insurance companies directly or through a broker as a means of risk management, sometimes

in practice including tax mitigation and other reasons described below. The ceding company

and the reinsurer enter into a reinsurance agreement which details the conditions upon

which the reinsurer would pay a share of the claims incurred by the ceding company. The

reinsurer is paid a "reinsurance premium" by the ceding company, which issues insurance

policies to its own policyholders. The reinsurer may be either a specialist reinsurance

company, which only undertakes reinsurance business, or another insurance company. Insurance

Companies that sell reinsurance refer to the business as 'assumed reinsurance'. Assumed

reinsurance is reported separately on their books from their non-reinsurance business.

For an example of a reason for purchasing reinsurance, assume an insurer sells 1,000

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 reinsurer

as this will reduce the ceding company's exposure to risk.

A healthy reinsurance marketplace helps to ensure that insurance companies can remain

solvent because the risks and costs are spread, particularly after a major disaster such as

a major hurricane. There are two basic methods of reinsurance:

Facultative Reinsurance, which is negotiated separately for each insurance policy that

is reinsured. Facultative reinsurance is normally purchased by ceding companies for individual

risks not covered, or insufficiently 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 for such business because

each risk is individually underwritten and administered. However as they can separately

evaluate each risk reinsured, the reinsurer's underwriter can price the contract to more

accurately reflect the risks involved. Ultimately, a facultative certificate is issued by the

reinsurance company to the ceding company reinsuring that one policy.

Treaty Reinsurance means that the ceding company and the reinsurer negotiate and execute a

reinsurance contract. The reinsurer then covers the specified share of more than one insurance

policy issued by the ceding company which come within the scope of that contract. The

reinsurance contract may oblige the reinsurer to accept reinsurance of all contracts within

the scope, or it may allow the insurer to choose which risks it wants to cede, with

the reinsurer obliged to accept such risks. Ultimately, a treaty is issued by the reinsurance

company to the ceding company reinsuring more than one policy.

There are two main types of treaty reinsurance, proportional and non-proportional, which are

detailed below. Under proportional reinsurance, the reinsurer's share of the risk is defined

for each separate policy, while under non-proportional reinsurance the reinsurer's liability is based

on the aggregate claims incurred by the ceding office. In the past 30 years there has been

a major shift from proportional to non-proportional reinsurance in the property and casualty fields.

Functions Almost all insurance companies have a reinsurance

program. The ultimate goal of that program is to reduce their exposure to loss by passing

part of the risk of loss to a reinsurer or a group of reinsurers. In the United States,

insurance is regulated at the state level, which only allows insurers to issue policies

with a maximum limit of 10% of their surplus, unless those policies are reinsured. In other

jurisdictions allowance is typically made for reinsurance when determining statutory

required solvency margins. Risk transfer

With reinsurance, the insurer can issue policies with higher limits than would otherwise be

allowed, thus being able to take on more risk because some of that risk is now transferred

to the reinsurer. The reason for this is the number of insurers that have suffered significant

losses and become financially impaired. Over the years there has been a tendency for reinsurance

to become a science rather than an art: thus reinsurers have become much more reliant on

actuarial models and on 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. Income smoothing

Reinsurance can make an insurance company's results more predictable by absorbing larger

losses and reducing the amount of capital needed to provide coverage. The risks are

diversified, with the reinsurer bearing some of the loss incurred by the insurance company.

The income smoothing comes forward as the losses of the cedant are essentially limited.

This fosters stability in claim payouts and caps indemnification costs.

Surplus relief An insurance company's random writings are

limited by its balance sheet. 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, whatever the class of insurance.

In general, the reinsurer may be able to cover the risk at a lower premium than the insurer

because: 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. Reinsurers may operate under a more favourable

tax regime than their clients. Reinsurers will often have better access to

underwriting expertise and to claims experience data, enabling them to assess the risk more

accurately and reduce the need for contingency margins in pricing 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 itself

of the expertise of a reinsurer, or the reinsurer's ability to set an appropriate premium, in

regard to a specific risk. The reinsurer will also wish to apply this expertise to the underwriting

in order to protect their own interests. 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 homogeneous

portfolio of insured risks. This would lend greater predictability to the portfolio results

on net basis 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.

Types Proportional

Under proportional reinsurance, one or more reinsurers take a stated percentage share

of each policy that an insurer produces. This means that the reinsurer will receive that

stated percentage of the premiums and will pay the same percentage of claims. In addition,

the reinsurer will allow a "ceding commission" to the insurer to cover the costs incurred

by the insurer. The arrangement may be "quota share" or "surplus

reinsurance" or a combination of the two. Under a quota share arrangement, a fixed percentage

of each insurance policy is reinsured. Under a surplus share arrangement, the ceding company

decides on a "retention limit" - say $100,000. The ceding company retains the full amount

of each risk, with a maximum of $100,000 per policy or per risk, and the balance of the

risk is reinsured. The ceding company may seek a quota share

arrangement for several reasons. First, they may not have sufficient capital to prudently

retain all of the business that it can sell. For example, it may only be able to offer

a total of $100 million in coverage, but by reinsuring 75% of it, it can sell four times

as much. The ceding company may seek surplus reinsurance

simply to limit the losses it might incur from a small number of large claims as a result

of random fluctuations in experience. In a 9 line surplus treaty the reinsurer would

then accept up to $900,000. 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 half of the premiums and losses to the reinsurer. The maximum automatic

underwriting capacity of the cedant would be $1,000,000 in this example.

Non-proportional Under non-proportional reinsurance the reinsurer

only pays out if the total claims suffered by the insurer in a given period exceed a

stated amount, which is called the "retention" or "priority". For instance the insurer may

be prepared to accept a total loss up to $1 million, and purchases a layer of reinsurance

of $4 million in excess of this $1 million. If a loss of $3 million were then to occur,

the insurer would bear $1 million of the loss and would recover $2 million from its reinsurer.

In this example, the insured also retains any excess of loss over $5 million unless

it has purchased a further excess layer of reinsurance.

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", "Per Occurrence or

Per Event 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. These contracts usually

contain event limits to prevent their misuse as a substitute for Catastrophe XLs.

In catastrophe excess of loss, the cedant's retention is usually a multiple of the underlying

policy limits, and the reinsurance contract usually contains a two risk warranty. For

example, an insurance company issues homeowners' 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. Aggregate XL affords a frequency protection

to the reinsured. For instance if the company retains $1 million net any one vessel, $5

million annual aggregate limit in excess of $5m annual aggregate deductible, the cover

would equate to 5 total losses in excess of 5 total 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" contracts.

Risks 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 during the whole policy period even if claims

are only discovered or made later on. 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. Losses occurring basis

A Reinsurance treaty under which all claims occurring during the period of the contract,

irrespective of when the underlying policies incepted, are covered. Any losses occurring

after the contract expiration date are not covered.

As opposed to claims-made or risks attaching contracts. Insurance coverage is provided

for losses occurring in the defined period. This is the usual basis of cover for short

tail business. Claims-made basis

A policy which covers all claims reported to an insurer within the policy period irrespective

of when they occurred. Contracts

Most of the above examples concern reinsurance contracts that cover more than one policy.

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 has no predetermined end date, but generally either party can give 90 days notice

to cancel or amend the treaty. 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.

Fronting Sometimes insurance companies wish to offer

insurance in jurisdictions where they are not licensed: for example, an insurer may

wish to offer an insurance programme to a multinational company, to cover property and

liability risks in many countries around the world. In such situations, the insurance company

may find a local insurance company which is authorised in the relevant country, arrange

for the local insurer to issue an insurance policy covering the risks in that country,

and enter into a reinsurance contract with the local insurer to transfer the risks. In

the event of a loss, the policyholder would claim against the local insurer under the

local insurance policy, the local insurer would pay the claim and would claim reimbursement

under the reinsurance contract. Such an arrangement is called "fronting". Fronting is also sometimes

used where an insurance buyer requires its insurers to have a certain financial strength

rating and the prospective insurer does not satisfy that requirement: the prospective

insurer may be able to persuade another insurer, with the requisite credit rating, to provide

the coverage to the insurance buyer, and to take out reinsurance in respect of the risk.

An insurer which acts as a "fronting insurer" receives a fronting fee for this service to

cover administration and the potential default of the reinsurer. The fronting insurer is

taking a risk in such transactions, because it has an obligation to pay its insurance

claims even if the reinsurer becomes insolvent and fails to reimburse the claims.

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