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Reinsurance - an expert's introduction


Reinsurance - an expert's introduction

My name is Gemma Borgia and I have been working in insurance in London since 2003.

I moved into reinsurance in 2004 and since then I have worked for two different reinsurance broking companies. I am currently a Partner with JLT Re in the North American Property Catastrophe team. Previously I worked for Aon Benfield and in my first year at the company I went out to the US for a 10-week training programme.

My aim here is to explain why reinsurance exists ie who buys reinsurance and why they need it. Since I deal in property reinsurance, my examples will reflect this line of business.

The way I explain reinsurance to someone outside of the profession is by defining it as the insurance of insurance companies.

The principles of insurance rely on the law of large numbers: sharing the losses of the few amongst the insurance premiums of the many. Reinsurance is an extension of this principle, the main difference being that reinsurance shares the total losses of an insurance company out between the reinsurance premiums of many insurance companies.

Insurance is used by businesses and individuals as a tool to reduce volatility; a known amount of premium is paid every year and in return any unforeseen losses are paid by the insurance company when or if they occur. Reinsurance has the same effect, but essentially the premiums are higher because there is the potential for much larger losses.

Consider the insurance you and I buy to protect us against large losses ie damage to our houses or cars, or costs associated with our personal liability. We do this because we wouldn’t easily be able to bear the financial burden of a significant loss. Insurance companies may seem like very wealthy entities from an individual’s perspective, but there will come a point at which they too cannot withstand the burden of a major loss. If we make the simple assumption that the total risk to an insurance company is the sum of all the risks that they assume (for example every house and/or car that they insure), such loss could be very significant.

As individuals we buy insurance to limit the downside of a loss and protect our assets; we limit ourselves to an excess that we can afford and our premium varies accordingly. Insurance companies limit their downside by purchasing reinsurance and protecting their often very significant assets, which they have accumulated over a long period of time.

Take for example, an insurance company in Florida that insures 50,000 homes; in the event of a hurricane, they could easily find that 10,000 of these homes suffer damage. If we assumed an average loss of $5,000 to each property, this would represent a final bill to the company of $50m if they had no reinsurance! Even if the insurance company has enough cash in the bank to cover their losses from the ground up, consider what the reduction in their bank balance would do to their credit rating going forward. A significant loss to their surplus may actually impair their ability to write business. Reinsurance acts as a financial instrument to protect the insurance company’s surplus, balance sheet, credit rating and ultimately their long-term survival.

Insurance plays an important role in society and individuals’ lives by indemnifying (restoring) them to their pre-loss situation. In order to ensure that insurance companies are able to continue to do this, it is important for them to be financially secure. Reinsurance is one way that they can protect themselves and ensures their ability to stay in business to protect their policyholders. 

The area of reinsurance that I have focused on for the last 10+ years is property catastrophe treaty reinsurance. This is purchased to protect insurance companies against large losses from a single, catastrophic event that impacts multiple policies. This could be an earthquake, a hurricane, a terrorism event, a tornado, brush fire, riot, winter storm or flood.

Major events such as these are relatively infrequent and tend not to happen in the same place each time they occur (there are of course certain regions of the globe which are more prone to loss such as hurricanes in Florida or earthquake in Japan). Therefore, the statistical probability of any of these events hitting a particular insurance company’s book of business is relatively low and reinsurers can charge premium rates that are attractive enough to convince insurance companies that they are better off spending their income on reinsurance as opposed to putting it in the bank to build up their own pot for the day when an event strikes (ie self-insurance).

Once an insurance company has decided that purchasing reinsurance is the best risk transfer option for them, they have to determine what sort of reinsurance to buy. Reinsurance can be purchased for individual risks (which exceed certain limits/criteria) by way of facultative placements, or for a group of risks by way of a treaty which covers a large number, or portfolio, of risks. There are two fundamental types of treaty reinsurance: Pro Rata reinsurance and Excess of Loss reinsurance.

These can be demonstrated by reference to two simple shapes: a pie and a ladder.

Pro Rata reinsurance is the pie. An insurance company cedes (gives up) a proportion of their income, say 40% (this would be shown as a slice of the pie) and in return, a reinsurer will assume (accept) 40% of all of their losses. The pro rata insurance is attractive to younger, less-established companies as they can share every penny of loss with their reinsurers (from the centre of the pie all the way out to the edge). The downside of this kind of reinsurance is that the insurance company would have to cede the agreed percentage of their premium even if there are no losses.  Often, reinsurers will offer the cedant a ceding commission that they pay back to the insurance company to cover the costs of writing the business.

Excess of Loss reinsurance is the ladder. An insurance company will retain an amount up to the first rung of the ladder (the retention – which is similar to the excess on your car or home insurance), after which, they will purchase reinsurance in layers. The reinsurance premium charged for each layer becomes smaller as you go higher up the ladder, since the chance of the insurance company experiencing losses of this size becomes more remote. Excess of Loss reinsurance requires the insurance company to pay for the loss up to the point where their retention ends and the reinsurance structure (the first rung of the ladder) attaches. Once that is exceeded, the reinsurer picks up the full amount of the loss (subject to upper limits of the programme/ladder). The price of Excess of Loss reinsurance is calculated up front by the reinsurers and is expressed as a percentage of the limit that they are purchasing.

In addition to the property reinsurance I have discussed above, reinsurance can also be purchased for workers’ compensation, general liability, directors and officers (D&O), professional liability, errors and omissions, medical malpractice and for many other specific lines of business.

Essentially, an insurance company should be able to purchase reinsurance on any line of business for which they provide insurance.

Generally speaking, reinsurance is written in Lloyd’s of London and by other company markets outside of Lloyd’s (in London and internationally) that also write insurance business. Reinsurance offers an effective method of risk transfer, but the risks reinsured need to be monitored carefully to ensure that accumulations of exposures are clearly identified and appropriately underwritten.

As with the insurance market, the reinsurance market goes through cycles where prices are higher and supply is lower (commonly known as a 'hard market') and where prices are comparatively lower and more capacity is available (a 'soft market'). Hard markets typically occur after major events such as Hurricane Andrew in 1992 and Hurricane Katrina in 2005.
 
If you have any questions relating to reinsurance, please email me at gemma.borgia@jltre.com


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