It works in exactly the same way as insurance, although on a much larger scale. Put simply, the year that your house burns down, a thousand other houses don't. The premium paid by those thousand policyholders covers the cost of rebuilding your one house, plus (hopefully) a profit for the insurer. And as long as nothing happens to increase the frequency of domestic fire losses, an insurance company will have no trouble paying claims.
Problems arise when a catastrophic event destroys all insured houses in a given area - for example, a hurricane. No amount of premium can cover the claims that the insurer will now have to pay. Therefore, the company itself buys insurance against that event happening. This is Reinsurance - the spreading of very large risks amongst a pool of mostly specialist reinsurers operating on a global basis. Again put simply, the year that there is a hurricane in Florida, there isn't an earthquake in Japan.
Functions of Reinsurance
Protecting against catastrophic events is only one kind of reinsurance. There are many reasons an insurance company will choose to reinsure as part of its responsibility to manage a portfolio of risks for the benefit of its policyholders and investors.
Risk transfer
The main use of reinsurance is to allow the ceding company to assume individual risks greater than its size would otherwise allow, and to protect the cedant against catastrophic losses. Reinsurance allows an insurance company to offer larger limits of protection to a policyholder than its own capital would allow. If an insurance company can safely write only $5 million in limits on any one policy, it can reinsure (or cede) the amount of the limits in excess of $5 million to reinsurers.
Reinsurance’s highly refined uses in recent years include applications where reinsurance was used as part of a carefully planned hedge strategy.
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.
Surplus relief
Reinsurance can improve an insurance company's balance sheet by reducing the amount of net liability, and thereby increasing surplus. Surplus, assets less liabilities, is roughly the same as shareholder equity on a balance sheet of a non-insurance company.
Arbitrage
The insurance company may be motivated by arbitrage in purchasing reinsurance coverage at a lower rate than what they believe the cost is for the underlying risk.
Types of Reinsurance
Proportional
Proportional reinsurance (mostly known as quota share reinsurance) is where the reinsurer takes a stated percent share of each policy the insurer writes and then shares in the premiums and losses in that same proportion. The size of the insurer might only allow it to write a risk with a policy limit of up to $1 million, 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) 3/4th's of all premiums and losses. The reinsurance company usually pays a commission on the premiums back to the insurer in order to compensate them for costs incurred in sourcing and administering (e.g. retail brokerage, taxes, fees, home office expenses) the business (usually 20-30%) This is known as the ceding commission.
The other (lesser known) form of proportional reinsurance is surplus share. In this case, a “line” is defined as a certain policy limit - say $100,000. In a 9 line surplus share treaty the reinsurer could 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). If they issue a $500,000 policy, they would cede 80% of the premiums and losses on that policy to the reinsurer (1 line to the company, 4 lines to the reinsurer 4/5 = 80%) If they issue the maximum policy limit of $1,000,000 the Reinsurer would then get 90% of all of the premiums and losses from that policy.
Non-proportional (excess of loss)
Non-Proportional reinsurance, also known as excess of loss reinsurance, only responds if the loss suffered by the insurer exceeds a certain amount, called the retention. 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 purchases a layer of reinsurance of $4m in excess of $1 million - if a loss of $3 million occurs the insurer pays the $3 million to the insured(s), and then recovers $2 million from their reinsurer(s). In this example, the insurer 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.
Excess of loss reinsurance can have two forms - “Per Risk” or “Per Occurrence” (Catastrophe or “Cat”). 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 insurance policy limits must be less than the reinsurance retention. For example, an insurance company issues homeowner's policy 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 losses in one event (i.e hurricane, earthquake, etc.)
This same principle applies to casualty reinsurance except that in the case of Catastrophe excess the word “Clash” is used.
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.
Markets
Many reinsurance placements are not placed with a single reinsurer but are shared between a number of reinsurers. (for example a $30,000,000 xs of $20,000,000 layer may be shared by 30 reinsurers with a $1,000,000 participation each) 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 (they follow the lead).
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.
Retrocession
Reinsurance companies themselves also purchase reinsurance and this is known as a retrocession. They purchase this reinsurance from other reinsurance companies, who are then known as “retrocessionaires.” The reinsurance company that purchases the reinsurance is known as the “retrocedent.”
It is not unusual for a reinsurer to buy reinsurance protection from other reinsurers. For example, a reinsurer which 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.
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 intentional creation of reinsurance spirals, which concentrated risks into the hands of a few reinsurance syndicates. A series of catastrophic losses in the late 1980s, bankrupted these syndicates causing many ceding insurance companies to lose their effective coverage.
It is important to note that the insurance company is obliged to indemnify their policyholder for the loss under the insurance policy whether or not the Reinsurer actually reimburses the Insurer. Many insurance companies have gotten into trouble by purchasing reinsurance from reinsurance companies that did not or could not pay their share of the loss.
In a 50% quota share the insurance company could then be left with half the premium and the entire loss. This is a genuine concern when purchasing reinsurance from a reinsurer that is not domiciled in the same country as the insurer. Remember that losses come after the premium, and for certain lines of casualty business (e.g. asbestos or pollution) the losses can come many, many years later.