The Reinsurance Market
Any market consists of buyers and sellers of a commodity. The same applies to the reinsurance market.
The buyers of reinsurance are insurance and captive insurance companies. The sellers are the reinsurance
companies themselves. In any market it is also possible to get middlemen and in the reinsurance market these are
called reinsurance brokers.
It is possible for the same company in reinsurance to trade as both a buyer and a seller of reinsurance.
Reinsurance markets can either be national or international. Major international markets have the following
attributes;
a) Sound financial background,
b) Strong technical expertise,
c) Currency that is freely negotiable,
d) Favorable exchange control regulations.
Leading international reinsurance markets of the world are, London, New York, Tokyo, Zurich, Bermuda etc
The more fragmented the market, the higher the demand for reinsurance. Small companies are financially weak
and seek support from reinsurance companies.
Reinsurance companies have co-business of supplying reinsurance but also operate as buyers of reinsurance
whenever they retrocede part of the business they would have accepted from direct insurers. Reinsurers buy
reinsurance for the same reasons that direct insurers buy reinsurance especially to manage the underwriting risk.
There are also state owned reinsurance companies that became a feature after World War 2. They originated in
Eastern Europe and spread to the Arab world and eventually to Africa e.g. Zim Re, KenyaRe, and NigeriaRe etc.
State owned reinsurance companies are controlled by legislation e.g. ZimRe Act of 1983.
German is home to the world’s largest reinsurer called Munich Reinsurance Company. Home to the world’s second
largest reinsurer, SwissRe, is Switzerland.
London Market
It transacts mainly non-life business as well as reinsurance on an international scale. It is home to the mighty Lloyds
of London. Reinsurance business placed with the Lloyds is done through reinsurance brokers.
There are more than 800 insurance and reinsurance companies in the London Market. Added to that are about
2500 broking firms and agents
Markets
Most reinsurance placements are not placed with a single reinsurer but are shared between a number of
reinsurers. For example a $30,000,000 excess of $20,000,000 layer may be shared by 30 or more reinsurers. The
reinsurer who sets the terms (premium and contract conditions) for the reinsurance contract is called the lead
reinsurer; the other companies subscribing to the contract are called following reinsurers.
About half of all reinsurance is handled by reinsurance brokers who then place business with reinsurance
companies. The other half is with “direct writing” reinsurers who have their own production staff and thus reinsure
insurance companies directly. In Europe reinsurers write both direct and brokered accounts.
Using game-theoretic modeling, Professors Michael R. Powers (Temple University) and Martin Shubik (Yale
University) have argued that the number of active reinsurers in a given national market should be approximately
equal to the square-root of the number of primary insurers active in the same market. Econometric analysis has
provided empirical support for the Powers-Shubik rule.
Insurers (that is to say, reinsureds) tend to choose their reinsurers with great care as they are exchanging insurance
risk for credit risk. Risk managers monitor reinsurers' financial ratings and aggregated exposures regularly.
Reinsurers
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Munich Re – Germany (US$31.4 billion Gross Written Premiums)
Swiss Re – Switzerland (US$30.3 billion)
Berkshire Hathaway / General Re – USA (n.a.)
Hannover Re – Germany (US$12 billion)
SCOR – France (US$6.9 billion)
Reinsurance Group of America – USA (US$5.7 billion)
Transamerica Re – USA (US$4.2 billion)
Everest Re – Bermuda (US$4.0 billion)
Partner Re – Bermuda (US$3.8 billion)
XL Re – Bermuda (US$3.4 billion)
(Based on the last company figures)
In addition, syndicates at Lloyd's of London wrote £6.3 billion of reinsurance premium in 2008
Basics of reinsurance
1.
Reinsurance Terminology
 Cede – pass business from insurer to reinsurer
 Cedant – the original insurer that passes business to the reinsurer
 Cession – the actual business passed from the insurer to the reinsurer
 Deductible excess – the 1st amount borne by the insurer for his own account for each loss. Used
as an underwriting tool in order to minimise the number of small administratively expensive
claims, or to reduce loss ratios, and to impose a duty of care on the insured.
 Limit – the maximum amount which an insurer is prepared to lose on any particular risk.
 Line – the amount of risk which an insurer keeps for its own account which is the maximum net
loss that can be sustained on that risk by the cedant.
 Reinsured – the direct writing insurer that takes out reinsurance protection, the cedant.
 Reinsurer – an organisation (insurer or reinsurance company) which accepts some of the
insurance risks underwritten by another insurer.
 Retention – the amount of a risk which an insurer keeps for its own account.
 Retrocession – a second reinsurance, that is where the reinsurer decides, having accepted a
cession to arrange a further reinsurance on its part of the risk.
2.
Legal Principles
Legal Principles applying to reinsurance contracts
The nature of reinsurance contracts
Reinsurance is a contract whereby one party, known at the reinsurer, undertakes to indemnify the other party,
either wholly or partially, for liabilities he may incur under a contract of insurance.
According to Lord Mansfield in Delver vs Barnes (1807) reinsurance is a new insurance policy, on the same risk
which was before insured in order to indemnify the underwriters from their previous subscriptions; and both
policies are in existence at the same time.
Legal considerations from this definition.
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Reinsurance contracts are types of insurance contracts.
For reinsurance there needs to be an original policy of insurance
Reinsurance may cover all or party of a cedant’s liability under an original policy of insurance.
Reinsurance is a separate contract between the cedent and reinsurer to which an original insured is not a
party (privy).
Features of reinsurance contracts
1) The Reinsurer’s undertaking to indemnify the primary insurer itself constitutes a contract of insurance.
2) The reinsurance may provide a complete or only partial indemnity against the liabilities the primary
insurer may incur under the head policy.
3) The reinsurance contract is a separate contract between the reinsurer and its reinsured to which the
original insured is not a party.
Is reinsurance a contract of insurance?
The characteristics of a reinsurance contract clearly fit accepted definitions of a contract of insurance. The
reinsurer enters into a binding agreement to pay the reinsured should a specified uncertain event occur which
involves the latter party suffering a loss under an original contract of insurance, which obviously affects it interest.
Therefore the courts have followed the judgment of Lord Mansfield virtually without question in treating
reinsurance agreements as contracts of insurance, at least where the point at issue concerned facultative
reinsurances.
English law is less certain in the case of reinsurance treaties. One interpretation of the position is that;
‘The parties are not in a partnership nor is the reinsured an agent of the reinsurer in accepting risks’. The fact that
a treaty is not a partnership was established in the case of Re Norwich Equitable Fire, it being held that the quota
share treaty in question constituted a contract of agency between the reinsurer and ceding company.
The law applicable to reinsurance contracts
Reinsurance contracts are subject to the general law of contract and the rules applicable to insurance contracts in
particular.
Consequently the provisions of contract law relating to such matters as an intention to create legal relationship,
offer and acceptance, consideration, capacity to enter into contracts, legality etc apply to the formation,
construction, performance and validity of reinsurance contracts. In addition they are subject to the special rules
governing insurance contracts, notably:
1) The must be an insurable interest.
2) The contract is one of utmost good faith.
3) The contract is one of indemnity.
The form of the contract
There is no general requirement in English law the reinsurance contracts take any special form, or even be in
writing. To be valid a reinsurance contract need only comply with basic requirements of simple contract as above.
It follows that a purely oral contract of reinsurance is valid. In practice it is preferable that all reinsurance contracts,
like direct insurances, should be embodied in documentary form signed by the reinsurer. Furthermore when there
are reciprocal obligation on both parties, as in reinsurance treaties, it is conventional for the document to be
issued in duplicate, both copies signed by both parties
Insurable Interest
In broad terms, an insured is deemed to have insurable interest if he/she stands in some legal or equitable
relationship to the subject matter of the insurance that will be prejudiced by the happening of the insured event.
It is a legal right to insure arising out of a financial relationship, recognized at law between the insured and the
subject matter of insurance.
Insurable interest in reinsurance has been has been described by the judge in the case of Uzielli vs Boston Marine
Insurance Company (1884) as follows:
“they were not the owners of the ship, and therefore they had none (insurable interest) as owners. But they have
an insurable interest of some kind, and that insurable interest is the loss which they might, or would suffer under
the policy, upon which they themselves were liable.”
Interest of the ceding company
The validity of a reinsurance contract likewise rests on the ceding company possessing an insurable interest in the
subject matter of the insurance. The insurable interest of the primary insurer (or a retrocedant) is limited to the
extent of the losses it may incur under the policy, or policies, it has issued, its liability being dependant on:
a) The sum(s) insured, or limit(s) of indemnity.
b) The things or liabilities insured.
c) The perils covered.
An insurer which by insuring a property against fire does not thereby acquire an insurable interest enabling it to
reinsure against burglary because it could not be prejudiced by such a loss.
If an original insured possesses no insurable interest then his/her policy is void and the direct insurer has no
interest to support a contract of reinsurance.
When must insurable interest in reinsurance exist for;
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In life insurance, at inception
In marine, at the time of loss
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In other insurances, at inception, time of loss and throughout the currency of the policy.
Utmost good faith
Like insurance contracts, all reinsurance contracts are subject to the principle uberrimae fidei – of utmost good
faith. It is not sufficient that the parties merely refrain from making misrepresentations; they have a duty to
disclose fully all material facts in the same way as the duty applies to contracts of direct insurance. It has been held
that this duty lies on both parties.
Breach of the duty by original insured
It has been held that where an insurer had been given by its insured false information that, without checking its
accuracy it passed on to the reinsurer, the latter was entitled to avoid the reinsurance agreement. If, despite a
breach of duty by the insured, the reinsured pays a claim, it maybe construed ex gratia by the reinsurer who may
seek a declaration that it is not liable to the reinsured.
Facts to be disclosed by the ceding company
The nature of facts which should be disclosed by the ceding company comprises full information regarding;
a) the risk to be reinsured, insofar as it is known to the company, and
b) the amount to be retained on that risk.
A ceding company will be held to have knowledge of those facts which in the ordinary course of its business it
ought to have (London General insurance Co v. General Marine Underwriters’ Association, (1921) I K.B. 104.)
It may be presumed by the reinsurer that the original insurances are subject to all of the terms and conditions
usually applying to that class of business, and the ceding company must disclose any unusual omissions or
additions.
Indemnity
All reinsurance contracts are contracts of indemnity, the general principle being that the liability of the reinsurer is
restricted to the actual loss, which the ceding company has suffered, subject to the limit of the contract of
reinsurance.
The general rule is that a ceding company must be able to prove that the loss for which it claims an indemnity from
the reinsurer(s) falls within the terms of the reinsurance contract, and that the company was itself liable to pay the
loss. Thus if a ceding company pays an ex gratia payment for a loss suffered by its insured, it will have no right to an
indemnity from its reinsurer(s). Given such a restriction on the reinsured’s right of recovery from the reinsurer(s), it
became market practice to seek to override the strict rules of common law by incorporating into reinsurance
contracts conditions purporting to give the primary insurer the right to settle all claims at its discretion and to look
to the reinsurer for an indemnity. Life insurance and personal accident are referred to as contracts of
compensation but all reinsurance contracts are contracts of indemnity.
Construction of the reinsurance policy
English courts follow the same general rules for construing the express terms of reinsurance contracts as apply to
other contracts, including other policies of Insurance, the over-riding objective being to give effect to the
intentions of the parties when entering into the contract.
Incorporating the terms of the original policy
Clauses are inserted in reinsurance contracts incorporating the terms of the original policy by reference for
example;
‘Every reinsurance ceded hereby is subject to all the conditions of the original insurance’
Errors and omissions clauses
Frequently reinsurance treaties contain ‘errors and omissions’ clauses which, it seems, first appeared in
proportional treaties in connection with the reinsured’s obligations to supply the reinsurer with information
regarding cessions, renewals, cancellations etc through regular submission of bordereaux; for example the
following clause is taken from a surplus treaty:
‘Error, delay or omission on the part of the company in rendering an account or furnishing of any bordereau or
making any entry in the reinsurance books or bordereau or notifying claims or giving any information which ought
under the provision hereof to be given shall not invalidate any obligation imposed on the reinsured hereunder’
The scope of the errors and omission clauses is not restricted simply to the completion of bordereaux under
proportional reinsurances. The clause quoted above also included, inter alia, the notification of claims, and as
excess of loss treaties do not require the completion of bordereaux, the following clause taken from an excess of
loss treaty presumably applies to the claims-reporting provisions of the treaty.
‘No error or inadvertent omission on the part of the company shall relieve the reinsurer of liability in respect of
losses hereunder provided that such errors and/or omission are rectified as soon after discovery as possible.
Rights of the reinsured’s policy holders
Generally it would seem to follow from the doctrine of privity of contract that in English common law the
reinsured’s policyholders, whether they be the original insured, or in the case of a retrocession an insurer, have no
interest in, and therefore neither obtain any rights nor incur any liabilities under, a reinsurance contract. A
reinsurer has no contractual obligation with original insured and is not liable to him.
However, in practice possible exceptions to the general principle may arise:
a)
Where the reinsured has acted as an agent of the reinsurer in entering into the original policies (such a
situation may exist, for example, in so called fronting arrangements where insurer A has arranged for
insurer B to write an original insurance on its behalf and the largely reinsures the risk with A).
b) Where a cut through clause is included in the reinsurance contact under which the reinsurer assumes
liability to the original insured in the event of reinsured’s liquidation.
Cut-through clauses
American courts have held that such a clause in a reinsurance contract giving an original insured the right to claim
direct against the reinsurer is enforceable in the insured’s favour even though he/she is not a party of the contract.
The clauses permit the reinsurer, in the event of the ceding company’s insolvency, to pay the company
policyholders direct for the reinsured portion of losses they suffered and to obtain from them a full discharge from
any further liability.
3.
Benefits of reinsurance
 Risk spreading – the loss lighteth rather easily upon many than heavily on few.
 Capacity boosting- insurers are able to write business that exceeds their capacity using the
“borrowed” capital of reinsurers.
 Financial advantage – random fluctuations are removed and the retained account can benefit
from a large pool of homogenous risks – law of large numbers. Offering a small line to the market
will mean that an underwriter will see much less business than organisations offering large
capacities. Secondly, administration costs are very similar for either a small or large acceptance.
Writing a larger line boosted by reinsurance promotes efficiency in administration costs.
Commission is another benefit of reinsurance.
 Financial stability –
 Protection against catastrophe- protection against accumulation and exposure to catastrophe
perils.
Reinsurance is insurance that is purchased by an insurance company (insurer) from another insurance
company (reinsurer) as a means of risk management, to transfer risk from the insurer to the
reinsurer. The reinsurer and the insurer enter into a reinsurance agreement which details the
conditions upon which the reinsurer would pay the insurer's losses (in terms of excess of loss or
proportional to loss). The reinsurer is paid a reinsurance premium by the insurer, and the insurer
issues thousands of policies.
For example, assume an insurer sells one thousand policies, each with a $1 million policy limit. Theoretically, the
insurer could lose $1 million on each policy – totaling up to $1 billion. It may be better to pass some risk to a
reinsurance company (reinsurer) as this will minimize the insurer's risk.
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1 Functions
o 1.1 Risk transfer
o 1.2 Income smoothing
o 1.3 Surplus relief
o 1.4 Arbitrage
o 1.5 Reinsurer's expertise
o 1.6 Creating a manageable and profitable portfolio of insured risks
o 1.7 Managing cost of capital for an insurance company
2 Types
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o 2.1 Proportional
o 2.2 Non-proportional
o 2.3 Risk-attaching basis
o 2.4 Loss-occurring basis
o 2.5 Claims-made basis
3 Contracts
4 Markets
5 Reinsurers
6 Retrocession
Functions
Almost all insurance companies have a reinsurance program. The ultimate goal of that program is to reduce their
exposure to loss by passing the exposure to loss to a reinsurer or a group of reinsurers. Therefore, they are
'transferring some of the risk to the reinsurer or a group of reinsurers'. Insurance, which is regulated at the state
level (in the USA), permits an insurer only to issue policies with a maximum limit of 10% of their surplus (net
worth), unless those policies are reinsured.
Risk transfer
With reinsurance, the insurer can issue policies with higher limits than it would otherwise be allowed, therefore
being permitted to take on more risk because some of that risk is now transferred to the reinsurer. Reinsurance
has gone from a relatively unsophisticated business to a highly sophisticated endeavor. The reason for this is the
number of reinsurers that have suffered significant losses and become financially impaired. From 2000 onward,
reinsurers have become much more reliant on actuarial models and tight review of the companies they are willing
to reinsure. They review their financials closely, examine the experience of the proposed business to be reinsured,
review the underwriters that will write that business, review their rates, and much more. Almost all reinsurers now
visit the insurance company and review underwriting and claim files and more.
Income smoothing
Reinsurance can help to make an insurance company’s results more predictable by absorbing larger losses and
reducing the amount of capital needed to provide coverage. The risk factor is diversified with the reinsurer bearing
some of the loss incurred.
Surplus relief
An insurance company's writings are limited by its balance sheet (this test is known as the solvency margin). When
that limit is reached, an insurer can do one of the following: stop writing new business, increase its capital, or buy
"surplus relief"
Arbitrage
The insurance company may be motivated by arbitrage in purchasing reinsurance coverage at a lower rate than
they charge the insured for the underlying risk, which can be in the area of risk associated with any form of the
asset that is being issued or loaned against. It can be a car, a mortgage, an insurance (personal, fire, business, etc.)
and alike.
In general, the reinsurer may be able to cover the risk at a lower premium than the insurer because:
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The reinsurer may have some intrinsic cost advantage due to economies of scale or some other efficiency
Reinsurers may operate under weaker regulation than their clients. This enables them to use less capital
to cover any risk, and to make less prudent assumptions when valuing the risk.
Even if the regulatory standards are the same, the reinsurer may be able to hold smaller actuarial reserves
than the cedant if it thinks the premiums charged by the cedant are excessively prudent.
The reinsurer may have a more diverse portfolio of assets and especially liabilities than the cedant. This
may create opportunities for hedging that the cedant could not exploit alone. Depending on the
regulations imposed on the reinsurer, this may mean they can hold fewer assets to cover the risk.
The reinsurer may have a greater risk appetite than the insurer.
Reinsurer's expertise
The insurance company may want to avail of the expertise of a reinsurer in regard to a specific (specialised) risk or
want to avail of their rating ability in odd risks.
Creating a manageable and profitable portfolio of insured risks
By choosing a particular type of reinsurance method, the insurance company may be able to create a more
balanced and homogenous portfolio of insured risks. This would lend greater predictability to the portfolio results
on net basis (after reinsurance) and would be reflected in income smoothing. While income smoothing is one of
the objectives of reinsurance arrangements, the mechanism is by way of balancing the portfolio.
Managing cost of capital for an insurance company
By getting a suitable reinsurance, the insurance company may be able to substitute "capital needed" as per the
requirements of the regulator for premium written. It could happen that the writing of insurance business requires
x amount of capital with y% of cost of capital and reinsurance cost is less than x*y%. Thus more unpredictable or
less frequent the likelihood of an insured loss, more profitable it can be for an insurance company to seek
reinsurance.
Methods of Reinsurance
There are two basic methods of reinsurance:
1.
Facultative Reinsurance
In facultative reinsurance, the ceding company cedes and the reinsurer assumes all or part of the risk
assumed by a particular specified insurance policy. Facultative reinsurance is negotiated separately for
each insurance contract that is reinsured. Facultative reinsurance normally is purchased by ceding
companies for individual risks not covered by their reinsurance treaties, for amounts in excess of the
monetary limits of their reinsurance treaties and for unusual risks. Underwriting expenses and, in
particular, personnel costs,are higher relative to premiums written on facultative business because each
risk is individually underwritten and administered. The ability to separately evaluate each risk reinsured,
however, increases the probability that the underwriter can price the contract to more accurately reflect
the risks involved.
1.
Treaty Reinsurance is a method of reinsurance requiring the insurer and the reinsurer to formulate and
execute a reinsurance contract. The reinsurer then covers all the insurance policies coming within the
scope of that contract. There are two basic methods of treaty reinsurance:
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Quota Share Treaty Reinsurance, and
Excess of Loss Treaty Reinsurance.
In the past 30 years there has been a major shift from Quota Share to Excess of Loss in the property and casualty
fields.
Types
Proportional
Proportional reinsurance (the types of which are quota share and surplus reinsurance) involves one or more
reinsurers taking a stated percent share of each policy that an insurer produces ("writes"). This means that the
reinsurer will receive that stated percentage of each dollar of premiums and will pay that percentage of each dollar
of losses. In addition, the reinsurer will allow a "ceding commission" to the insurer to cover the initial costs
incurred by the insured (marketing, underwriting, claims etc.).
The insurer may seek such coverage for several reasons. First, the insurer may not have sufficient capital to
prudently retain all of the exposure that it is capable of producing. For example, it may only be able to offer $1
million in coverage, but by purchasing proportional reinsurance it might double or triple that limit. Premiums and
losses are then shared on a pro rata basis. For example, an insurance company might purchase a 50% quota share
treaty; in this case they would share half of all premium and losses with the reinsurer. In a 75% quota share, they
would share (cede) 3/4 of all premiums and losses.
The other form of proportional reinsurance is surplus share or surplus of line treaty. In this case, a retained “line” is
defined as the ceding company's retention - say $100,000. In a 9 line surplus treaty the reinsurer would then
accept up to $900,000 (9 lines). So if the insurance company issues a policy for $100,000, they would keep all of
the premiums and losses from that policy. If they issue a $200,000 policy, they would give (cede) half of the
premiums and losses to the reinsurer (1 line each). The maximum underwriting capacity of the cedant would be $
1,000,000 in this example. Surplus treaties are also known as variable quota shares.
Non-proportional
Non-proportional reinsurance only responds if the loss suffered by the insurer exceeds a certain amount, which is
called the "retention" or "priority." An example of this form of reinsurance is where the insurer is prepared to
accept a loss of $1 million for any loss which may occur and they purchase a layer of reinsurance of $4 million in
excess of $1 million. If a loss of $3 million occurs, then insurer will retain $1 million and will recover $2 million from
its reinsurer(s). In this example, the reinsured will retain any loss exceeding $5 million unless they have purchased
a further excess layer (second layer) of say $10 million excess of $5 million.
The main forms of non-proportional reinsurance are excess of loss and stop loss.
Excess of loss reinsurance can have three forms - "Per Risk XL" (Working XL), "Per Occurrence or Per Event XL"
(Catastrophe or Cat XL), and "Aggregate XL". In per risk, the cedant’s insurance policy limits are greater than the
reinsurance retention. For example, an insurance company might insure commercial property risks with policy
limits up to $10 million, and then buy per risk reinsurance of $5 million in excess of $5 million. In this case a loss of
$6 million on that policy will result in the recovery of $1 million from the reinsurer.
In catastrophe excess of loss, the cedant’s per risk retention is usually less than the cat reinsurance retention (this
is not important as these contracts usually contain a 2 risk warranty i.e. they are designed to protect the reinsured
against catastrophic events that involve more than 1 policy). For example, an insurance company issues
homeowner's policies with limits of up to $500,000 and then buys catastrophe reinsurance of $22,000,000 in
excess of $3,000,000. In that case, the insurance company would only recover from reinsurers in the event of
multiple policy losses in one event (i.e., hurricane, earthquake, flood, etc.).
Aggregate XL affords a frequency protection to the reinsured. For instance if the company retains $1 million net
any one vessel in the cover of $10 million in the aggregate, the excess of $5 million in the aggregate would equate
to 5 total losses (or more partial losses). Aggregate covers can also be linked to the cedant's gross premium income
during a 12 month period, with limit and deductible expressed as percentages and amounts. Such covers are then
known as "Stop Loss" or annual aggregate XL.
Risk-attaching basis
A basis under which reinsurance is provided for claims arising from policies commencing during the period to
which the reinsurance relates. The insurer knows there is coverage for the whole policy period when written.
All claims from cedant underlying policies incepting during the period of the reinsurance contract are covered even
if they occur after the expiration date of the reinsurance contract. Any claims from cedant underlying policies
incepting outside the period of the reinsurance contract are not covered even if they occur during the period of the
reinsurance contract. Reinsurers usually limit claims up to a maximum of 12 months after expiry of the contract.
Loss-occurring basis
A Reinsurance treaty from under which all claims occurring during the period of the contract, irrespective of when
the underlying policies incepted, are covered. Any claims occurring after the contract expiration date are not
covered.
As opposed to claims-made policy. Insurance coverage is provided for losses occurring in the defined period. This is
the usual basis of cover for most policies.
Claims-made basis
A policy which covers all claims reported to an insurer within the policy period irrespective of when they occurred.
This solves the problem of long tail business.
Contracts
Most of the above examples concern reinsurance contracts that cover more than one policy (treaty). Reinsurance
can also be purchased on a per policy basis, in which case it is known as facultative reinsurance. Facultative
reinsurance can be written on either a quota share or excess of loss basis. Facultative reinsurance is commonly
used for large or unusual risks that do not fit within standard reinsurance treaties due to their exclusions. The term
of a facultative agreement coincides with the term of the policy. Facultative reinsurance is usually purchased by
the insurance underwriter who underwrote the original insurance policy, whereas treaty reinsurance is typically
purchased by a senior executive at the insurance company.
Reinsurance treaties can either be written on a “continuous” or “term” basis. A continuous contract continues
indefinitely, but generally has a “notice” period whereby either party can give its intent to cancel or amend the
treaty within 90 days. A term agreement has a built-in expiration date. It is common for insurers and reinsurers to
have long term relationships that span many years.
Retrocession
Reinsurance companies themselves also purchase reinsurance, a practice known as a retrocession. They purchase
this reinsurance from other reinsurance companies. A reinsurance company that sells reinsurance is a
"retrocessionaire". A reinsurance company that buys reinsurance is a "retrocedent".
It is not unusual for a reinsurer to buy reinsurance protection from other reinsurers. For example, a reinsurer that
provides proportional, or pro rata, reinsurance capacity to insurance companies may wish to protect its own
exposure to catastrophes by buying excess of loss protection. Another situation would be that a reinsurer which
provides excess of loss reinsurance protection may wish to protect itself against an accumulation of losses in
different branches of business which may all become affected by the same catastrophe. This may happen when a
windstorm causes damage to property, automobiles, boats, aircraft and loss of life, for example.
This process can sometimes continue until the original reinsurance company unknowingly gets some of its own
business (and therefore its own liabilities) back. This is known as a "spiral" and was common in some specialty lines
of business such as marine and aviation. Sophisticated reinsurance companies are aware of this danger and
through careful underwriting attempt to avoid it.
In the 1980s, the London market was badly affected by the creation of reinsurance spirals. This resulted in the
same loss going around the market thereby artificially inflating market loss figures of big claims (such as the Piper
Alpha oil rig). The LMX spiral (as it was called) has been stopped by excluding retrocessional business from
reinsurance covers protecting direct insurance accounts.
It is important to note that the insurance company is obliged to indemnify its policyholder for the loss under the
insurance policy whether or not the reinsurer reimburses the insurer. Many insurance companies have
experienced difficulties by purchasing reinsurance from companies that did not or could not pay their share of the
loss. (These unpaid claims are known as uncollectibles.) This is particularly important on long-tail lines of business
where the claims may arise many years after the premium is paid.
Facultative Reinsurance
The use of facultative reinsurance
Although the facultative method of placing reinsurance has largely been superseded by the extensive use of
treaties, it still plays a useful role in reinsurance markets in 4 circumstances;
1) Where the required reinsurances would be unattractive to reinsurers if offered on a treaty basis. E.g. if a
company requires very little reinsurance each year for a particular class of insurance, the loss potential on
any one reinsured risk may be so high in relation to the total annual reinsurance premiums that a treaty
would be very unstable in the sense of being exposed to highly variable total claim costs in one year.
2) Where;
a) The risk to be reinsured would fall outside the company’s existing treaties, for example, because
the insured risk is located outside the geographical limits or is a (possibly hazardous) excluded
class of risk; or
b) The sum insured exceeds the treaty limits; or
c) The risk is of such a nature that the ceding company would not want to cede to a treaty, perhaps
because of its potentially destabilizing effect.
3) Where, to accommodate a special case, a company wishes to increase its gross capacity, perhaps in order
to retain or to acquire the lead on a coinsured insurance.
4) Where a company wishes to increase its net account by offering business in exchange for inward
facultative reinsurance.
Essential Characteristics
The two basic features of the facultative method of handling reinsurances are;
1) Its optional character, with the ceding insurer and the prospective reinsurer being free respectively to
offer and to accept or reject the reinsurance
2) Its use for placing individual risks
Thus for the direct insurers it provides a greater degree of flexibility in their reinsurance arrangements than
otherwise would be possible, while it remains the one area where the reinsurer can exercise its underwriting
judgement in relation to individual risks, in that it retains the right to accept or reject each risk offered.
The advantages
1.
2.
3.
4.
5.
6.
Risks are considered by underwriters whose judgement and experience can be put to mutual advantage.
No wastage of income as only those policies that need reinsurance are ceded to reinsurers.
Underwriting control is achieved by rejecting those risks that reinsurers do not want and accepting those
whose terms are favourable.
You achieve risk spreading to many players in the market.
Brokers benefit from the brokerage if involved.
Cheaper for reinsurers since the cedant incurs most of the underwriting and acquisition costs.
The disadvantages
1) Some delay inevitably occurs in the placing of reinsurances facultatively because each case must be
negotiated individually with the prospective reinsurer(s). Consequently final acceptance of the original
insurance may be prolonged too.
2) The administrative costs both parties incur in individually negotiating and accounting for facultative
reinsurances, and subsequently dealing with individual renewals, are far higher than for treaty
reinsurances. Consequently, a ceding company is also likely to suffer some loss of reinsurance commission
because, in order to compensate for reinsurers’ higher administrative costs, rates of commission on
facultative reinsurances tend to be lower than for treaties, though rates paid also allow for the cost of the
technical support services (i.e. engineering, claims handling, etc) supplied by either the ceding company or
broker. Moreover, generally no profit commission is allowed on facultative reinsurances.
3) There is the ever-present danger that a ceding company will overlook the need to place or to renew
facultative reinsurance.
4) Cedant receives a lower level of reinsurance commission.
Procedures for placing facultative reinsurances
The pressures that are exerted on insurers by competition, public opinion, and in some cases supervisory
authorities, to economize on their administrative costs have led to a streamlining of procedures for handling
facultative reinsurances.
Traditionally the placing of a facultative reinsurance commences with the ceding company or its broker preparing a
slip providing brief details of the original sum insured and the risk to be placed, including the total sum insured,
perils covered, premium and conditions; its own retention and the amount (if any) ceded to treaties.
Next the slip is taken to prospective reinsurers who, if they are prepared to accept, will initial it indicating the
proportion of the risk each is prepared to underwrite. If there is a substantial sum to be placed it may be necessary
to obtain the acceptance of several reinsurers and as a reinurer’s liability only commences from the time the slip is
initialed, sometimes there is a considerable delay before a risk is fully reinsured. However, facultative reinsurers
are usually willing to backdate their cover provided no loss is known to have occurred. The reinsurer(s) will accept
the risk offered at the original premiums rate less an agreed commission..
After the initialing of the slip it was the practice for the ceding office to issue a ‘request’ note, again briefly setting
out the details of the risk to be reinsured including the dates of commencement and termination of cover, and the
reinsurer would respond by sending a ‘take’ note formally accepting the reinsurance in accordance with the details
on the request note. In Zimbabwe, facultative reinsurance is placed by telephone, where the ceding office phone
the prospective reinsurers disclosing all the risk details required and the reinsurer indicating the proportion they
are willing to accept or rejecting the risk all together. Then a slip is prepared by the ceding office and circulated to
all participating reinsurers to sign the slip. The signing or initialing of the slip shall constitute evidence of the
existence of a reinsurance contract.
The final stage would be for the ceding company to supply the reinsurer with a copy of the original policy or
specification and for the reinsurer to issue a reinsurance policy expressly incorporating the specifications and
terms and conditions of the original insurance. When there is regular flow of facultative reinsurance business
passing between companies it is now usual to dispense with the issue of reinsurance policies. The ceding office
then prepares a bordereau, with the premium details of the risk covered. It will show the amount of premium to be
paid to the reinsurer (s) less agreed commission.
Information for be disclosed at time of risk placement
The reinsured should disclose the following;
1) Name of the Insured
2) Situation of risk
- For fire risks with location we are concerned with accessibility to such facilities and resources as
the fire brigade and water points.
3) The trade and occupation of the insured
4) Inception and renewal dates
5) The perils covered
6) The construction and fire prevention equipment on the insured risk.
7) The total sum insured
8) The estimated maximum loss (EML) or maximum probable loss (MPL).
9) The indemnity period for loss of profits risks
10) The rates applicable.
11) Commission.
12) Loss history of the risk in question
13) The ceding office’s gross share. Its includes cessions to treaties.
14) The ceding company’s net retention.
15) The share offered to the reinsurer
Renewal
The renewal of facultative reinsurances also requires individual consideration.
From a pure legal point of view unless prior notice is given to the contrary the assumption is that reinsurance is
automatically renewed subject to the existing terms remaining unchanged. If either party wishes to terminate the
reinsurance contract then due notice must be given to the other party in terms of the contract. Normally notice is
30 days prior to renewal.
At renewal all material changes to the risk must be notified to the reinsurers. A material change could be any thing
having a bearing on the premium, sum insured perils covered etc. With non-marine business reinsurers usually
accept liability for alterations from the time they are notified by the cedant. In marine markets reinsurers generally
accept automatic liability from the date the alteration occur. Where the alteration results in additional or return
premium, reinsurer must be credited or debited accordingly.
Facultative Claims
Facultative claims are treated basically as cash calls in treaty reinsurance, in other words reinsurers are expected to
settle their share of the claim immediately. Reinsurers must be notified of all claims irrespective of size. Normally
where ex gratia payments are made reinsurers have no legal liability towards them.
Proportional reinsurance treaties
Surplus Treaty
Allows cedant to reinsure surplus liability in excess of what it can retain (above its net retention). Retention is
equal to one line. Treaty capacity is expressed in multiples of the cedant’s retention. Thus the premium for the risk
is ceded in the same proportion as the sum insured of the risk.
The treaty may specify different levels of maximum retention for different categories of risks i.e. Table of limits
Assume a direct insurer with a retention of $50 000.00 and has a 10 line surplus treaty.
Risk
Sum Insured
Retention
Cession to treaty
Balance
1
200 000
50 000
150 000.00
0
2
20 000
20 000
0
0
3
250 000
50 000
200 000.00
0
4
50 000
50 000
0
0
6
600 000
50 000
500 000
50 000
7
300 000
50 000
250 000
0
It is possible to arrange a second surplus treaty whereby another group of reinsurers will write additional lines
above those written under first surplus treaty. The same happens where a 3 rd surplus is deemed necessary.
Normally the second surplus treaty will not be involved in a risk until the ceding office has committed the first
surplus to its full capacity. A surplus treaty will only operate / engage if the cedant’s gross commitment exceeds its
net retention. Therefore the cedant is not bound to cede on each and every risk.
Advantages of a surplus treaty
a)
Cedant can retain more premiums than would be the case under a Quota Share treaty. Unlike under a
quota share treaty, under surplus treaty the cedant does not cede risks under his capacity.
b) Cedant’s account remains consistent, homogeneous and is likely to be profitable. The cedant can vary
retention depending on how hazardous the risk is.
c) Lower commission is payable by the reinsurer.
d) It accords the cedant more freedom and flexibility compared to Quota share arrangement.
Disadvantages of a surplus treaty
a)
Reinsurer’s account may not be as profitable as there is an element of selection against reinsurers in the
way the surplus treaty operates.
b) Reinsurers are usually faced with target risks only and deprived of the benefit of sharing in the smaller
risks, hence in terms of composition; Reinsurer’s portfolio is usually unbalanced.
c) Reinsurer’s loss experience can vary widely compared to the cedant’s where as in Quota share treaties
there is total community of interest hence the loss ratios of the cedant’s account and that of reinsurers
always move in tandem.
d) The cedant’s administration is more complex under surplus arrangement.
e) Cedant receive lower commission.
Quota Share treaty
Ceding company is obliged to cede and reinsurer is obliged to accept a fixed proportion of every risk accepted by
the ceding company i.e. Reinsurers share in all losses and receive the same proportion of all premiums less
commission.
Example – 80% Quota share treaty. Cedant’s retention will be 20% of each and every risk.
A definitive monetary limit can be stated with such limit not to be exceeded as a reinsurer’s acceptance. E.g. ‘to
accept 80% of every risk insured, not to exceed US$800 000 any one risk.
Advantages to Cedant





Simple administration
Support for new product, new company, other treaties
Decrease of the total exposure
Decrease of the required solvency margin
Higher commission obtainable as the treaty is generally profitable than other proportional treaties.
Disadvantages to cedant




Cedant cannot vary its retention for any particular risk and thus it pays away premiums on small risks,
which could be retained 100%.
Portfolio of risks retained not homogeneous, cedant retains fixed percentage of all risks written.
High level of premiums ceded
U/W capacity remains limited
Inadequate against large claims
Inadequate against accumulation of small claims
-
Advantages to reinsurer
Reinsurer receives a share of each and very risk. No selection against reinsurer as he participates on both
bad and good.
- Reinsurer obtains larger share of profits from cedant than would be obtained under any other type of
reinsurance.
Disadvantages to reinsurer
-
-
reinsurer pays higher commission to cedant compared to other types of treaties.
Comparison of the Quota Share and surplus treaty
Quota Share Treaty
Surplus Treaty
Cessions are made on each and every risk.
Cessions made only on risks which are surplus to
the cedant’s retention
Basic commission is higher
Basic commission is lower
More suitable for companies in the formative
Suitable for a company that has passed formative
stage.
stage
Cessions are determined on the basis of fixed
percentages
Cessions are denoted on lines
Common features of Proportional treaties
Premium and Loss Reserve
Proportional treaties are subject to premium and loss reserves. Premium reserves are an arrangement where a
portion of the reinsurance premiums payable under proportional treaties is retained by the cedant as security for
the fulfillment of the reinsurer’s obligations under the treaty. The practice of premium reserves is historically
linked to concerns by ceding companies on the financial standing of reinsurance companies. There is a strong
argument suggesting that the dominant motive behind premium reserves is the need to protect the balance of
payment positions of individual countries.
Retention of premium reserves is disadvantageous to reinsurers because;
a) It fragments the income of reinsurers
b) It deprives the reinsurer of the opportunity of investing his fund in better markets
c) It causes reinsures to lose investment income
Occasionally when the treaty is cancelled reserves can be used to cover run off losses. When ceding companies are
allowed to retain premiums due to reinsurers, reinsurers lose investment income; this is partly compensated for by
interest payable on the reserves. In some markets instead of holding the reserve in cash the cedant may agree to
any of the following options;
i)
ii)
A deposit of suitable securities equal in value to the premium reserve. A security is any instrument
capable of being liquidated into cash, e.g. shares, bonds etc. The advantage with such an
arrangement is that it removes the potential for disputes over investment income because reinsurer
will continue to receive his interest or dividend on invested security in question.
Arranging an irrevocable letter of credit issued by a reputable bank in favour of the cedant. Such
letters are normally provided by the reinsurer’s banker’s and they are irrevocable as a way of
ensuring that the reinsurer does not go behind the scene to withdraw the security.
Apart from the premium reserve, proportional treaties are also open to loss reserve deposits. A loss reserve
deposit is intended to cover the reinsurer’s share of outstanding losses. Normally the loss reserve is 100% of the
value of outstanding losses.
Premium and Loss Portfolio
Proportional treaties may be subject to premium and loss portfolios. Premium portfolio does cater for those risks
ceded to the treaty that would not have expired at the time the treaty accounts are prepared and at the time of
closing the treaty. Premium portfolio are usually withdrawn from the current reinsurers and credited to reinsurers
who are joining the treaty in the new year. Portfolio transfers necessitate the valuation of the unexpired risks.
Return of Premium = Ui/Ti X Pi
Where
Ui = Unexpired period of insurance
Ti = The total period of insurance
Pi = The reinsurance premium less reinsurance commission
For the ith risk ceded
In practice however it is not possible to calculate the unearned premium on ach and every risk thus stated
percentages of between 35 – 40% are usually used and this will be applied on the premium for the immediate past
year. Where a stated percentage is used, the assumption is that the business ceded to treaty is evenly distributed
through out the year. Where that assumption is true then approximately half of the periods of insurance will be
unexpired at the end of the year. In practice however business patterns vary from year to year and from quarter to
quarter. The business patterns tend to follow financial year in a given market. To cater for this variation I business
market various methods have been derived aimed at producing more accurate estimates of unearned premium.
These methods include the 8th system and 24th system. Under the 8th system reinsurance premium is analysed
quarterly and under the 24th system reinsurance premiums are analysed monthly.
Example illustrating portfolio together with reserve changes that will occur when a reinsurer increase his share
from 20% in the current year to 30% in the ensuing year.
QUARTER
PREMIUM TO TREATY
40% PREM. RESERVE
1st
$106 295.00
$42 518.00
2nd
$113 285.00
$45 314.00
3rd
$95 690.00
$38 276.00
4th
$128 590.00
$51 436.00
$443 860.00
$177 544.00
Portfolio rates – Premium 40% and loss 90%
Outstanding claims at the close of year = $95 645.00
Reinsurance share for year 1
= 20%
Reinsurance share for year 2
= 30%
Interest on reserves
= 4%
i)
Calculate Portfolio withdrawal of close of year 1
Portfolio withdrawal = $443 860 X 0.4 X 0.2 = $35 509 (Due from the reinsurer)
ii)
Premium Reserve for year 1
$177 544 X 0.2 = $35 509 (Due to Reinsurers)
Interest due
Quarter
Reserve
Interest
No. of months
for interest
accrual
Interest Amount
1st
$42 518.00
4%
9 months
$1 276.00
2nd
$45 314.00
4%
6 months
$ 906.00
3rd
$38 276.00
4%
3 months
$ 383.00
4th
$51 436.00
4%
0 months
$
0.00
$2 565.00
$2 565.00 X .2 = $513 Due to Reinsurers
iii)
Portfolio Loss withdrawal
$95 645.00 X 0.9 X 0.2 = $17 216.00 (due by Reinsurers)
iv) Portfolio Premium assumed at the start of Year 2
$443 860.00 X 40% 30% = $53 263.00 Due to reinsurers
v) Portfolio Loss assumed at start of Year 2
$95 645.00 X 90% X 30% = $25 824 (Due to reinsurers)
Surplus
Advantages :
 Increase of the U/W limit
 Limitation of the maximal exposure
 Makes the portfolio more homogeneous
Disadvantages :
 Heavy administration
 Still a large proportion of premium ceded
 Inadequate against accumulation of small claims
 Risk of antiselection for the reinsurer
 Small losses hitting large risks are also reinsured
Per risk
Per event : all claims caused by the same event are grouped in one loss
Excess-ofloss per risk
Advantages
 Limitation of the maximal exposure
 Simple administration
 Small premium
Disadvantages
 Fixing the reinsurance premium
 Inadequate against accumulation of small claims
 Conditions can change faster
Excess-of-loss per
event
Advantages
 Limitation of the maximal exposure in case of event
 Simple administration & small premium
Disadvantages
 Fixing the reinsurance premium
 Conditions can change faster
Stop-loss
Advantages :
 Ideal coverage
 Simple administration
Disadvantages
 Fixing the reinsurance premium
 Often difficult to buy
Original Gross Premium:
The premium actually received from the Insured.
Original Net Premium:
The premium actually received from the insured, less any commission payable to the broker or agent.
Reinsurance Commission
Reinsurance commission is a financial advantage arising out of the reinsurance business. Cedants benefit from
contributions by reinsurers towards their acquisition and management expenses. Reinsurers acquire business
without the expense of underwriting primary accounts.
Reinsurance commission usually applies to proportional business. If reinsurance is arranged through a broker, then
the broker’s remuneration becomes known as brokerage.
Profit commission
Cedants are entitled to some compensation from reinsurers in respect of the disparity in workloads arising from
the account; this is the principle of reinsurance commission. Too high a rate of commission can generate problems
for the reinsurer, so profit commission is the answer.
profit commission is an extra commission payable by the reinsurer over and above the flat rate commission based
on the net profit made by the reinsurer from the treaty. Profit commission is calculated based on an agreed rate on
profit.
Sliding scale commission
Sliding scale commission is another technique which attempts to maintain a reasonable relationship between
cedant and reinsurers as far as payment of an equitable commission is concerned. Here is created an alternative
form of profit sharing whereby the ceding commission is varied according to the loss ratio experience of the treaty.
Loss ratio is the claims ratio as a percentage of premium; all the terms need to be agreed and defined for each
individually treaty.
Example;
Loss ratio
Less than 45%
52% but not more than 45%
56% but not more than 52%
60% but not more than 56%
64% but not more than 60%
Over 64%
Rate of commission payable
40%
38%
36%
34%
32%
30%
Loss participation
A loss participation clause also known as MALUS clause is a form of reverse profit commission. A share of the losses
under a proportional treaties must be borne by the cedant if loss ratio exceeds a certain percentage. The cedant’s
share of the losses will be capped at an agreed maximum figure. Loss participation is a threat to cedants or penalty
borne by cedant.
Premium Reserve:
The amount or percentage of the premium retained by the ceding company as a guarantee for the fulfilment of the
obligations of the reinsurer. It is actually in respect of so-called unearned premiums ie to allow for the fact that not
all policies underwritten by the ceding company commence on the commencement date of the treaty, thus at the
end of any underwriting year there is still liability outstanding.
Loss Reserve:
This is an amount equivalent to the actual known outstanding (ie unpaid but incurred) claims of the company. As
with the premium reserve it is effectively a guarantee of the payments of the reinsurers.
Cash losses:
Treaty accounts are normally prepared quarterly and thus if a large claim occurs in the ordinary course the ceding
company would be unable to claim from its reinsurers the amount due until the next account. Therefore, a
provision is included in reinsurance treaties that, in the event of a single claim exceeding a certain amount, this is
to be paid on demand by the reinsurers.
Reinstatement:
On excess of loss contracts the reinsurer who only receives a percentage of the premium does not wish to be
committed for an unlimited amount in the event of a series of losses and therefore includes a restriction which
states that the cover will only be full reinstated for a given number of times. This amount reinstated is in respect of
a full loss of the cover and partial losses are covered up to a total of the treaty cover, multiplied by the number of
reinstatements.
Run off:
In the event of cancellation of the treaty as mentioned under "premium reserve" not all policies have expired,
some having been commenced in mid year. If the treaty provides for run off protection this means that reinsurers
are liable in respect of any policies which have been issued or renewed before the cancellation until the next
renewal date of such a policy.
Portfolios:
On the cancellation of a treaty if it is the wish of the ceding company and/or the reinsurer liability should be
terminated immediately, this may be done by the reinsurer paying an amount to the ceding company. The
premium portfolio is normally the amount unearned at the cancellation date ie where policy liability is still
outstanding and this may in effect be the same as the figure as the amount retained as a premium reserve. The
loss portfolio is normally the amount of the known outstanding losses, ie incurred but not paid.
Problems of Adverse Selection:
This problem arises when the customer knows his situation better than the seller of insurance. The problem of
adverse selection is common in insurance markets all over the world. By withholding some vital information
regarding their insurability, some of the insured may be able to obtain favourable prices and terms and conditions.
To fix a fair premium that reflects the expected value of the losses of the potential insured, the insurer must have
full and relevant information about the insured. The underwriter has to use his/her underwriting skills to judge the
risk and properly rate it to avoid adverse selection.
(c ) Distinguish between Coinsurance and Reinsurance
Ans: Coinsurance
Reinsurance
i) It is a system whereby one insurer shares direct risk with one (or)
more insurance companies
i) This is insurance of an insured risk where original
insurer retains a part and cedes balance to the
reinsurers
ii) Each Co’s liability is limited to the share amount mentioned in the
policy
ii) This is done to ensure greater spread and reduce
liability on the original insurer
iii) This is used mainly for covering big risks / mega projects
iii) This is governed by a pre-approved policy and
elaborate IRDA regulations.
Non Proportional Treaties
Also known as excess of loss treaties. Link reinsurance to the actual loss sustained as opposed to linking it to
the sum insured. They are convenient administratively and as the volume of business increases nonproportional treaties become better. These cut down on unnecessary clerical work. They are developed to
contain the accumulation problem. Accumulation means a situation where many risks are involved in one
insured loss event. With excess of treaties liability plus premium from insured risks are not shared in the same
proportion between the direct insurer and the reinsurer, but are calculated by reinsurers using different
methods and by subjective judgments. No commission is normally payable by the reinsurers to the reinsured,
unlike in proportional reinsurance
Under excess of loss reinsurance the cedant’s retention is referred to as the ‘underlying layer’, ‘deductible’ or
‘priority’. The cedant or reinsured decides the maximum amount in can bear in the event of a claim; the
reinsurer bears the balance (the excess) of the claim over and above the reinsured’s retention; or deductible
(sometimes known as the loss threshold) up to agreed limits. Excess of loss reinsurance is arranged in layers
applying consecutively depending on claim size. Example
First Layer: 500 000 in excess of 100 000
Second Layer: 500 000 in excess of 600 000
Third Layer: 500 000 in excess of 1 100 000
100 000 is the deductible and what appear above is the cover.
Second layer reinsurers never pay before the first layer reinsurers have paid. Third layer reinsurers pay after
the second layer reinsurers have paid. The cedant is at risk most because he is committed on every loss that
occurs and gets a greater portion of the premium. The further from the deductible your layer is, the lower the
premium you get.
Like the proportional treaties they are arranged in advance.
The reasons for layering are;
a) To divide the cover into smaller limits which are easier to place on the market.
b) To cater for those reinsurers who specialize in particular layers, either lower working layers or the
higher catastrophe layers.
c) The nature and extent of risk is different at different levels of cover and layering makes if easy to
calculate premium.
Risk Excess (Working Excess) of loss treaty/ Per event covers
Protect losses of a routine nature. Excess points are low and easily attained by losses. Reinsurer to pay all
losses arising out of one event but calculated risk by risk. That is why it is called the ‘risk excess of loss’ treaty.
Example: Cyclone erupts destroying 2 adjacent factories causing damage of $20 000 to the first factory and
$50 000 to the second factory.
XL Treaty effected is $100 000 in excess of $15 000
The risk excess of loss treaty pays per risk. For the first factory it pays $5 000 and for the second factory it pays
$35 000.00
If the excess of loss in place was: $100 000 in excess of $60 000, the reinsurer will pay nothing as none of the
losses exceed the cedant’ retention/deductible.
Characteristics
1) Protects the reinsured’s net retained account (i.e. after proportional treaties and facultative
reinsurance)
2) Reinsurers pay only when claims exceed the deductible (net retention), and then only for the excess
amount, up to agreed limits.
3) The cover basis is ‘Each and every loss, each and every risk’
4) May be Facultative (single risk of policy exposure), or Treaty (Section or whole portfolio of business)
5) Cover may pay every claim in excess of deductible and a limited number of claims (with additional
premium): governed by the reinstatement condition.
6) Cover is not primarily intended for catastrophes (affecting many risks).
7) Known as a ‘working excess’ when deductible is set at a level likely to produce relative frequency of
claims.
Advantages
a) The reinsured can retain more income than if wholly dependent on pro rata treaties.
b) Administratively simple to operate.
c)
Disadvantages
Reduction of the impact of large claims has a stabilizing effect on the protected account.
a) Excess of loss rates are subject o rapid and wide fluctuations, depending on claims experience.
b) If free of claim the ‘cost’ may not be cheaper than pro rata treaties (bearing in mind their factors of
commission and pro rata contribution on claims recoveries)
c) No cover for small and medium sized claims.
d) No commission from reisurers.
e) Cover maybe limited
- ‘Vertically’ – to less than 100% of sum insured
- ‘Horizontally’ – limited reinstatements, not every claim covered.
Underwriting Considerations
Rating Methods
Details of retentions, by Class and Type
Geographical split of account
Loss history (minimum 5 years) of actual large claims
Premium income development, split by class of business (minimum 5 years), plus forecast for
the coming year.
Original premium rates or indications of kinds of rates charged.
Details of policy coverage and any changes likely, especially to standard covers.
Working covers are rated by the’ burning cost’ method
Burning Cost = Incurred Claims (net of deductible) X 100
Earned Premiums
Result is pure burning cost to be loaded by a factor (usually either 100/70 or 100/75) for expenses and
fluctuation in future results and profit.
Catastrophe/Event/Occurrence Excess of loss treaty
Reinsurer to pay all losses arising out of one event irrespective of the number of risks affected by the loss.
They are designed to deal with the problem of accumulation of loss from one event. Example: Cyclone erupts
destroying 2 adjacent factories causing damage of $20 000 to the first factory and $50 000 to the second
factory.
Cat XL Treaty effected is $100 000 in excess of $15 000
Catastrophe cover combines the losses and pay $55 000.00
If the treaty in place was: $100 000 in excess of $60 000, the reinsurer will pay $10 000 after the cedant’s $60
000 retention.
Characteristics
a) Different from Risk/working excess treaty which operates ‘any one risk’
b) Protect the reinsured’s net retained account (i.e. after pro rata, facultative and excess of loss
reinsurance), in respect of accumulation of claims of varying sizes in any one event or catastrophe or
occurrence as defined in the contact.
c) Example of catastrophes covered are; Storm, Flood Earthquake etc
d) Reinsurers pay only when the total of ‘reinsured’ claims exceed the deductible (net retention or
threshold) and then only for the excess amounts up to the agreed limits.
e) The cover basis is on ‘Each and Every loss occurrence’. This does not imply unlimited reinstatements;
in fact such covers on property classes are usually, and not always, subject to only one full
reinstatement, for additional premium.
f) Draws all the Reinsured’s net claims together to limit the reinsured’s net loss accordingly.
g) If intended to operate as a true Catastrophe cover, as the name implies, the contact may be subject to
a ‘Two Risk Warranty’ to avoid the treaty being asked to respond to loss arising from a claim on one
risk.
Advantages
a) The reinsured can retain more income than if wholly dependent on pro rata treaties.
b) Natural peril exposures are limited and capacity is supplied.
c) Administratively simple to operate.
d) Reduction of the impact of large claims has a stabilizing effect on the protected account.
Disadvantages
a)
Catastrophe excess of loss rates are subject o rapid and wide fluctuations, depending on claims
experience.
b) The ‘cost’ may be a high percentage of the net income if there are significant aggregation exposures
and the deductible is within the amount of previous reinsured losses.
f) If free of claim the ‘cost’ may not be cheaper than pro rata treaties (bearing in mind their factors of
commission and pro rata contribution on claims recoveries)
g) No cover for small and medium sized claims.
h) No commission from reisurers.
i) Cover maybe limited
- ‘Vertically’ – to less than 100% of sums insured
- ‘Horizontally’ – limited reinstatements, unless further ‘back up is purchased.
Underwriting considerations
-
Exposure to Catastrophe Peril: details of exposure by Country and/or Zone of exposure
Frequency and severity of Catastrophe Losses: past record of catastrophe claims
Level of threshold (deductible): in relation to Claims record ‘from ground up’
Adequacy of the cover bought: of first loss nature or realistic, relative to exposures
Definition of ‘Loss occurrence’: any variation to ‘standard’ wording sought.
Original rating levels or indications relative to assessed adequacy in area(s) concerned
Economic & political factors: potential influence on insurance/reinsurance coverage.
Future development of the portfolio protected: trends of relevance to exposure levels
Rating Methods
Not rated in the same way as working covers. This is because losses occur very rarely. Reinsurer relies on his
own personal experience of the treaties with similar characteristics and usually charges a flat premium for the
whole year, not adjustable. Alternatively a flat rate on the gross premiums with minimum deposit premium
paid.
Stop Loss (Excess of Loss) Treaty
Also known as Excess of Loss Ratio treaty. Protects ceding company from losing more than a specified
percentage of loss for a given class of business.
Reinsurer not liable for any losses until the loss ratio for the year exceeds an agreed percentage of the
premiums. Thereafter the cedant is responsible for all losses, great or small, until the limit of liability under the
treaty is reached. Such Limit is expressed in the form of a Loss Ratio.
E.g. 90% loss ratio up to 150% (Sometimes expresses to cover the amount in excess of 90% loss ratio up to a
further 50%)
Assume a premium income of $30mln and a loss of 36mln. Loss ratio is 120%. Amount payable by treaty is;
Total loss 36mln – premiums $30mln = 6mln. Treaty pays 90% * %6mln = 5,4mln
It differs from the other types of Excess of Loss and Proportional reinsurance, in that no reference is made to
individual claims nor event-related claims but instead to all claims falling under a defined portfolio or class of
business.
Characteristics
a)
Protects the net retained account (i.e. after the deduction of all Proportional reinsurances and
Risk/Event/Whole account excess covers, if any) in respect of the total net claims arising in the
defined account during the period of reinsurance (usually 12 months)
b) The retention or deductible maybe expressed as a claims ratio.
c) Reinsurers pay only when the defined deductible is exceeded and only in respect of the agreed
further percentage.
d) In addition to specifying the account to be protected, it is necessary to define the premium income
basis (‘written’, ‘earned’, ‘accounted’) and claims basis (‘paid’, ‘reported’, “made” or ‘incurred’).
e) As the cover is expressed as a relationship to the whole account over a period (most often 12
months), only one claim can be experienced by the Excess treaty in any one period. Therefore
reinstatement is not applicable. Equally, as the cover is on a portfolio of insurances, it cannot be done
facultative.
f) Co-insurance will be built into the contract, i.e. the reinsured will be expected to keep to net account
a percentage part of the otherwise reinsured loss, as well as its net involvement, as an incentive to
limit the overall loss on the business
Underwriting Consideration
-
Level of cover bought
Premium income development, past years and forecast
Changes in original premium rates: influence an overall income for the class (es) covered.
Loss history, Claims ratio over past years
Rating
Treaty premium will usually be a rate percent of the reinsured’s rateable income on the protected business,
but maybe fixed amount.
Aggregate Excess of loss
Operates in much the same way as the stop loss treaty except that the amounts are represented as figures
unlike the stop loss treaty. The treaty can pay up to $50mln in the aggregate of all claims falling under a treaty
that are in excess of $100mln . when total losses exceed $100mln the reinsurer participates upto $150mln.
Ultimate Net Loss
Defines what constitutes a loss in terms of the treaty. Ultimate net loss is that portion of loss, which the
reinsured sustains after deducting all recoveries from facultative reinsurance, Proportional treaties etc and any
salvage value. The intention is that the reinsurer shall only be liable when the amount (including legal costs
and similar claims-settlement expenses) actually paid by the ceding company, less recoveries from underlying
reinsurances or other sources, exceeds the lower excess limit.
The ultimate net loss calculated for purposes of the excess of loss treaty should not be increased by any
amount that the company for any reason is unable to recover from underlying reinsurer.
Net Retained Lines Clause
Clause places emphasis on the fact that the treaty protects only that portion of insurance that the reinsured
retains net for its account. It supports the dictations of the definition of Ultimate net loss.
Reinsurance treaty wordings
Proportional wordings
1.
Business Covered clause.
The purpose of this clause is to clearly define what original business is to be ceded to the treaty. It may be
specific such as “all business written by the reinsured in its fire department” or more general such as “all
policies underwritten by cedant”.
2.
Territorial Scope
This clause sets the geographical limits for underlying business that is to be ceded to the treaty.
3.
Method of cession clause.
This specifies the nature and extend of cessions and will need to cover the following:
 The form of the cession: quota share, surplus or facultative obligatory;
 The maximum permitted cession. Quota share expressed in percentages eg 80 %, surplus lines.
 The cedant’s retention
 If cessions a on a per risk basis, what constitutes a risk.
 If cedant is allowed to arrange specific fac. Protection prior to cession to treaty, this will need to be
allowed for.
 If the cedant has the right to arrange common account protection this too will need to be allowed for
in the wording.
4.
Attachment of cessions
This states how the cover applies:
 For quota share treaties: simultaneously and automatically with the liability of the cedant under its
original acceptance.
 For surplus treaties: simultaneously and automatically with the liability of the cedant as soon as the
cedant’s retention is exceeded.
 For fac obligatory treaties: as with surplus with a possible variation if the treaty is to be provided with
an element of business other than in circumstances where capacity demands it.
5.
Attachment and termination of treaty
Concerns the commencement of the treaty itself other than the session to the treaty. It details the manner in
which the treaty can be cancelled. Normally cover allows for new and renewing business which is a continuing
treaty. The arrangement may be on a continuous treaty. The circumstances such as insolvency of one of the
parties, war between countries of domicile of the parties or failure to observe the terms of the agreement,
may give right to immediate termination by the other party.
6.
Business excluded
This clause makes specific exclusions on classes or types of risk, perils not allowed, territories not covered and
general exclusions such as those relating to war and nuclear risks.
7. Original Net Premium:
The premium actually received from the insured, less any commission payable to the broker or agent.
8. Reinsurance Commission:
The amount allowed by the reinsurers to the ceding company to pay the ceding company's office expenses,
including salaries of claims officials etc. If it is calculated on original gross premium the commission also
includes any amounts payable to brokers or agents.
9.
Profit commission:
The amount paid to the ceding company out of the profits which it makes for reinsurers ie after paying
reinsurance commission and expenses expressed as a percentage of the profit.
10. Management Expenses (Profit Commission):
A percentage of the premium is usually deducted before the actual profit for reinsurers is calculated to allow
for the reinsurers own expenses, as well as any reinsurance brokerage which may be payable. Without this
reinsurers could be making a loss and still pay profit commission.
11. Deficits carried forward to extinction (Profit Commission):
Any deficit in the profit commission is carried forward into the next year until reinsurers are once again
showing an overall profit.
12. Premium Reserve:
The amount or percentage of the premium retained by the ceding company as a guarantee for the fulfilment
of the obligations of the reinsurer. It is actually in respect of so-called unearned premiums ie to allow for the
fact that not all policies underwritten by the ceding company commence on the commencement date of the
treaty, thus at the end of any underwriting year there is still liability outstanding.
13. Loss Reserve:
This is an amount equivalent to the actual known outstanding (ie unpaid but incurred) claims of the company.
As with the premium reserve it is effectively a guarantee of the payments of the reinsurers.
14. Cash losses:
Treaty accounts are normally prepared quarterly and thus if a large claim occurs in the ordinary course the
ceding company would be unable to claim from its reinsurers the amount due until the next account.
Therefore, a provision is included in reinsurance treaties that, in the event of a single claim exceeding a certain
amount, this is to be paid on demand by the reinsurers.
15. Run off:
In the event of cancellation of the treaty as mentioned under "premium reserve" not all policies have expired,
some having been commenced in mid year. If the treaty provides for run off protection this means that
reinsurers are liable in respect of any policies which have been issued or renewed before the cancellation until
the next renewal date of such a policy.
16. Portfolios:
On the cancellation of a treaty if it is the wish of the ceding company and/or the reinsurer liability should be
terminated immediately, this may be done by the reinsurer paying an amount to the ceding company. The
premium portfolio is normally the amount unearned at the cancellation date ie where policy liability is still
outstanding and this may in effect be the same as the figure as the amount retained as a premium reserve. The
loss portfolio is normally the amount of the known outstanding losses, ie incurred but not paid.
17. Periodical accounts
This clause allows for rendering of accounts and settlement of balances between the parties. The majority of
the treaties work on a quarterly basis in arrears but can also be biannually, annually or even monthly. Matters
of detail covered here will include;
 How soon after the closure of the relevant period the account is to be rendered
 How and when the account is to be confirmed and the balance settled
 Whether the account is to be rendered on annual or underwriting year basis
 Any special currency provisions such as the rendering of separate accounts for specified currencies.
18. Losses, advice and settlement
This section deals with all aspects of claims affecting the treaty and embraces the following;
 Losses will normally be debited to reinsurers in the accounts as described in the periodical accounts
clause.
 Any individual large losses above a prearranged sum insured can be put forward by the cedant for
immediate payment by reinsurers. These are often called cash calls.



Reinsurers must be advised of large losses of a predetermined amount.
The cedant has the sole right to adjust, compromise and settle claims, and reinsurers agree to be
bound by the cedant’s decisions.
Outstanding losses may have to be reported to reinsurers. This is often a requirement at the
anniversary date of the treaty.
19. Premium and loss portfolios
As treaties are designed to be continuous, premium and loss portfolios are needed to cope with changes and
alterations in treaties. Transfer of portfolio can arise in any of the following;
 Where a cedant wants a new treaty to pick up some business that is already in force at the inception
of the treaty. It may also be that the reinsurer of the treaty picks up business from another
withdrawing reinsurer.
 In terms of premiums it will be a percentage of the premiums charged for the preceeding 12 months,
a percentage of outstanding losses will be transferred.
 There may be an option in the treaty that allows the cedant to terminate the treaty. This will also
provide for the withdrawal of premiums that allows it to cope with the run – off of business.
 The treaty may be on a clean cut basis under which each individual year of business is calculated
independently. Portifolios will operate to close the account at the end of each year. The clause allows
that the old year will be debitd and the new year credited with exactly the same amounts. These
again will be agreed percentages of premiums and outstanding losses.
 A treaty may be operating on an underwriting year basis designed to close each year after a certain
number of years (say 3 or 5 years) have elapsed. The idea is that after 3 to 5 years the bulk of the
transactions relevant to an underwriting year should have been completed. Nonetheless, there may
be unexpired liabilities and outstanding losses.
20. Currency clause
Business under a treaty may be written in more than one currency. Usually separate accounts will be
maintained in each currency and settlement paid in each currency respectively. The currency may be
converted to one account for settlement.
Non Proportional wordings
1. Business covered and territorial scope
They serve the same purpose as in proportional treaties.
2. Basis of cover
This sets out in what circumstances a recovery is available to the cedant and the extent of the recovery.
The two necessities for recovery under non proportional treaties are that the reinsured has suffered a loss
covered by the reinsurer and that the loss has exceeded the previously agreed point, the priority or
deductible.
The basis of cover clause will identify:
 The amount of the deductible
 The reinsurer’s limit of liability
 The basis on which the reinsurance applies;
 Each loss each risk for risk excess of loss
 Each accident for accident or third party excess of loss
 Each loss occurrence for catastrophe excess of loss
 In the aggregate each year for stop loss/ aggregate excess of loss
3. Period of cover
This clause will identify the dates of cover provided. The three basis are;

Policies issued or renewed

Losses occurring

Losses discovered or claims made
Broadly the period clause needs to embrace the following clauses;



It must refer to the basis of cover clause and link that with which ever method applies: policies issued,
losses occurring or claims made.
It must all allow for any necessary variations. On a losses occurring basis covering property and
percuniary business, some policy types will not fit.
This clause may allow for possible run off business if the reinsurance cover is cancelled or not
renewed and some risks still still have an unexpired portion of risk.
4. Business excluded
The business excluded clause links with the business covered clause and again it is important that
definitions are clear. There will also be special clauses to carter for special problems in different
underwriting accounts.
Reinstatement:
On excess of loss contracts the reinsurer who only receives a percentage of the premium does not wish to be
committed for an unlimited amount in the event of a series of losses and therefore includes a restriction which
states that the cover will only be full reinstated for a given number of times. This amount reinstated is in
respect of a full loss of the cover and partial losses are covered up to a total of the treaty cover, multiplied by
the number of reinstatements.
In excess of loss reinsurers provide cover of 1mln in excess of $500 000 and a loss of $750 000 occurs.
Reinsurers pay $250 000. Claim is a quarter of the security and reinstatement premium need to be reinstated
by a quarter of the premium.
Example;
Cover is for 2mln in excess of 1mln per event. It runs for 12 months from 1 January @ a premium of $200 000.
An event on 31 March causes a loss of $1.5mln. calculate the premium required if:


If reinstatement premium is pro rata as to amount only
The reinstatement premium is pro rata as to amount and time
Solution
Pro rata amount
Loss to reinsurer *annual premium
Security
$500 000
x
200 000 = $50 000 payable
2 000 000
Pro rata amount and time
Loss to reinsurer x annual premium x 9months
Security
12months
500 000 x 200 000 x 9 = $37 500 payable
2 000 000
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