Uploaded by Kevin Bett

Topic One

In their book Reinsurance in Practice, Robert and Stephen Kiln describe reinsurance as:
The business of insuring an insurance company or underwriter against suffering too great
a loss from their insurance operations; and
Allowing an insurance company or underwriter to lay off or pass on part of their liability
to another insurer on a given insurance which they have accepted.
Reinsurance serves a number of purposes. Its main purpose is a means by which an insurance
company or an underwriter (for instance, a syndicate at Lloyd’s) can reduce – from the point of
view of possible material losses – the financial consequences of the risks it has accepted as an
insurer. An insurer acting as a buyer of reinsurance cover is generally known as a ‘reinsured’, but
may also be called a ‘ceding company’ or a ‘cedant’. Overall, the losses are not reduced, but the
reinsured benefits from the smoothing effect that the transfer of any part of the risk has on the
material consequences of the loss.
Purpose of reinsurance
Spreads 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 – in contracts of indemnity – to put them in the same
financial position that they were in immediately prior to the loss.
Increases capacity
An insurance company’s capacity is its ability to provide a limit of cover in the policy it issues to
its insured. In determining its capacity, the insurance company has to calculate how much of its
capital it is prepared to put at risk. In addition to the capacity it can offer on a single risk, the
insurance company also has to consider the extent to which it takes on aggregations of liability
from writing many risks that are all exposed to the same potential loss.
An insurance company can offer a greater gross capacity than it considers prudent to retain for its
net account by paying a reinsurer to take on the difference. Its net capacity is the amount it retains
for itself after it has laid off (or passed on) part of its liability to a reinsurer.
Provides security
Another reason for the purchase of reinsurance is that the insurance company wants to be relieved
of some of the uncertainty of loss. This can be achieved by the purchase of reinsurance. It is
important, of course, to check the security of the reinsurer: it must be able to pay should a loss
occur that is recoverable under the terms of the contract between the insurer and reinsurer.
Increases stability in results
The insurer can also avoid fluctuations in claims levels from year to year and within a year by the
purchase of reinsurance. Again, parallels can be drawn here between the motives that persuaded
the insured to purchase insurance in the first place.
Increases confidence
We are already beginning to see that reinsurance is not the only option open to an insurance
company that wants to protect its trading position and grow its core business, while seizing
opportunities to expand into new products and markets. Opportunities may exist to transfer risk
into financial markets and investors in insurance companies may invest with confidence – safe in
the knowledge that a number of risk uncertainties have been removed in this way.
Portfolio and asset management
An insurance company’s portfolio is the entire range of risks that it underwrites. It can include
motor, household, commercial and professional indemnity among many other classes. Insurance
underwriters are increasingly being judged by their gross underwriting results. They aim to achieve
a gross profit without reinsurance being in place and use reinsurance to protect the exposure of
their account against any adverse annual fluctuation.
There is also the question of whether a company protects its portfolio overall, or chooses to
consider individual classes of business. Individual underwriters within an organization used to
purchase reinsurance for their separate classes of business, but reinsurance buying is now
becoming more centralized, with the trend towards cross-class portfolio protection.
Taxation advantages
Insurance companies are taxed on their technical underwriting results: that is, their final position
after taking into account:
 all the premiums received;
 losses and loss settlement costs;
 administration costs;
 subrogation recoveries;
 reinsurance premiums paid; and
 reinsurance recoveries made (included in this result is any reserve for outstanding losses
less any expected recovery for those outstanding losses from reinsurance).
Therefore, unlike equity returns which are taxable, reinsurance premiums are included within the
underwriting result and as such are tax deductible. This is a consideration for insurance companies
planning how to resource their company for any exceptional losses that might arise from their
Cash flow advantages
Effectively, an insurer has to maintain a balance between 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 cost of reinsurance against the
potential gains to be realised from the investments. It would also have to consider the type of
reinsurance bought as to whether, and to what extent, it would have to release its premium as
reinsurance premium and when it could expect to obtain payment from the reinsurer for claims.
Corporate strategy
The extent to which a company will risk its assets – if at all – 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 find themselves risking more than they would choose, and would probably
seek comfort from the arrangement of reinsurance.
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 services
company might want to offer insurance products. As a case in point several banks have branched
out into selling insurance services in Kenya in partnership with an existing insurance company. In
order to do this without affecting its overall results, an insurer may look for reinsurance to protect
the new venture.
Buyers of Reinsurance
Insurance companies
Insurance companies form the most important group of reinsurance buyers in terms of the volume
of reinsurance business transacted. It is a very diverse group, ranging from small, newly
established companies operating in a developing country to the major international insurance
groups with annual premium incomes in excess of Kshs.200 billion from business transacted in
many different countries.
Lloyd’s syndicates
The Lloyd’s market does not consist of a single risk-bearing organisation, but is made up of many,
separate, underwriting operations, known as syndicates.
The nature of the account written by a Lloyd’s syndicate can be more complex and varied than
that of a general insurance company and this possibility demands a more sophisticated approach
to buying reinsurance. This is arranged by Lloyd’s brokers.
Lloyd’s is dominated by syndicates backed up by corporate capital; the reinsurance needs of these
corporate entities can be said to be similar to those of insurance companies.
State-owned insurance corporations
Many countries have established state-owned insurance corporations, especially (but not only)
those with emerging economies and insurance markets. These corporations may be granted up to
100% monopoly of all insurance business. In Kenya, we had the Kenya National Assurance
Company before its collapsed in 1987
A monopoly state-owned insurance corporation is usually required to meet all of its country’s
insurance needs, including cover for such entities as state air and shipping lines. Consequently, it
requires extensive reinsurance facilities to provide the underwriting capacity for such large risks.
Regional insurance corporations
Regional insurance corporations operate in a similar way to state-owned insurance corporations.
They are most prevalent in areas where individual states are united by close political and cultural
They are characterised by a common desire to retain premiums within the region and a belief that
local investment should help local economies, rather than act as a feeder for overseas economies
that are already at advanced stages of development. An example is the COMESA insurance and
the Africa Reinsurance Corporation
Takaful companies
Takaful insurance is an Islamic insurance concept which observes the rules and regulations of
Islamic law. ‘Takaful’ is an Arabic word meaning ‘guaranteeing each other’. This system is based
on mutual cooperation, shared responsibility, joint indemnity, common interest and solidarity
between groups of participants.
Takaful has come into prominence in recent years in the Muslim world because traditional
insurance has some features that are at variance with certain essential values of a financial contract
in Islam. It is, therefore, an alternative means of Muslims obtaining protection against the risk of
loss, with similarities to mutual insurance. Policyholders avoid gambling on the fortunes or
misfortunes of others as money is paid into a communal fund and those participating take out what
they need in the event of a claim.
Captive insurance companies
Changing risk management practices mean more risks are being retained by organisations instead
of being passed on to insurers. A key mechanism in this shift has been the captive insurer: a riskbearing entity controlled or owned by an organisation whose primary business is not insurance.
The captive then needs reinsurance for the same reasons a primary insurer does.
Mutual insurance companies
Although they have largely disappeared from the insurance arena, passing mention should be made
of mutual insurance companies. Mutual insurance companies are owned by their policyholders,
who share in the profits of the company by means of lower premiums or preferential cover. In
theory, the policyholders are liable for losses made by the company; in reality, mutuals are limited
by guarantee. This means that the maximum liability of a policyholder is usually limited to the
premium paid. Over the years many mutuals have become proprietary companies through the
process known as demutualisation. An example is the Old Mutual Insurance Company of Kenya
Reinsurance companies
The term ‘professional reinsurance company’ is used to describe those companies that only
underwrite reinsurance business. As specialist sellers of reinsurance, they obtain business through
brokers, in addition to establishing direct relationships with their clients.
These professional reinsurers need to buy reinsurance protection, known as retrocession, for their
own accounts. This is needed to provide for liabilities in excess of their own underwriting capacity
and so protect them against potentially crippling losses.
Reinsurance pools
Reinsurance pools have been formed on both a national and a regional basis to handle particular
types of reinsurance. Pools are multi-reinsurer agreements under which each reinsurer in the pool
assumes a specified portion of each risk ceded to the pool. They buy reinsurance as a means of
protecting their trading results.
This is the limit of liability the insurer retains for its net account after reinsurance ceded. It is
usually expressed in monetary amounts or as a percentage share in conjunction with a monetary
The retention may apply to a single risk or to a series of risks, or to a single loss or a series of
losses. Retentions are usually fixed for each class of business (i.e. property, casualty, marine, e.t.c.)
separately with classes subject to further subdivisions e.g. marine hull and marine cargo
The factors that influence retention include;
 Assets, capital and free reserves together with solvency
 Size of portfolio, premium income and profitability
 Type and spread of risks
Motivation for selling Reinsurance
Reinsurance is generally a profitable industry over a sustained period – otherwise it would be
unlikely to exist. Companies endeavour to ensure that their combined ratio is kept below 100%.
In this context, the combined ratio is a calculation of two ratios for the year added together to
provide a simple indication of current underwriting performance. These ratios are:
 the loss ratio: this is the percentage of incurred losses (may also include loss adjustment
expenses) to earned premiums; and this is added to
 the expense ratio: this is the percentage of incurred expenses to written premiums. When
there have been increasing investment returns available from reinsurance, capital
investment has arisen. This is because investment vehicles have considered the relative
return from reinsurance to be higher than other investment opportunities.
Investment income
Underwriting reinsurance business gives companies income that can be used for investment
purposes. Until recently, many companies underwrote reinsurance on the basis that the investment
return on their assets would cover any shortfall in their combined ratios. When reinsurance is
transacted with market share rather than underwriting profit as the principal objective, downwards
pressure is created on reinsurance pricing.
Companies may also participate in the selling of reinsurance because they consider the return on
equity from it to be stronger than other forms of equity investment. This is particularly relevant if
reinsurance market prices are high when interest rates are low
Spread of risk
Insurance companies, in particular those that have their assets strongly linked to one market, may
wish to participate in reinsurance in order to obtain a spread of risk, and thus reduce the impact of
any catastrophe that could occur in their home market. Here we can see that an insurance company
can also assume the role of a reinsurer.
Companies may underwrite inwards reinsurance as part of a reciprocal arrangement with other
insurance or reinsurance companies. Insurance companies providing substantial business to a
reinsurer may expect business in return by participating in that company’s outwards reinsurance
National retention of premiums
Some governments, especially in countries with emerging markets, have set up domestic
reinsurance vehicles in order to ensure that not all reinsurance premiums flow from the country –
which could affect the balance of payments.
Core business
Some companies focus on the selling of reinsurance as they consider this their core business.
Examples of these are the large multinational reinsurance companies. With uncertain stock market
fluctuations, these companies would prefer to concentrate on growing their core business of
reinsurance, rather than experiment with developing new avenues of potential income.
Sellers of reinsurance
The sellers of reinsurance are the companies and Lloyd’s syndicates that are in the business of
accepting reinsurance business.
Reinsurance companies
A professional reinsurance company may be a multinational organisation obtaining its business
through a network of branch offices and subsidiary companies in many different countries.
Alternatively, it may be located in only one market while accepting a full international account,
either through reinsurance brokers or on a direct basis with its ceding companies. While some of
these companies may have ownership links with direct insurance companies, they operate largely
on an independent basis.
Lloyd’s syndicates
Many of the individual syndicates in the Lloyd’s market are important sellers of reinsurance –
relying on Lloyd’s brokers to bring in business. Within that market, there are major syndicates that
will quote and lead risks, as well as other syndicates that offer a considerable amount of supporting
Direct insurance companies
On a worldwide basis there are many direct insurance companies that also accept significant
volumes of reinsurance business as an adjunct to their main business. The scale and methods of
their involvement with reinsurance business varies as much as the type of company. Some small
domestic insurers may restrict their reinsurance activity to reciprocal exchanges only. Other
domestic insurers are prepared to underwrite an international reinsurance account, most of which
will be acquired through brokers.
State reinsurance companies
The governments of many countries, particularly those with emerging economies and insurance
industries, have formed State reinsurance corporations to meet the reinsurance needs for local
insurers. Some of these corporations may derive their reinsurance business from compulsory
cessions from the local insurers. Many of them also write international reinsurance business.
These corporations need to pass on some of their liabilities to the international reinsurance markets.
Sometimes, this is done in the form of reciprocal exchanges. However, the development of an
international account remains an objective for many such companies, and the option to establish a
branch or contact office in one or more of the existing international markets has been taken by a
number of these organisations.
ReTakaful companies
ReTakaful, or Islamic reinsurance, is a risk acceptance method in which the Takaful ceding
company resorts to a reTakaful operator to lay off part of an original risk that happens to be above
its normal underwriting limit. The ‘operator’ manages, in a Sharia-compliant manner, the
reTakaful fund, including claims handling, accounting, reserving of policy liabilities and risk
management. In return for carrying out its duties and responsibilities, the operator receives a fee
and a share of the investment income coming from the managed fund.
Reinsurance pools
Reinsurance pools comprise a number of insurance and/or reinsurance companies operating in a
particular country or region. They accept local or regional reinsurance business, sometimes of a
specialist nature, with the business accepted being shared among the participants of the pool.
So-called ‘sidecars’ provide additional capacity to a sponsoring (re)insurer through, typically, a
fully collateralised quota share arrangement. Third-party investors, such as hedge funds and
private equity funds, provide these extra resources by being offered debt in the sidecar. Sidecars
are often targeted at specific lines of business and tend to have a short lifespan, although some are
permanently structured to underwrite new business at each renewal season.
Reinsurance brokers
Although not normally an underwriter of risk, the reinsurance broker has a significant effect and
influence on the transaction of reinsurance business. Therefore, we must look at the role of the
broker in relation to the buyers and sellers of reinsurance.
To operate, a broker must have two markets available to them: one in which they can acquire
business and one in which they can place the business so acquired. Without these two facilities
they cannot operate.
Role of the Broker
The traditional role of the broker is the placing of reinsurance business. For this function to be
performed successfully there must be a party wishing to buy and another party wishing to sell. The
broker’s skill is identifying buyers and sellers and negotiating a deal involving the availability of
a product or service at a sufficiently attractive price that both buyers and sellers wish to strike a
The broker is typically remunerated by a deduction of brokerage from the premium paid to the
How brokers acquire business
A broker acquires business in the following ways:
by a direct approach from a ceding insurer that is used to dealing through a broker, probably
because it has a large or complicated reinsurance programme to place that may need the
international connections that the broker has built up;
through the development of a new form or contract of reinsurance that has been
successfully sold to clients;
through personal relationships based on past dealings and experience, which lead to an
insurance underwriter offering some of its new or existing business;
through a long-standing business relationship with a ceding insurer that considers the
broking firm to have a better overall view of international markets, and to be in a superior
position to design and place reinsurance programmes than itself;
through its level of expertise and contacts with reinsurance markets; and
from intermediary brokers wishing to place reinsurances or retrocessions on behalf of a
ceding insurer or reinsurer, which it does not have the authority or power to carry out itself.
How brokers place business
Brokers provide details of their client’s reinsurance to potential markets by means of a ‘slip’, or in
the London Market, by a complete contract. In either case, the document sets out details of the risk
to be placed and it shows the terms and conditions that are to form the contract between the
reinsured and the reinsurer.
Depending upon the location of the broker and the reinsurer, business will be placed in the
following ways:
 locally, with face-to-face negotiation supported by electronic exchanges of data and
telephone calls; or
 Internationally, with letters, or increasingly by electronic communication systems (where
they exist) with acceptances, amendments and declinatures being recorded in the broker’s
office. Negotiations with overseas markets may sometimes be by personal contact, with
the broker travelling with all the relevant information to the various markets that it wishes
to use.
How brokers service clients’ business
Frequently, the broker will be required to perform the functions of the marketing and production
departments of a professional reinsurer. Therefore, it requires experienced staff capable of keeping
up to date with clients’ businesses and needs. They service clients business by;
Prepare and collect claims
Claims are negotiated and collected from the markets and reinsurers that were used for placements.
The broker will ensure that claims payments are passed on to the client in a timely fashion without
any undue delay.
Provide market intelligence
Market intelligence is becoming increasingly important for larger clients. All have an integral
interest in what is happening in the reinsurance industry and matters that affect it. Brokers’ clients
expect to be fully appraised of market developments.
Arrange reciprocity
The broker may also have a role to introduce inwards or reciprocal business for risks shown to a
particular reinsurer. This may be by means of strict reciprocity, whereby the contracting parties
make an agreement to offer a specified volume of business in return for receiving a comparable
volume of premium from a similar portfolio. Loose reciprocity applies where a general broad
account of reinsurance business is offered in a two-way flow of business between two insurers.
Check security offered by reinsurers
Most clients expect their broker to monitor the performance and suitability of the markets that are
available to write their reinsurances, although many of the larger buyers do this monitoring
themselves. While the viability of security cannot be guaranteed, brokers are expected to inform
clients of potential problems, using information from internationally recognised financial rating
agencies, where appropriate.
Provide documentary and analytical services including contract wordings
Brokers advise on the preparation of the contract wording for the reinsurance arrangement and
obtain the agreement of all the parties concerned. The larger brokers can also provide actuarial
analysis and market benchmarking data.
Provide risk management
In addition to basic risk transfer services, brokers help large insurers control the total cost of risk
by developing bespoke strategic risk management programmes. These understand business needs
and make informed decisions about risks that go beyond simple identification and evaluation.