Reinsurance refers to situations where insurance companies insure against losses they may incur. Insurance companies have a limited amount of capital and to protect this capital they will often cap the losses they may incur by purchasing reinsurance. Typically, the smaller the insurer the more reinsurance they will buy. Reinsurance also can reduce the risk facing a company when policies are issued with a high probability of lapse or surrender, as in policies whose premiums rise sharply from one year to the next. Similarly, reinsurance may limit the investment risk inherent in high concentrations from single products—especially annuities.
A second reason for reinsurance is to obtain the reinsurer’s underwriting assistance and expertise. The risk pool from which reinsurers develop and provide underwriting knowledge is generally much larger and wider than that of a single primary insurer.
A third reason companies reinsure is to help them either enter or exit given lines of business or product lines. A company associated with a given product line that wants to discontinue that line can reinsure most or all of the risk on that product. Alternatively, a company desiring to offer a new product line can obtain the help of reinsurers to develop and underwrite the product until the company develops its own expertise in the underwriting of that particular line of business. In some cases, the reinsurance agreement (or treaty, as the reinsurance agreement is typically called) has provisions that permit the ceding company to take back some of the risk the reinsurer had assumed as the ceding company’s ability to assume the risk grows over time.
Another reason for the use of reinsurance is to help a company manage its financial position. A reinsurer can provide allowances based upon its anticipation of future profits. This may increase the ceding company’s statutory earnings and surplus during the year paid. By ceding business, the reinsurer sets up reserves on its books and lessens the amount the ceding company has to set up in reserves. If a company is growing quickly, this is especially advantageous since initial costs (expenses plus reserves) are higher than premiums received.
Sixty-nine percent of life insurers ceded life premiums from some of their policies as reinsurance in 2002.
In traditional reinsurance, or indemnity reinsurance, the company transferring the risk (the ceding company) retains its financial relationship with, and legal obligation to, the policyholders. In most cases, the policyholders are not even aware that part of the risk on their policies is covered by a reinsurer (the assuming company).
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM