Principles of Insurance and Reinsurance

Reactions covers all aspects of the insurance and reinsurance industry including insurers, reinsurers, brokers. A lot of our focus is on how the industry transfers risk and the financial risks and opportunities inherent in the process. The following is a guide for people new to the industry – or people who have managed to bluff their way through up to now.

The risk transfer chain

Insurance companies are in the business of taking on the risks of firms and individuals, which will often run to billions of dollars worth of exposure across an insurer’s portfolio of risks.

In most instances the absolute level of exposure an insurance company has will outweigh the capital it has on its balance sheet. As a consequence insurance companies find it necessary to transfer their risk to third parties, whether they are in the traditional reinsurance market or the capital markets through the services of an intermediary (or broker) or directly with the reinsurer.

Reinsurance is a means by which an insurance company can protect itself with other insurance companies against the risk of losses. Individuals and corporations obtain insurance policies to provide protection for various risks (hurricanes, earthquakes, lawsuits, collisions, sickness and death, etc.). Reinsurers, in turn, provide insurance to insurance companies.



The insurance industry typically uses the following methods and participants to transfer risk.

1. Insurance
2. Captives/Self-insurance
3. Treaty Reinsurance
4. Facultative Reinsurance
5. Insurance Linked Securities

Insurance Broker

An insurance broker acts as an intermediary between clients and insurance companies. Clients can be either individuals or commercial businesses and organisations.

The role of an insurance broker is to use its knowledge of risks and the insurance market to find and arrange suitable insurance policies for their clients.

Insurance brokers are independent and are able to place risks with more than one insurer to ensure that their clients get the best deal with regards to price, security, terms and conditions, and coverage.

Brokers receive a commission for placement and other services rendered.

Reinsurance Broker

A reinsurance broker acts in much the same way as an insurance broker, but they work on behalf of the ceding insurance company.

A reinsurance broker negotiates contracts of reinsurance on behalf of the reinsured, receiving a commission for placement and other services rendered.

Under the terms of one widely used intermediary clause, premiums paid to a broker by the ceding insurance company are considered paid to the reinsurer, but loss payments and other funds (such as premium adjustments) paid to a broker by a reinsurer are not considered paid to the ceding company until actually received by the reinsured.

Reinsurer

Simply put, reinsurers provide insurance for insurance companies.

Reinsurance is provided either by proportional reinsurance, which includes quota-share and surplus reinsurance, or non-proportional reinsurance. Proportional reinsurance involves one or more reinsurers taking a stated percent share of each policy that an insurer writes. The reinsurer will receive that stated percentage of each dollar of premiums and will pay that percentage of each dollar of losses.

Non-proportional reinsurance (also known as excess of loss) only responds if the loss suffered by the insurer exceeds a certain amount (this is known as the retention).

Reinsurance allows an insurance company to offer higher limits of protection to a policyholder than its own assets would allow. For example, if the principal insurance company can write only $10m in limits on any given policy, it can reinsure (or cede) the amount of the limits in excess of $10m.
Most reinsurance placements are not placed with a single reinsurer but are shared between a number of reinsurers. The reinsurer who sets the terms for the reinsurance contract is called the lead reinsurer; the other companies subscribing to the contract are called following reinsurers.

Treaty Reinsurance

The most common form of reinsurance contract, treaty reinsurance, contractually binds the ceding company reinsurer to cede and assume a specified portion of a category of risks insured by the ceding company. Treaty reinsurers do not separately evaluate each of the individual risks assumed under their treaties and are dependent on the original risk underwriting decisions made by the ceding insurer.

This raises the possibility that the ceding companies have not adequately evaluated the risks to be reinsured and that the premiums ceded may not adequately compensate the reinsurer for the risk assumed.

The reinsurer's evaluation of the ceding company's risk management and underwriting practices as well as claims settlement practices and procedures will usually affect the pricing of the treaty.

Facultative Reinsurance

When a ceding insurer is unable to have their risks placed within a treaty contract they will turn to facultative reinsurance.
Facultative reinsurance is negotiated separately for each insurance contract that is reinsured and is normally purchased by ceding companies for individual risks not covered by their reinsurance treaties, for amounts in excess of the financial 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.

Islamic Insurance

Sharia, the religious law of Islam, forbids certain elements of conventional insurance contracts, including Riba, or interest, Maisir, or gambling, and Gharar, or excessive uncertainty. The main Islamic insurance technique is takaful or retakaful for reinsurance.

The takaful system is considered fully Sharia compliant, and achieves this because its purpose is not profit, but to uphold the principal of sharing the burden or risk. The name originates from the Arabic word Kafalah, which means “guaranteeing each other”.

Takaful companies are very similar to mutual or cooperative insurance companies in that participants contribute to a common pool from which claims are paid. The surplus from the pool is then distributed to members in some form of profit-sharing device. For the purpose of takaful, premiums are classed as donations – a voluntary contribution to the pool for those in need of assistance.

Takaful companies are usually structured in one of two ways: Wakala – a fee-based model – or Mudaraba, a profit-sharing model.

Capital markets solutions

Since the 1990s a number of methods of transferring risk to the capital markets have emerged.. These include insurance-linked securities (ILS), industry loss warranties (ILWs), sidecars and catastrophe futures contracts.

To date, ILS has been most commonly used by insurance companies to buy supplemental protection for high-severity, low-probability catastrophe risks from the capital markets through catastrophe bonds, which often cover risks that are similar to the high layers of a primary insurer’s traditional reinsurance programme.

• Catastrophe bonds

Catastrophe bonds are risk-linked securities that transfer a specified set of risks from the sponsor to capital markets investors through a fully-collateralised special purpose vehicle (SPV). The SPV issues floating-rate bonds of which the principal is used to pay losses if specified trigger conditions are met.

They are typically used by insurers as an alternative to traditional catastrophe reinsurance.

• Industry loss warranties

ILWs are a type of contract through which one party purchases protection based on the loss to the entire insurance industry arising from a particular event, rather than the buyer’s losses. These agreements can be documented in either reinsurance or derivative form.

• Catastrophe futures contracts

Catastrophe futures contracts now trade on the New York Mercantile Exchange (NYMEX), the Chicago Mercantile Exchange (CME) and the Chicago Climate Futures Exchange (CCFE).

The NYMEX and CCFE contracts settle on industry losses and can be used in a manner similar to ILWs. The CME contracts settle based on storm intensity as measured by an index designed by Carvill to calculate a storm’s destructive potential.

Catastrophe bond structure

• Derivatives

Derivatives are increasingly being used in the ILS market to facilitate the transfer of risk among capital markets investors. Derivative transactions may settle based on the performance of an existing catastrophe bond, industry losses (ie, ILWs) or a parametric index such as a wind storm making landfall within a certain distance of a given location or an earthquake of a minimum magnitude within a predetermined distance of an exposure. These structures can be used by clients who may desire a capital markets structure, but who do not have enough risk to transfer to make the issuance of a catastrophe bond cost-effective.

• Sidecars

Reinsurers that accept business from one company, with backing from that company and other investors. Sidecars are used as a temporary vehicle to ease capacity constraints or allow a firm to write more business than it would otherwise, and act much like a quota-share contract. For example, sidecars were widely used to provide temporary capacity for the US catastrophe market in the aftermath of Hurricane Katrina.