence Excess
Property insurers are particularly subject to large accumulations of losses arising
from a single occurrence such as a hurricane or earthquake. Most of the individual
claims may be relatively too small for a per-risk excess treaty to apply, but the
accumulated amount can have a disastrous effect on the financial results of a
company. A per-occurrence treaty, called catastrophe treaty, is the only type of
reinsurance that provides protection for this fundamental type of risk.
Like a per-risk contract, the retention of the ceding company is stated as a
monetary amount. However, all the losses arising from a single occurrence are
totalled to determine the amount of the loss. The definition of a single occurrence
is probably the most important part of a catastrophe treaty.

Aggregate Excess or Stop loss

Under an aggregate excess treaty, the reinsurer begins to pay when the ceding's
company losses for some stated period of time, usually one year, exceed the
retention negotiated in the treaty. The retention may be defined as a monetary
amount, as a loss-ratio percentage or as a combination of the two.
An aggregate excess contract is the most effective form of stabilizing the
underwriting results of a ceding company since it puts a limit on the ceding
company's losses (or loss ratio). However, the limit is never set at a level that
would guarantee the cedent an underwriting profit otherwise, the cedent could
underwrite an extremely bad book of business and still achieve a profit. Only the
reinsurer would suffer and the risk of adverse selection is too important.
A co-insurance factor is usually introduced in the contract. For example, the
loss ratio in health insurance ( the ratio of losses incurred over premiums earned)
would be computed by using the company's (or market) experience of the last five
years:
year t = 73.2%
t -1 = 81.3%
t -2 = 82.5%
t -3 = 87.1%
t -4 = 80.9% average loss ratio = 81%

Assuming that at a loss ratio of 81% the underwriting result for this line of
business (after deductions for the operating expenses), is zero, a stop loss treaty
might be stated as: "90% of the amount by which the loss ratio of the ceding
company exceeds 81% provided always that the maximum amount recoverable
shall be limited to $1,000,000 in the aggregate."
Principle of a Reinsurance Program
The first step in creating a reinsurance program for an insurance company is
choosing a correct amount of net retention and the limits of reinsurance coverage.
If the net retention is too low, then the insurer's capital and surplus is not put to
effective use. Low retention means probably lower underwriting results and
investment income, but also shows a lack of involvement on the part of the insurer.
The practice of reinsuring large proportions of risks has been called "fronting"
and has been criticized by many as bad insurance practice.
On the other hand, if the retention level is too high, the insurer runs a risk of
high variability in the results and in extreme cases, financial ruin. Generally, the
retention decision is based in the following factors:

1). Insurer's own resources, i.e., paid-up capital and surplus.

2). Amount of premiums written expected to be generated by a portfolio.
3). Composition of the portfolio, i.e., size and number of policies.
4). The class of business
5). Geographical location and spread of risks.
6). Past experience of the insurer in the class of business
7). Expected underwriting profitability.
8). Probability of ruin.
9). Company's investment strategy.
10). Availability and cost of reinsurance.
11). Local regulations and foreign exchange controls.

The four functions of financing, capacity, stabilization and catastrophe

protection will all be needed at different times in a company's development, and
the reinsurance program, far from being written forever, will have to change to
adapt to the company's needs (See example in Appendix 1).
 Table 14.1
The Functions of Reinsurance
TYPE FINANCING CAPACITY STABILIZATION CATASTROPHES

QUOTA-SHARE YES To some extent NO NO

SURPLUS To some extent YES NO Not the purpose

EXCESS
PER-RISK NO YES YES Not the purpose

PER-OCCURENCE NO NO YES
YES

AGGREGATE NO Not the Purpose YES YES

Note: Adapted from Webb et al., 1984, p. 348.

According to a recent study by the Reinsurance Association of America, 80

percent of all reinsurance contracts written in 1988 were treaties and the
remaining were facultative reinsurance. From 1980 to 1988 this percentage varied
between 80 and 90 percent.4

Cost of Reinsurance
In pro-rata treaties the ceding commission paid by the reinsurer to the ceding
insurer will vary according to the reinsurer's estimate of the loss ratio to be
incurred and the premium volume ceded under the treaty. It will generally cover
the acquisition expenses of the primary insurer without providing a long term
commission "profit" or incentive to the insurer to cede a larger amount of business
than needed. Retrospective (or profit-sharing) commission arrangements are quite
common.
In excess-of-loss treaties, the rate-making procedure is more complicated
because the reinsurer expects a long term profitability. However, market
competition in reinsurance quite often drives the reinsurance rates below the
"normal" rate. The rate is usually defined as the expected losses divided by the
premium volume ( often called the "burning cost") and multiplied by a profit
margin. Note that when the net retention of the primary company increases (a
similarity with the deductible clause), the rate also declines.
Very often reinsurance brokers are used as intermediaries between the ceding
companies and the reinsurance companies. The broker's remuneration is paid by
the reinsurer as a fixed percentage of the premiums ceded to the treaty.
Reserve Deposit

The practice of keeping as security a certain proportion of the premium due to the
reinsurer has grown because, in the event of the insolvency of the reinsurer, it is
easy for the ceding company to use that amount to offset premiums. The ceding
company keeps the reserve for a year and releases it at the end of the year or at
the close of the treaty.
The purpose of a loss reserve deposit is to provide the ceding company with
further security for the obligations of the reinsurer in respect of outstanding
claims. The deposits are usually kept by the ceding company, but they belong
ultimately to the reinsurer.
_____________________________________________________
DISCUSSION:
An insurance company has developed the following reinsurance
program for homeowners insurance line of business:

Market and Rate-making conditions:

Average frequency of losses = 0.02
Average severity of losses = $15,000
Pure-premium = $300
Portfolio: 210 policies
Total premium volume = $ 63,000

Quota-Share reinsurance treaty 40%

Total net premium volume = $ 37,800
Excess-Loss reinsurance treaty over $40,000 per risk
Stop-Loss reinsurance treaty 90% over 85% loss ratio

Claims for the year: Excess-Loss Quota-share Stop-Loss

$ 500 - - $ 200 -
$ 65,000 - $ 25,000 - $ 16,000 -
$ 5,000 - - $ 2,000 -
$ 500 - - $ 200 -
$ 15,000 - - $ 6,000 - $ 4,023
$ 1,000 - - $ 400 - $ 540

Total : $87,000 $62,000 $ 37,200 $ 32,637

Loss ratio: 138.1 % 98.4 % 98.4 % 86.3

______________________________________________________
Functioning of the Reinsurance Market
Reinsurance helps the functioning of the law of large numbers in two ways. First
by reinsuring a large number of primary insurers, a reinsurance company can
diversify a risk in a manner that is not possible for a single insurer. 3 ways: 1) by
allowing primary insurers to underwrite a larger number of loss exposures, 2) by
improving geographical spread, and 3) by reducing the effective size of the
exposures insured.
Reinsurance is a process of financial intermediation which distinguishes itself
from a pure brokerage role in several manners:
1) by providing a mechanism to allocate funds to the most efficient capacity,
2) by enabling risks to be diversified and transferred from ultimate insurers,
3) by enabling changes to be made to the structure of insurance portfolios.
These considerations apply equally to national and international transactions.
The geographical location of the actors is irrelevant. The presumption must be
that efficiency in reinsurance intermediation is enhanced to the extent that agents
have access to a global system of universal information about world-wide options,
transactions costs, exchange rate uncertainty and any extra dimension to risk
involved with sovereign exposure.

Reinsurance Marketing
Reinsurance can be marketed through independent agents or brokers, or through
employees of the reinsurance company. The reinsurance department of the larger
insurance companies is also involved in cessions and retrocessions.
The function of a reinsurance broker is essentially the same as that of any
other insurance broker. The brokerage commission is paid by the reinsurer
seeking business and it is not very clear whether the reinsurance broker is a
representative of the ceding company or the reinsurer. Many insurance
companies, especially the small ones, do not have a reinsurance department and
must rely on outside expertise.

Utmost Good Faith

Most certainly, reinsurance contracts belong to that class of contracts known as

"Uberrimae fidei" which demand a high standard of good faith between the
parties. There must be the fullest disclosure of any fact which is considered
material. This doctrine applies equally to both treaty and facultative reinsurance.
Details of every risk ceded to the reinsurer are forwarded in the form of
bordereau. It includes information on the risk insured as well as an indication of
the maximum possible loss, the company's net retention and the amount reinsured.
 Reinsurers are always bound to follow the settlements of the primary insurer
and reinsurance is therefore an indemnity against payment of a claim by the
insurer.

Claim Settlement
The adjustment of claims is the responsibility of the primary insurer. However,
in highly technical lines of business, the reinsurance company often participates
in the adjustment of claims that will ultimately result in reinsurance claims.
The reinsurance company is legally obligated to make payment to the ceding
company as soon as the proof of loss has been received. In practice, excess loss
contracts do not come into play until the adjusted losses exceed the retention.

Pools
The principle of a reinsurance pool is that all members of the pool create a
common fund for a particular category of risk and share the aggregate claims
arising in agreed proportions. Profits, losses and expenses are shared in the same
way. The main advantage of a pooling system is the creation of capacity to handle
risks of a catastrophic nature or of a special category with large risks (for example
aviation). It does not necessarily improve the underwriting results of the class of
business.
Governmental pressure has been the initiating force in the formation of some
pools like the nuclear energy pools. Other classes of risks, where high value is not
necessarily the only problem, such as in livestock cover, crop insurance, are also
handled under pooling arrangements. A pooling arrangement may be organized
by a group of insurers or reinsurers for their own benefit, such as the FAIR pool.5
Pools have been created among developing countries in some regions to
reduce the flow of reinsurance premiums going to reinsurers outside that region.
Members must cede to the pool all business which fall within the scope of the
arrangement. This pooled portfolio is then protected with a suitable excess of loss
reinsurance treaty. The usual practice is also to retrocede to each member
proportionately according to volume of business ceded by the member.
Joint underwriting associations and reinsurance plans exist in many countries
in lines of business, like motor insurance, where some persons or companies are
unable to obtain insurance coverage in the market and are assigned to the pool.

The World Reinsurance Market

Initially, reinsurance was transacted amongst primary insurers in the same market
and on a facultative basis. In the middle of the nineteenth century, the first
specialized reinsurance company was created in Germany and soon followed by
other companies in Europe.6 According to Golding (1965, p.26), it is the
limitation of facultative reinsurance that forced the creation of professional
reinsurance companies offering treaties.
With the increasing number, size and complexity of risks insured and the
emergence of risks of an international character, international reinsurance has
grown dramatically after World War Two.
Traditionally, there were a few major markets which were in a position to
offer reinsurance facilities on an international scale. The increased demand for
reinsurance all over the world has spurred a rapid expansion in the number of
reinsurers, particularly in countries that offer off-shore facilities. Captive
companies, syndicates like Lloyds, associations and pools have also been formed
to provide a market. In recent years this market has been enlarged by large primary
insurers.
Recalling the extent of State intervention in the field of direct insurance
(primary insurers) in almost all the countries, it would probably be hopeless to
attempt to draw up a list of companies controlled by outside concerns and which
are operating on a worldwide basis. An estimate is provided in table 14.2.
On the other hand, due to the international nature of reinsurance, reinsurers
have enjoyed, and on the whole are still enjoying, relatively preferential treatment.
The same political and economic forces working towards nationalization of direct
insurance, and the establishment of national insurance markets, also favour
international reinsurance. At the same time, reliance on foreign insurers has
decreased, and reliance on foreign reinsurers has consequently increased.
Moreover, as reinsurance is practically invisible to the public, and not directly in
contact with it, it does not offend nationalistic sentiments.

Table 14.2
Number of International Reinsurers

Region 1965 1975 1985

North America 31 55 117
Europe 129 121 175
Rest of the World 37 53 84
World Total 197 229 376
Source: Sigma, Zurich: Swiss Reinsurance Company, no.10, October 1985.

The increase in the number of reinsurers and the expansion of the market
have brought a wider international distribution and coverage of risks.
Unfortunately, the increase has also brought serious problems of the security of
new reinsurance companies. Reinsurance underwriting has been affected by a
deterioration in the quality and experience and traditional insurance markets have
been affected by the increased competition on rates. 7
International brokers play a dominant role in the negotiation of reinsurance
contracts and the placing of reinsurance worldwide. The broker is free to place
the business with any reinsurer and he has a certain leverage to stir up competition
amongst reinsurers. According to the legal definition, the reinsurance broker is an
agent of the ceding company because he acts on its behalf in negotiating and
procuring reinsurance cover (Butler, 1979).
The image of the reinsurance broker has also suffered in recent years from
the involvement of a number of brokers having inappropriate standards of ethical
professionalism. This was a major concern for many insurers from developing
countries which did not have the necessary technical know-how.

Size and Market Shares

Today the volume of international reinsurance is certainly quite important
although not known with precision. According to data published by the review
ReActions, the first 100 reinsurers wrote in 1986 US Dollars 38,963 million and
in 1992, the total net premium had almost double to US $ 63,844 million. This
market is in the hands of a few companies. The first 30 companies wrote about
69 percent of total net premiums in 1986 and 71% in 1992. The largest companies
originate from only 8 countries (table 14.3).
An analysis of the top 100 reinsurance companies in 1986 and 1992 confirms
the relative importance of eight countries in the world reinsurance business (table
14.4).

Table 14.3
The Largest Reinsurance Companies in the World
Market share of the first: 1986 1992 Nb of countries
of origin
3 companies 27.3% 23.9% 3
5 companies 33.4% 31.1% 3
10 companies 44.8% 45.2% 5
15 companies 52.3% 55.3% 7
30 companies 69.0% 71.2% 8
 Table 14.4
Market share and Number of Reinsurers by Country
Country 1986 1992
Market Share Nb Cies Market Share Nb Cies
United States 28.81% 28 26.52% 26
Germany 24.16% 16 26.48% 12
Japan 12.68% 16 26.48% 17
Switzerland 11.66% 5 12.23% 9
France 6.33% 10 7.20% 8
United Kingdom 5.54% 6 4.71% 9
Sweden 3.46% 3 2.83% 4
Italy 1.99% 2 2.91% 1
Finland 1.28% 4 - -
Netherlands 0.79% 1 - -
Brazil 0.72% 1 - -
Denmark 0.58% 2 1.65% 2
Norway 0.45% 1 0.81% 1
Bermuda 0.43% 1 0.50% 1
Bahrain 0.32% 1 0.22% 1
Iraq 0.31% 1 - -
Korea 0.29% 1 0.63% 1
Algeria 0.20% 1 - -
Australia - - 0.62% 1
Belgium - - 0.59% 1
Spain - - 0.47% 1
Canada - - 0.24% 1
Turkey - - 0.21% 1
South Africa - - 0.18% 1
______ ___ ______ ___
100.00 100 100.00 100

Source for tables 14.3 & 14.4: Top 100 companies listed by Standards & Poors,
ReActions, March 1988 and March 1994.

The Retention Capacity of Developing Countries' Markets

The retention capacity is defined as the total volume of business retained at the
country level by the market for its own net account. One of the important reasons
why reinsurance is taken out abroad is obviously to make up the shortage of
capacity of the internal market. The sizes and quantities of risks normally vary
from one company to another and also from one country to another. The portfolio
of a company operating in a small and highly fragmented market will inevitably
be very different from that of a company enjoying a complete monopoly, and their
respective retention capacities and reinsurance needs will also differ.
In appendix 3, the retention capacity of selected developing countries is
shown for two lines of business. Countries are ranked by means of the dollar
amount of premium per capita in the non-life insurance market. Excess of loss
treaties are usually subscribed in motor (automobile) insurance and, countries
having an important share of motor insurance business have to retain a large share
of the risks. On the other hand, because of the heterogeneity of the fire insurance
business and the lack of diversification, countries having an important share of
fire insurance business in the overall portfolio have to cede a larger share of the
risks.
In most developing countries, insurance is less than 100 years old and the
practice of reinsurance is even more recent. Thirty years ago, reinsurance was
provided almost exclusively by reinsurers from Europe. Today, reinsurance
companies have been formed in many countries and regional companies have
been established by governments like the African Reinsurance Corporation in
1978 and the Asian Reinsurance Corporation in 1980. However, developing
countries have certainly not improved their positions in the world market. 8
Structural characteristics of the market for financial institutions play also a
major role in determining the allocational efficiency of the demand and supply of
financial services and particularly reinsurance services. If the objective is to retain
in the country as much insurance business as is technically possible, with due
regard to the stability of the insurance concerns, market structure is certainly an
important aspect to be considered. The problem of reinsurance in many
developing countries is that these structures have rarely been established
according to given retention requirements.

Summary

Regardless of the type and size of an insurance company, the use of reinsurance
is universal. The transaction between the primary insurer and the reinsurer is not
only a transfer of money, it enhances the functioning of the insurance mechanism.
The functions and methods of reinsurance are explained in this chapter. The need
for risk diversification, capacity and expertise has been increasing in the past
decades and is reflected in the growing importance of the reinsurance market.

Concepts: Ceding company, Reinsurer, Cession, Retrocession, Retention, Treaty,

Capacity, Quota-Share, Surplus, Excess of Loss, Stop-Loss, Pools.

________________________________________________________________
References
Bellerose, Philippe, R., Reinsurance for the Beginner, London: Witherby & Co,
1978.
Blanc, Pierre M. J., Qu'est ce que la réassurance? ,
Paris: Editions de l'Assurance Française, 1977.
Butler, J.S., The Legal Position of Reinsurance Brokers, London: ROA, 1979.
Denenberg, H.S., Eilers, R.D., Melone, J.J. and R.A. Zelten, Risk and Insurance
, Englewood Cliffs, NJ: Prentice Hall, Inc., 2nd ed., 1974.
Doherty, N. and S. Tinic, "Reinsurance Under Conditions of Market
Equilibrium," Journal of Finance, vol. 36, 1981, pp. 949-953.
Gerathewohl, K., Reinsurance Principles and Practice, Karlsruhe: Verlag
Versicherungswirtschaft, 1980.
Golding, C.E., The Law and Practice of Reinsurance, 4th ed., Brentford,
Middlesex, 1965.
Grossmann, M., Rückversicherung - eine Einführung, Bern, CH: Verlag Peter
Lang, 1977.
Irukwu, J.O., Reinsurance in the Third World, Ibadan, Nigeria: The Caxton
Press Ltd., 1980.
Kiln Robert, Reinsurance in Practice, London: Witherby & Co, 1981.
Michelbacher, G.F. and N.R. Roos, Multiple-Line Insurers: Their Nature and
Operation , Chap. 5, New York: McGraw-Hill Book Co., 1970.
Rangarajan, G., The Theory and Practice of Reinsurance, Singapore: Insurance
Training Center, 1979.
Riegel, R., J.S. Miller and C.A. Williams, Insurance Principles and Practices,
Englewood,NJ: Prentice-Hall, 1976.
Webb, B.L., Launie, J.J., Willis Park Rokes, J.D. and N.A. Baglini, Insurance
Company Operations , vol. 1, Malvern, Pennsylvania: The American Institute
for Property and Liability Underwriters, 3rd ed., 1984.
 Appendix 14.1
Defining a Reinsurance Program for a Small Company
EVA Insurance Co. is a small property and liability insurer in Canada, writing
only individual property insurance (homeowners insurance), and its portfolio is
expected to be at the end of the year as the following: (to simplify the example we
will assume that premiums are net of acquisition expenses)
Property insurance $3,800,000
Liability insurance $1,200,000
Total net earned premiums $5,000,000
Capital and surplus $1,000,000

Property insurance General liability insurance

Policy limits ($) Nb of Policies Policy limits ($) Nb of policies

0 to 50,000 24% 100,000 or less 600 60%

50,001 to 75,000 31% 100,001 to 250,000 250 22%
75,001 to 100,000 20% 250,001 to 500,000 180 15%
100,001 to 150,000 14% 500,001 to 1,000,000 70 3%
150,001 to 200,000 7% _____ _____
200,001 to 300,000 3% 1,100 100%
300,001 to 400,000 1%
400,001 or more 0%
_____
100%

The capital paid-up and surplus of the company amount to 1 million for an
expected net premium volume of 5 million. The ratio of 5:1 is clearly too high
compared to the industry standard and the company requires financing. This ratio
can be reduced to 2.5:1 by purchasing a 50% quota share contract.

Before Quota Share After Quota Share

Net premiums 5,000,000 2,500,000
Expected losses 4,600,000 2,300,000
________ ________
Underwriting profit 400,000 200,000

Capital and Surplus 1,400,000 1,200,000

Before the quota share treaty the company could support losses of 1.4 million
beyond the expected losses of 4.6 million before being forced into liquidation.
The loss ratio would have to exceed 120%. After the quota share treaty, the loss
ratio would have to exceed 140%. This result in a much lower probability of
bankruptcy for the company.
What is a reasonable retention per risk is a matter of management concern
rather than a mathematical or actuarial analysis. It usually varies from 0.5% of the
cedent's net premium income. Another approach is to consider that the first loss
retention should be set between 1% and 5% of the company's capital and surplus:
1% of net premium written before quota share = $50,000
5% of capital and surplus at the beginning of year = $50,000

It is important to consider that only 24% of the cedent's property business has
policy limits below $50,000. The per-risk excess of loss program could be design
as follow:
1st layer: $100,000 in excess of $50,000 This will cover 89% of the
property portfolio.
The rate will be determined at posteriori based on the following formula :
Rate = 100/70 x (loss cost / net earned premiums)
subject to a minimum of 1% and to a maximum of 3%.
(note: loss cost / net earned premiums is called the "burning cost" )

2nd layer: $250,000 in excess of $150,000 This will cover 100% of

the property portfolio.
Rate = 0.80% of net earned premiums.

3rd layer: $600,000 in excess of $400,000 The purpose is to cover

the potential large liability losses representing
only a small percentage of the portfolio.
The ceiling at 1 million correspond to the
maximum coverage offered by the company.
Rate = 0.25% of net earned premiums.
In this example, the net earned premiums are considered equal to 5 million
before quota share. Under the first layer, the reinsurer will get a minimum of
$50,000 and a maximum of $150,000. The result will be a gross profit of 42.9%
(30/70 ths) as long as the loss is between $35,000 and $105,000. This profit
margin is intended to provide for the reinsurer's expenses and profit. However, if
the incurred loss is bellow $35,000, the cedent is paying too much, and if the loss
is above $105,000 the reinsurer will probably loose money.
The insurance company will also purchase a catastrophe treaty ( per-
occurence excess ). The retention being $50,000 on each policy, the company
would become insolvent if more than 20 policies are affected by the same event
at the same time. The geographical location and the spread of the risks assumed
in the portfolio are the major factors affecting the decision. Two catastrophe
treaties could be purchased as follow:
1st layer: $1,000,000 in excess of $1,000,000
 Rate: 0.15% of net earned premiums
2nd layer: $2,000,000 in excess of $2,000,000
Rate: 0.12% of net earned premiums.

Appendix 14.2
Financial Reinsurance
A reinsurance contract can be prospective, retroactive or both. Under a
prospective contract, the ceding company pays a premium to the assuming
company in return for indemnification against loss or liability relating to events
that occur following the effective date of the contract. Under a retrospective
contract, the ceding company pays a premium to the assuming company in return
for indemnification against loss or liability relating to events that have already
occured. This reinsurance practice called loss portfolio transfer has become very
popular in the recent past.
By definition, the insurance risk involves uncertainties as to the ultimate
amount of any claim payments ( the underwriting risk) and the timing of these
payments (the timing risk). A reinsurance contract is an agreement between the
ceding company and the assuming company whereby the later assumes all or part
of the insurance risk. Contracts that do not transfer underwriting risk are referred
to financing arrangements or financial reinsurance. They have become a
common practice to artificially inflate the surplus and provide window-dressing
for the ceding company's operating results.
Historically, non-risk bearing contracts have taken the form of quota share
agreements with high provisional commissions adjusted on a point-for-point basis
with losses incurred. Thus, the surplus created through the transfer of unearned
premiums would eventually disappear as the book of business developed. Modern
days versions are highly complex contracts that are packaged in a variety of ways
and are mainly based on the time value of money when expected interest rates are
high.
Reinsurance contacts that do not transfer the insurance risk must not be
accounted for reinsurance. These contracts have the following common elements:
- There is no intention by either party to actually share losses and the
agreement has retrospective adjustments like sliding scale commissions,
contingent commissions, or other similar provisions that guarantee the ex-post
underwriting result of the assuming company.
- The agreement has provisions that specify payments schedules at
determinable dates or formulas that delay reimbursement to the ceding company
to guarantee an investment return to the assuming company.

Example of quota share agreement (prospective):

Coverage: 40% of losses applicable to the book of business.
Premium: 40% of written premiums.
 Commission: 32% of reinsurance premiums with unlimited retrospective
adjustment as the actual loss ratio deviates from the target
loss ratio of 73%.

If the ex-post loss ratio is 85%, the commission is adjusted downward by

12%. There is clearly no transfer of underwriting risk and a guaranteed result to
the reinsurer unless the loss ratio exceed an unrealistic 105%.

Example of loss portfolio transfer (retrospective):

Coverage: $10 million of unpaid incurred losses as of December 31, 1990.
Premium: $ 7.5 million.

If less than $10 million of losses are ultimately paid, only the amount of losses
paid will be recovered from the reinsurer, but usually, the ultimate amount paid is
very close or even higher. There is a transfer of underwriting risk, however, if the
contract includes a claim payment provision, the contract may guarantee in fact
an investment return to the reinsurance company.
Example of claim payments clause: Payments of covered losses will be
due only after December 31, 1992.

The position of regulatory authorities:

The ceding company's real solvency margin has not improved in the long run.
The surplus gain from a financial reinsurance contract may not be considered
earned surplus until such time as the actual liabilities transferred have been
recovered and terminated.
 Appendix 14.3
Retention Capacity of Selected Countries

Country Size in 1989 Retention (average 1988-89)

Premium/Head Fire Line Motor Line
in US$ % %

Barbados 230.0 24.0 88.8

Singapore 147.0 61.6 95.5
Malta 110.6 89.4 99.8
Cyprus 94.1 55.7 91.4
Korea, Rep. of 78.4 78.0 99.8
Gabon 53.4 45.6 88.4
Oman 45.8 20.7 95.7
Malaysia 45.0 43.6 80.8
Mauritius 32.0 20.4 75.5
Chile 25.4 20.5 89.4
Mexico 17.4 54.8 99.7
Egypt 15.4 38.7 84.1
El Salvador 12.0 23.4 87.5
Morocco 11.9 36.7 78.1
Zambia [M] 10.9 71.2 99.1
Ecuador 9.2 26.3 78.0
Thailand 9.0 32.1 96.0
Paraguay 8.3 27.1 90.7
Honduras 6.5 27.2 91.0
Guatemala 5.5 37.1 90.7
Syrian Arab Rep. [M] 4.8 53.2 95.0
Togo 4.0 36.3 89.0
Sudan 3.0 10.7 86.0
Indonesia 2.5 40.8 86.1
Benin [M] 2.2 26.6 93.4
Nigeria 1.7 34.0 77.3
Tanzania [M] 1.4 78.7 98.2
Ethiopia [M] 1.3 58.6 100.0
Mali 1.2 40.6 89.2
Chad 0.9 10.8 94.4

Note: [M] = Monopolistic market.

 1
See the following papers:
L.J. Berger, J.D. Cummins, and S. Tennyson, Reinsurance and the Liability Crisis,"
The Journal of Risk and Uncertainty, vol. 5, 1992, pp. 253-272.
J.R. Garven, "The Demand for Reinsurance: Theory and Empirical Tests," Working
Paper, Department of Finance, Graduate Business School, The University of Texas at
Austin, 1990.
D. Mayer and C. Smith, "On the Corporate Demand for Insurance: Evidence from the
Reinsurance Market," Journal of Business, vol. 63, 1990, pp. 19-40.
J. F. Outreville, “Reinsurance in Developing Countries,” The Journal of Reinsurance,
vol. 2, Spring 1995, pp. 42-51.
2
The theoretical relationship between premium volume and surplus is open to debate.
The practical limit often imposed by regulators vary from one line of business to another.
A ratio of 3 to 1 is usually considered very safe.
3
Some contracts are called obligatory facultative or automatic facultative and the
distinction between facultative and treaty may become more complicated to understand.
4
Reinsurance Association of America, Reinsurance Underwriting review: 1988
5
The Federation of Afro-Asian Insurers and Reinsurers is an Association known as
FAIR. The Pool was created in January 1974 and is managed by Milli Re in Istanbul.
6
The world's first professional reinsurer was the Cologne Reinsurance Company
incorporated in Germany in 1842. In Switzerland, the first reinsurance company was the
Swiss Reinsurance Company which was founded in 1863. The "Münchener
Rückversicherung Gesellschaft" (Munich Re) was established in 1880.
7
See two studies prepared by UNCTAD with a group of experts on the security and
credibility of reinsurers:
Reinsurance security, Geneva: United Nations, no. TD/B/C3/221, January 1987.
Reinsurance security for developing countries, Geneva: United Nations, no.
TD/B/C3/228, November 1989.
8
See UNCTAD, Reinsurance Problems in Developing Countries, Geneva: United
Nations, no. TD/B/C3/106, 1973.

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