rajesh 100 marks 6th semester

8/8/2019 Rajesh 100 Marks 6th Semester

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PRINCIPLES & TYPES OF REINSURANCE

Principles of Reinsurance

Table of Contents

Chapter One - Introduction to Reinsurance

Origins of Reinsurance

Reinsurance Types

Facultative Reinsurance

Treaty Reinsurance

Proportional Reinsurance

Quota Share

Surplus Share

Non-Proportional Reinsurance

Chapter Two - Types of Life and Property & Casualty Reinsurance

Proportional Reinsurance for Life Insurance Companies

Yearly Renewable Term

Coinsurance

Modified Coinsurance

Reinsurance for Property & Casualty Companies


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Quota Share

Surplus Share

Non-proportional Reinsurance

Individual

Occurrence

Aggregate

Layering

Non-proportional Reinsurance for Life Insurance Companies

Stop Loss Reinsurance

Catastrophe Reinsurance

Spread Loss Reinsurance

Chapter Three - Purposes of Reinsurance

Assumption Reinsurance

Indemnity Reinsurance

Entering New Lines of Business

Underwriting Impaired Risks

Chapter Four - Reinsurance Agreements

The Facultative Agreement

The Treaty Agreement

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The Cession Form

Chapter Five - Reinsurance in Operation

Claims

Change in Reinsurance Amounts

Agreement Duration

Experience Rating

Supplemental Coverage

Substandard Reinsurance

Decisional Factors in Setting Retention Limits

Chapter Six - The Reinsurance Environment

Product, Market and Classification Development

New Products

Classification of Life Insurance Risks

Emergence of New Reinsurance Markets

Company Restructuring

Increased Risk

Competition

Interest Rates and Financial Volatility

Chapter Seven - Reinsurance Regulation

Introduction

Disclosure

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Assessment of Risk Transfer and Accounting

Security

Glossary

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Chapter One

Introduction to Reinsurance

Origins of Reinsurance

Think about a business in which you have invested all of your assetsyour

savings, your house and everything else of value. In fact, you have invested

more than that because you have borrowed against your future profits in

order to raise the capital to start and run the business. Now, consider the

possibility that all of your assets could be lost because of a storm. If you can

mentally transport yourself back to the 17th century, you may begin to have

an understanding of the business environment in which English and other

ship owners operated in the year 1688, the year that the worlds most famous

reinsurerLloyds of Londonhad its first meeting.

For many ship owners in the 17th century, the example above was a very real

fact of business life. Since few ship owners could afford to bet everything

on a single roll of the diceor on a single voyagethey would seek out

others that would, for a fee, agree to accept a part of the risk. Typically, a

ship owner would write information about the impending voyage on a piece

of paper and solicit investors willing to accept some or all of the risk by

posting the description on or near the wharf.

An investor wishing to accept a part of the risk of the voyage would place

his initials below the line on the notice and would indicate the percentage of

the risk that he would bear. The investors that accepted some or the entire

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risk incident to the voyage became known as underwriters since they were

writing their name under the description of the risk.

Since each of these underwriters would typically bear only a part of the total

risk rather than the entire risk, the ship owner needed to take the information

about the voyage to multiple underwriters until all of the riskor at least the

portion of the risk that he wouldnt agree to bear himselfwas assumed. As

the number of voyages increased and potential investors grew in number as

they became more familiar and comfortable with the risks, the business of

insuring these voyages became chaotic. In 1688, a group of investors met

for the first time in a central place in order to facilitate these insurance

transactions. That first meeting took place at Lloyds Coffeehousea

location from which Lloyds of London took its name.

It wasnt long before Lloyds Coffeehouse became the center of marine

insurance in England and, subsequently, worldwide. As the marine

insurance industry grew, fewer ship owners had contact with the

underwriters. Instead, ship owners and underwriters used middlemen to

bring the transaction together for a fee. These middlemen, individuals that

came to be known as brokers, negotiated the insurance, and when a claim

was incurred the brokers collected the claim from each underwriter and

made payment to the ship owner.

By the late 18th century, the underwriters that continued to use Lloyds

Coffeehouse moved the insurance operation to the Royal Exchange in the

city London and formed a committee to manage the day-to-day operation of

the organization. About a hundred years after its move to the Royal

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Exchangelate in the 19th centuryLloyds was incorporated and became

known as the Society of Lloyds.

The bulk of Lloyds of Londons business continues to come from the

transportation sector, where they insure or reinsure airline, shipping and

other risks related to transportation. About one-third of its income is derived

from a type of reinsurance that we will discuss, known as treaty

reinsurance and about 15 percent is the result of facultative reinsurance, a

reinsurance type that we will also consider.

While Lloyds of London still looks to Great Britain for the largest part of its

income, much of its income comes from other parts of the world and from

non-marine type coverages. Now that we have looked at the beginnings of

the worlds best-known reinsurer, lets turn our attention to some of its basic

concepts.

Just the way that any individual may choose to insure a certain riskor part

of a riskand retain other risks, an insurance company may also elect to

insure some of the risk it has assumed. When an insurance company makes

that choice to insure some of its risk, it is known as reinsurance, and the

policy that it negotiates is called a reinsurance treaty.

Although there are certainly some similarities between the individual as

purchaser of insurance and an insurance company as purchaser of

reinsurance, there are many differences. One reinsurance situation may

differ from another in the:

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Type of reinsurance

and

Use of reinsurance

As we will see, the types and uses of reinsurance can be quite complex.

The concept of risk-sharing is as fundamental to reinsurance as it is to

insurance in general. It involves the spreading of a significant risk over a

number of individuals and, thereby, exchanging the possibility of a

potentially catastrophic financial loss for a certain, but manageable, lossknown as the premium. When insurance companies share their risk through

reinsurance, the amount of the risk that they dont share is known as their

retention; the amount of risk shared is the amount ceded to the reinsurer.

The presence or absence of reinsurance is not generally something of which

the policyowner is aware. Typically, the policyowners interaction has only

been with the primary insurer rather with the reinsurer. And, if the

policyowner has a claim covered under the policy, the primary insurer is

obligated to honor it, irrespective of whether there is any reinsurance

involved. So, the parties to the reinsurance contract are the primary insurer

and the reinsurer; the policyowner is not a party to it.

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Reinsurance Types

There are two basic types of reinsurance, known as:

Facultative reinsurance

and

Treaty reinsurance

Facultative Reinsurance

The difference between the two types of reinsurance lies in the power of the

primary insurer and the reinsurer to decide whether or not to assume the risk.

In facultative reinsurance the reinsurer retains the power to assume or

decline any risk presented to it. In other words, it retains the faculty to

take on the risk or reject all or part of it. The agreement in facultative

reinsurance is negotiated for each risk. In the property & casualty insurance

industry, facultative reinsurance is employed when the value of the property

is higher or the risk is greater than those risks covered by the reinsurance

treaty. Similarly, the primary insurer can choose whether or not to purchase

reinsurance for a particular risk and from whom.

Treaty Reinsurance

If the facultative type of reinsurance enables both the primary insurer and

the reinsurer to determine whether or not to reinsure each particular risk,

treaty insurance is just the opposite. Once the agreement for treaty insurance

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Quota share

and

Surplus share

Quota Share

In quota share reinsurance a fixed percentage of coverage provided under

each policy is retained and the balance is ceded. The percentage of coverage

retainedwhich could be 10%, 25%, 50% or some other percentageisgenerally the same for every policy, regardless of the amount. The

corresponding premium is also paid to the reinsurer. In turn, the primary

insurer receives a commission for the business from the reinsurer.

In the event of a claim under the policy the reinsurer would pay that

percentage of the claim equal to its percentage share of the policy.

For example, suppose a property and casualty insurer entered into treaty

reinsurance with a reinsurer to share risks on a 25% - 75% quota share basis.

Following the establishing of the reinsurance agreement, the primary insurer

entered into the following risks:

Insurance Amount Amount Ceded

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Amount Retained

$50,000

$150,000

$12,500

$37,500

$37,500

$112,500$500,000 $125,000 $375,000$1,000,000 $250,000 $750,000

As we can see, in the case of a quota share treaty reinsurance agreement,

each and every insurance policy is split between the primary insurer and the

reinsurer according to the quota share percentage stated in the reinsurance

agreement.

Surplus Share

But, as we noted earlier, quota share is not the only type of proportional

reinsurance agreement; a surplus share agreement might be negotiated

instead.

In a surplus share agreement, the primary insurer retains a fixed amount of

the issued coverage. If the liability under the issued policy is less than the

dollar amount retained by the primary insurer, none of the coverage is ceded

to the reinsurer; conversely, if the liability under the issued policy is greater

than the dollar amount retained by the primary insurer, the excess is

reinsured. The premium for each policy reinsured is shared in the ratio ofthe retained liability to ceded liability. If the premium paid by the applicant

was $1,200 and the reinsurer was ceded $40,000 of a $100,000 policy, the

reinsurer would also receive a 40 percent share of the premium, or $480.

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Looking back at the example of the amounts retained and the amounts ceded

under the quota share agreement, we can see the difference in a surplus share

agreement. Under a surplus share agreement that provides for the primary

insurers retention of the first $50,000 of coverage, the split would look like

the following:

Insurance

Amount

Amount Retained Amount

Ceded

$50,000

$150,000

$50,000

$50,000

$ 0

$100,000$500,000 $50,000 $450,000$1,000,000 $50,000 $950,000

As we can see, the basic difference between quota and surplus share is in

terms of the retention by the primary insurer. Under quota share, it is a fixed

percentage; under surplus share, it is a fixed amount.

So, we have seen that reinsurance may be proportional or non-proportional.

If it is proportional, it is either quota share or surplus share. But, what if it is

non-proportional?

Non-Proportional Reinsurance

Non-proportional reinsurance is also called excess of loss reinsurance. In

this type of reinsurance, the primary insurer, i.e. the ceding company, is

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indemnified for the portion of a loss that exceeds the ceding companys net

retention. The primary difference between excess of loss reinsurance and

surplus share reinsurance, which it closely resembles, is the premium paid

by the primary company to the reinsurer. In the case of surplus share

reinsurance, the premium paid by the primary insurer to the reinsurer is

based on the proportionate share of the liability borne by each party. In

excess of loss reinsurance, the premium paid by the primary insurer to the

reinsurer bears no proportional relationship to the original premium paid by

the policyowner. Instead, it is a charge based on the potential for loss.

Excess of loss plans may cover policies on an individual basis, but they may

also apply to an occurrencean earthquake, for examplethat would allow

the ceding company to recover losses associated with a single catastrophic

event in excess of a particular amount. They may also be written to cover an

aggregate of losses that are incurred over a period of time. Although that

period is often a year, it may be a period of several years. These latter

reinsurance contracts are often referred to as stop-loss contracts.

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Chapter Two

Types of Life and Property & Casualty Reinsurance

Proportional Reinsurance for Life Insurance Companies

We have looked at reinsurance in a general fashion and considered the

differences between treaty and facultative, proportional and non-

proportional and between quota share and surplus share. We will turn our

attention now to the application of these types of reinsurance to different

insurance industries, beginning with proportional reinsurance the life

insurance industry.


Two basic approaches are taken to the providing of proportional reinsurance

in the life insurance industry:

The yearly renewable term insurance plan

and

The coinsurance plan

Yearly Renewable Term

In the case of proportional reinsurance provided under a yearly renewable

term insurance plan, the primary company purchases term life insurance

from the reinsurance company on a yearly renewable term insurance basis.

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The amount of yearly renewable term life insurance purchased is equal to

the net amount at risk in the policy that is in excess of the primary life

insurance companys retention limit.

The net amount at risk in a life insurance policy is simply the amount

payable as a death benefit under the policy less the policys terminal reserve.

Although the reserve is technically defined as the difference between the

present value of future benefits (which increase with age) and the present

value of future net premiums (which decrease with age), resulting in a steady

increase in terminal reserve over the years, it approximates a life insurance

policys cash valueand that is sufficient for our purposes.

Net amount at risk

The net amount at risk is generally equal to the difference between the death

benefit of a life insurance policy and its cash value. To the extent that a life

insurance policys cash value increases over time while the death benefits

remain constant, the net amount at risk will decrease as the policy ages. The

net amount at risk is graphically illustrated below:

Death benefit

Cash value

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To illustrate how the yearly renewable approach would work in the case in

which a primary life insurer has a retention limit of $500,000, lets suppose

that the insurers agent sells a whole life insurance policy for $1 million to a

35 year-old applicant. At the end of the first year, the terminal reserve is

about $8,800. The net amount at risk under this policy, according to our

definition, is the difference between the death benefit of $1 million and the

terminal reserve of $8,800. The net amount at risk, therefore, is $991,200.

($1,000,000 - $8,800 = $991,200)

Since the primary insurer purchases one year renewable term life insurance

from the reinsurer in an amount equal to the difference between its retention

limit and the net amount at risk, if greater, it will purchase term insurance

for $491,200 in the first year. ($991,200 - $500,000 = $491,200) What the

primary life insurer has done by purchasing the term insurance is simple; it

has transferred the risk of the insureds death, to the extent that the net

amount at risk exceeds its retention limit, to the reinsurer. Reinsurance often

Death benefit

Cash value

Net amount atrisk

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remains in effect for many years, so the one year term insurance purchased

by the primary insurer must be renewed from year to year. Lets look at

what happens by year 8.

Since the policy is whole life insurance, it is characterized by a level death

benefit and a constantly increasing cash value that approximates the policys

terminal reserve. Because the policys terminal reserve has increased, the

net amount at risk has decreased commensurately. The policys terminal

reserve at the end of the 8th year would be $77,800, so the net amount at risk

has decreased to $922,200, and the amount of one year term life insurance

purchased from the reinsurer would be reduced to $422,200.

In the case of the yearly renewable term insurance plan of life reinsurance,

the primary insurer purchases liability-reducing coverage for a portion of the

death benefit only. As a result, the reinsurers obligations extend solely to

paying a part of the death benefit upon the insureds death. There are no

reinsurer obligations in the case of the yearly renewable term insurance plan

for any dividends, cash surrender values or nonforfeiture provisions. As we

will shortly see, this is a major difference between the yearly renewable term

insurance plan or reinsurance and the coinsurance plan.

The benefits of the yearly renewable term insurance plan to the primary

insurer are its:

Simplicity

Favorable impact on asset growth

and

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Ability to choose a reinsurer that is unlicensed in the primary

insurers domiciliary state

Because the yearly renewable term insurance plan is characterized by greater

simplicity, it is considerably easier to administerand that translates into

administrative savings. The more important benefits of this life reinsurance

approach, however, are the remaining two: asset growth impact and

reinsurer choice.

By employing a yearly renewable term insurance plan as a method ofreinsuring, the primary insurer generally retains most of the policyowners

premiums, since it is purchasing the type of life insurance with the lowest

premium, i.e. yearly renewable term insurance. As a result, this reinsurance

arrangement has the smallest adverse impact on the primary insurers asset

growth. Although this characteristic may appeal to any primary insurer, it is

usually of greatest appeal to smaller primary life insurance companies.

A primary life insurance company may choose the yearly renewable term

insurance approach because of its desire to reinsure its risk with a reinsurer

that is not licensed in the primary insurers state of domicile. The reason for

the preference for yearly renewable term insurance rather than another

approach in this case is because the primary insurer cannot deduct the

reinsurers reserves held against the liability from its own reserves if the

reinsurer is not licensed in the primary insurers state. Since it cannot

deduct the reinsurers reserves from its own, it makes much more sense for

the primary insurer to opt for the yearly renewable term insurance approach

in which it holds all of the policy reserves anyway.

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Coinsurance

The yearly renewable term insurance plan of reinsurance is quite simple and

straightforward. The parties to the reinsurance agreement need not have a

particularly close working arrangement. The second type of life insurance

reinsurance that we will examinethe coinsurance planis quite different

with respect to virtually all the characteristics of the first type.

In the first place, the coinsurance plan is significantly more complex than the

yearly renewable term approach, and that greater complexity arises

principally from the nature of the relationship between the two parties to the

reinsurance agreement. We noted earlier that the relationship between the

two parties to the yearly renewable term plan was a fairly arms-length

arrangement. In the coinsurance plan, the relationship is much closer since

the two insurersprimary and reinsureragree to provide all of the benefits

purchased by the policy owner jointly.

We noted that, in the yearly renewable term insurance plan, the reinsurer

was obligated only to provide its portion of the death benefits if the insured

died during the period of reinsurance. Other than that, the reinsurer has

virtually no obligation to the primary insurer. In the coinsurance plan, to the

contrary, the reinsurer is liable for its proportionate share of the policys:

Death benefits

Cash surrender value

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Dividends, in the event the insurance is participating

and

Non forfeiture benefits

Clearly, the two insurance companies are bound much closer in the

coinsurance plan of reinsurance than they are in the yearly renewable term

insurance plan. That greater proximity comes at a price.

You will recall that one of the advantages to the primary insurer of the

yearly renewable term plan was its ability to retain the lions share of the premium, and that translated into faster asset growth. In that case, the

reinsurer received a relatively small portion of the total policy premium.

The reinsurers portion of the premium in the coinsurance plan is much

greater.

Lets return to our earlier example of the 35 year-old applicant that

purchased a $1 million whole life insurance policy from the primary insurer

whose retention limit was $500,000. Of the approximately $15,000 annual

premium for the policy, the reinsurer may have received $500 or so in the

first year of the agreement; the primary insurer kept the balance. If the

reinsurance agreement in effect called for coinsurance of 50 percent, the

reinsurer would have received one-half of the total premium, or $7,500.

From a death benefit perspective, the result between the two arrangements

would have been identical.

The remitting of one-half of the total premium to the reinsurer is, however,

not the whole financial story. In the case of the coinsurance plan, the

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reinsurer pays the primary insurer a commission, known as a ceding

commission that reimburses the primary insurer for the costs incurred by

the company in putting the business on its books. As we will discuss when

we examine the uses of reinsurance, this ceding commission is vital for

many small companies with substantial growth rates and relatively small

surplus positions who may want to use reinsurance to finance their growth.

The ceding commission that is paid by the reinsurer is designed to include:

An allowance for the commissions paid by the primary insurer to itsagent

The premium taxes paid by the primary insurer

and

A part of the primary insurers overhead expenses

The ceding commission is negotiated between the primary insurer and the

reinsurance company and is often greater than the first year premium that is

cededalong with the liabilityto the reinsurer. This approach is

consistent with the primary insurers new business acquisition cash flow in

which the life insurance companys first year costs to acquire new life

insurance business may exceed its first year premium by 50 percent or more.

In more concrete terms, a primary insurer may pay out in first year

commissions, overrides, expense allowances and other acquisition costs a

total of $1,500 to put a life insurance policy with a $1,000 annual premium

on its books. That additional $500 by which the expenses exceed the

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revenue must generally come from the primary insurers surplus. So, a life

insurance company with limited surplus may look forward to reinsuring

much of its new business as a way of replacing that lost surplus.

As we noted, in addition to this commission arrangement, the coinsurance

plan requires much more from the reinsurer. If the life insurance policy that

was reinsured is a participating policy, the reinsurer must be ready to pay

dividends as declared by the primary insurer. Since participating policy

dividends generally reflect the experience of the company paying the

dividends, and since the primary company and the reinsurance company may

have vastly different experience, this arrangement can cause significant

concerns for the reinsurer.

Assume, for example, that the reinsurers net investment earnings are less

than those of the primary insurer. In such a case, the reinsurers dividend

scale would be lower than the primary companys scale, and yet the

reinsurer must pay dividends according to that higher scale.

Although participating policy dividends tend to be affected more

significantly by investment earnings than by mortality experience, mortality

is still a factor in any companys dividend declaration. However, if the

reinsurers mortality experience is less favorable than that of the primary

company, the reinsurers normal dividend scale will be even further out of

step with the dividend scale of the primary insurer.

To make matters more complicated for the reinsurer, the mortality results

experienced on life insurance business that is reinsured are generally poorer

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than the mortality experience on business that is written directly and fully

retained. Conventional wisdom suggests that the underwriting standards of

smaller companies that rely most heavily on reinsurance may be somewhat

more liberal than the standards of companies with higher retention limits.

Despite these complications in the relationships between primary insurers

and their reinsurers, there is generally little reason for concern; the

reinsurers actuaries have considered all of the issues in their determining of

the amount of ceding commissions paid to the primary insurer, so that the

differences in dividend scales generally create little difficulty for the

reinsurer.

In addition to dividends, the reinsurer, in the case of coinsurance, is liable

for a part of the policys surrender value if it is surrendered for its cash

value. Alternatively, a terminated policy may be placed under one of the

non forfeiture provisions, such as reduced paid-up or extended term

insurance. If either of those conditions apply, the reinsurer continues to be

liable for its proportionate share of those benefits as well.

Modified Coinsurance

It is possible that for any particular primary insurer, neither the coinsurance

plan nor one year renewable term insurance plan fits particularly well. As a

result of this, reinsurers have developed a reinsurance arrangement known as

modified coinsurance.

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The benefit to the primary life insurer derived from yearly renewable term

reinsurance, when compared to coinsurance, is that the primary insurer is

able to retain much more of the policy premium. Since retaining a greater

amount of the premium helps the company grow its assets more quickly,

many companies prefer this particular feature. The disadvantage of yearly

renewable term insurance to the primary insurer is that it is responsible for

paying all of its acquisition costs. Because of its payment of these

acquisition costs that often exceed the first year premium, new business

drains the primary insurers surplus and limits its ability to write additional

new life insurance business. So, the yearly renewable term approach has

both important advantages and significant disadvantages.

The coinsurance plan approach to reinsurance resulted in the reinsurers

paying a large portion of the primary insurers acquisition costs through its

payment of a ceding commission. While this commission has a favorable

impact on the primary insurers surplus position, the coinsurance plan also

has certain disadvantages: the primary insurer must pay a portion of each

annual premiumpossibly a substantial portionto the reinsurer. As we

noted, this arrangement helps surplus but negatively affects asset growth.

Primary insurersparticularly those that are most sensitive to the surplus

and asset issuesview the reinsurers accumulation of substantial premium

funds as an unnecessary and undesirable feature of reinsurance. Because of

this concern, an approach to reinsurance was developed that enables the

primary insurer to retain the entire reserve of the reinsured policy. This third

approach is known as the modified coinsurance plan.

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Under the modified coinsurance plan, the primary insurer pays the

reinsurance company a pro rata portion of the premium for the reinsured

policysimilar to the coinsurance plan. The premium payment made to the

reinsurer is netted by the amount of the ceding commissions that would have

been paid to the primary insurer.

The big difference in the modified coinsurance plan is that at the end of each

policy year the reinsurer pays to the primary insurer an amount that is equal

to the net increase in the policy reserve that year. Although the actual

reserve increase payment calculation is somewhat more complicated than

suggested, this is what occurs.

Under this modified coinsurance arrangement, as a result of this annual

payment back to the primary insurer, the reinsurance company never holds

more of the premium than the amount equal to the gross premium on the

death benefit reinsured for a single year. In simpler terms, the reinsurer has

not been permitted to accumulate significant premium funds.

As we can see, this modified coinsurance plan answers the critics of both the

yearly renewable term plan and the coinsurance plan. By reducing the

amount of premium held by the reinsurer, it helps the primary insurer to

grow its assets more quickly. Furthermore, the recouping of much of the

primary insurers acquisition cost from the reinsurer helps the primary

insurer to maintain a more favorable surplus position. In many respects, the

modified coinsurance plan of reinsurance is the best of both worlds.

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Reinsurance for Property & Casualty Insurance Companies

The types of reinsurance we examined thus faryearly renewable term,

coinsurance and modified coinsuranceare all proportional reinsurance

types used in the life insurance industry. The same proportional reinsurance,

however, is used in the property and casualty industry. Lets turn our

attention now to how this proportional reinsurance functions in property and

casualty insurance.

The idea behind reinsurance is, of course, identical in the life insurance and

property & casualty industries: a spreading of the risk among two or more

insurance carriers. The language and operation of the reinsurance, however,

are different. Reinsurance in the property & casualty industry tends to be

somewhat less complicated than the reinsurance that we have already

examined.

We noted that there are two basic types of proportional reinsurance plans in

the life insurance industry: yearly renewable term and coinsurance. There

are also two types of proportional reinsurance plans in the property &

casualty insurance industry. These proportional reinsurance plans are called:

Quota share

and

Surplus share

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Quota Share

Under a quota share agreement, the primary insurer cedes a fixed percentage

of each policy it issues in a particular line or class of business.

In a quota share reinsurance arrangement, a primary insurer might agree to

reinsure 70 percent of every policy that it issues and retain the remaining 30

percent. Just as we noted in the coinsurance arrangement in the life

insurance industry, the reinsurer pays a ceding commission to the primary

insurer.

Once the percentage to be ceded has been agreed upon, the premium and

loss division that occurs after that is completely automatic. In the 70 percent

quota share arrangement, the primary insurer retains 30 percent of the

premium and liability, and 70 percent of the premium and liability is

assumed by the reinsurer. The arrangement is quite simple and

uncomplicated and applies to all policies issued by the primary insurer in the

class of policies reinsured, regardless of the policy size.

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Example -Quota share reinsurance arrangement

A quota share reinsurance arrangement would produce the following

revenue and claims liability for the primary insurer and the reinsurer,

assuming the limit of the policy in question is $100,000:

Insurance policy limit $100,000

Primary insurance company retention 30%

Primary insurers coverage share

Reinsurers coverage share

Total insurance coverage

30,000

70,000

100,000

Total annual policy premium $1,200

Primary insurers premium shareReinsurers premium share

Total insurance premium

360840

1,200

Hypothetical claim $75,000

Primary insurers claim share

Reinsurers claim shareTotal claim

22,500

52,50075,000

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Surplus Share

The other property & casualty proportional reinsurance arrangement is

known as surplus share. The surplus share approach to reinsurance has

some resemblance to the coinsurance method that is used in the life

insurance industry.

In a surplus share arrangement, the primary insurer retains astated amount,

rather than a stated percentage as in the quota share method. Under this

agreement, the reinsurer does not become involved in any particular risk

until the policy limits exceed the primary insurers retention limit.

However, once the amount of reinsurance is determinedby the amount that

the policy provides in excess of the primary insurers retentionthe

premium is shared in the same proportion. So, if the coverage is shared on a

50%-50% basis between the primary insurer and the reinsurer, each receives

one-half of the premiums. It is entirely possible that the reinsurance

outcomein terms of liability and premiumscould be the same under a

quota share and surplus share reinsurance approach.

Example -Surplus share reinsurance arrangement

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A surplus share reinsurance arrangement would produce the following

revenue and claims liability for the primary insurer and the reinsurer,

assuming the limit of the policy in question is $100,000:

Insurance policy limit $100,000

Primary insurance company retention $30,000

Primary insurers coverage share

Reinsurers coverage shareTotal insurance coverage

30,000

70,000100,000

Total annual policy premium $1,200

Primary insurers premium share

Reinsurers premium share

Total insurance premium

360

840

1,200

Hypothetical claim $75,000

Primary insurers claim share

Reinsurers claim share

Total claim

22,500

52,500

75,000

To summarize the proportional approach to reinsurance in the property &

casualty industry, the difference between the surplus share and quota share

arrangements is only in terms of how the primary insurers retention is

stated. In the case of quota share, it is stated as a percentage of every policy,

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regardless of its size; in the case of surplus share, it is stated as a dollar

amount.

As a result of this difference in approach, the percentage of liability assumed

by the reinsurer under quota share is the same irrespective of the policy size.

However, under a surplus share arrangement, the reinsurers liability

percentage increases as any policys limits increase in excess of the primary

insurers retention limit.

Individual

We noted at the outset of our discussion of reinsurance that it may be either

proportional or non-proportional. Thus far, we have examined only the

proportional type. Lets turn our attention, now, to this second type: non-

proportional reinsurance. We will begin with its application in the property

& casualty industry.

When we talk about non-proportional reinsurance in the property & casualty

industry, we really mean coverage better known as excess of loss

reinsurance. This reinsurance coverage is so-called because it protects the

primary insurer against losses in excess of a particular deductible. In this

case, the ceding company is indemnified for any losses that exceed a

specified amount that is the primary insurers retention.

Similar to yearly renewable term reinsurance in the life insurance industry,

the premium paid for excess of loss reinsurance by the primary insurer bears

no proportional relationship to the policyowners premium. Rather, the

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reinsurance premium is based solely on the likelihood of loss. In a sense,

the primary insurer is purchasing coverage, like renewable term insurance,

from the reinsurance company.

There are three forms that excess of loss reinsurance takes in the property &

casualty industry:

1. Individual

2. Occurrence

and

3. Aggregate

Lets examine each of these approaches.

Individual

In the case of individual excess of loss reinsurance coverage, the reinsurer

pays any claim on an individual policy to the extent it exceeds the retention

limit of the primary insurer. For example, if the primary insurers retention

limit is $25,000 and an individual claim is received for $30,000, the $5,000

excess amount would be paid by the reinsurer.

Occurrence

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The occurrence approach to excess of loss reinsurance coverage is equally

straightforward. In that case, a loss resulting from a catastrophic eventan

earthquake, tornado or hurricane, for examplethat exceeds an agreed-upon

total is paid by the reinsurer. The primary insurer may feel that its financial

status would not be severely affected until and unless it was required to pay

losses for a specific event exceeding $10 million. So, it would establish

occurrence reinsurance for any amount over the $10 million.

Aggregate

Aggregate reinsurance simply provides protection for a primary insurer

against any losses that exceed a specified amount over a period of time or

for a particular policy. This type of reinsurance is also called:

Stop-loss coverage

and

Excess of loss ratio reinsurance

The aggregate reinsurance coverage limits a primary insurers liability to a

specified amount under a particular policy or for a specified period. The

period is usually one year, but it may be several years, depending on the

needs of the primary insurer and the reinsurance agreement. It is not

unusual for this type of coverage to reinsure losses that exceed $100 million

in a calendar year.

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We can represent the relationship of these coverages graphically as shown

below:

Excess of loss reinsurance

Excess of Loss

Non-proportional coverage for losses in excess of primary insurers retention

Individual

Coverage on an

individual policy

basis

Occurrence

Coverage for an

occurrence, such as

an earthquake

Aggregate

Coverage for

losses in excess of

a total amount, or

per policy, or per

year

Layering

The insurance industry is creative in its use of reinsurance to enable

companies to meet customer requirements. An example of that creativity

can be seen in the use of various reinsurance agreements to produce a

layering effect.

A customer that needs $20 million of coverage may apply for it from a

primary insurer that chooses to limit its own exposure to $50,000. Clearly,

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in such a case there is a substantial need for large amounts of reinsurance.

Often, the reinsurance needed exceeds even the reinsurers limits, so

multiple reinsurers are enlisted to provide coverage. In the example shown

below, two automatic reinsurance arrangements apply in the case of

reinsurers 1 and 2.

Layering of reinsurance coverage

Primary

Insurer

Reinsurer

1

Reinsurer

2

Reinsurer

3

$20,000,

000

$15,000,000

Facultative

reinsurance

(excess of

loss)

$5,000,0

00

$4,500,000

Treatyreinsurance

(excess of

loss)

$500,00

0 Treaty

reinsurance

(surplus

share)

$50,000

Primary

insurer

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retention

limit

Primary

insurerexposed to

$50,000

limit under

retention

schedule

Reinsurer 1

exposed torisk of

$450,000

after first

$50,000

assumed by

primary

insurer

Reinsurer 2

has $4.5million

exposure

after first

$500,000 of

loss

Reinsurer 3

has $15million

exposure

after first $5

million of

loss

As we can see in the example above, the primary insurer has several

reinsurance arrangements. It has a surplus share agreement with Reinsurer 1

under which all business above its $50,000 retention limit is reinsured.

However, since Reinsurer 1s limit is only $500,000, additional reinsurersare needed. In this case, two additional reinsurers are pressed into service.

Reinsurer 2 has a limit of $5 million, so that a third reinsurer is needed to

cover the entire liability up to the $20 million that is needed by the

customer.

Layering like this is not uncommon in the property & casualty industry,

especially among insurers that provide very large coverage for their

customers. While the illustrated coverage is, of course, hypothetical, such

arrangements are not particularly rare.

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Non-Proportional Reinsurance for Life Insurance Companies

Unlike the property & casualty industry, in which much of the reinsurance is

non-proportional, reinsurance in the life insurance industry has traditionally

been accomplished on the proportional basis that we examined initially.

However, in the recent past, increasing interest has been shown in a

reinsurance approach in which the life insurance reinsurers liability is

related to the primary insurers mortality experience on all of its book of

business instead of on an individual policy.

This kind of non-proportional arrangement is used widely in the property &

casualty business. In the life insurance business, non-proportional

reinsurance may be:

Stop loss reinsurance

Catastrophic reinsurance

or

Spread loss reinsurance

Stop Loss Reinsurance

Stop loss reinsurance is used in the life insurance industry principally as a

supplement to proportional reinsurance. It is designed to ensure that the

primary insurer is not placed in financial jeopardy due to abnormally-high

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mortality in a prescribed period. That period is usually one calendar year.

Typical stop loss reinsurance arrangements provide that the reinsurer must

reimburse the primary insurer to the extent that claims exceed 10 percent of

its normal mortality.

Reimbursement payments from the reinsurer may be equal to 100 percent of

the amount in excess of the primary insurers limit or may only be a portion

of the excess. In order to ensure that the primary insurer has a vested

financial interest in properly underwriting even reinsured business,

reinsurers are tending to reimburse only a portion of the excess mortality.

The result is that the primary insurers are likely to underwrite these risks

more carefully.

The stop loss reinsurance arrangement is a very flexible one. The reinsurer

may agree to cover:

selected portions of the primary insurers book of business

varying levels of mortality

or

periods of varying duration

The appeal of stop loss reinsurance to primary insurers is its providing of

protection against unexpected swings in mortality. These swings might arise

out of an unexpectedly large number of small claims of an increase in the

individual claims average size. Regardless of the cause, these swings can

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wreak havoc on a companys financial results, especially in smaller

companies.

Another advantage of stop loss reinsurance is its relatively low cost.

Primary insurers may choose to reduce their total reinsurance outlay by

increasing their retention limits under proportional agreements and

reinsuring any retained amounts under stop loss agreements. Its final appeal

lies in the fact that, because it is so uncomplicated, it is easy and inexpensive

to administer.

Catastrophe Reinsurance

Catastrophe reinsurance is the second type of non-proportional reinsurance

employed in the life insurance industry. Catastrophe reinsurance generally

calls for the reinsurer to reimburse a fixed percentage of the primary

insurers:

aggregate losses

in excess of the primary insurers conventional

reinsurance

which exceed a prescribed limit

and

which result from a single catastrophic event

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The reinsurance agreement normally requires the reinsurer to reimburse 90

percent to 100 percent of these excess aggregate losses.

The limit of coverage may be expressed in an aggregate dollar amount or in

terms of the number of lives lost. It normally covers a one-year period and

limits the reinsurance companys liability to that prescribed period.

Catastrophe reinsurance is a prime example of coverage that is designed to

protect the primary insurer from a risk that has very low probability of

occurring but, if it does occur, it has an enormous liability attached to it. For

example, although the likelihood of another San Francisco earthquake is

fairly small, an insurers resulting liability could be astronomical.

Spread Loss

Spread loss is the final type of non-proportional reinsurance used in the life

insurance industry that we will consider. Although reinsurance tends to be

somewhat complicated, especially when it is being put to creative use,

spread loss reinsurance is probably the least complicated. This reinsurance

coverage has a single function: to spread an abnormally large loss incurred

in a single year over several years.

Spread loss reinsurance typically works as follows. In any calendar year in

which the primary insurers aggregate death claims exceed a specified

amount, the reinsurer steps in and assumes the claim payment liability.

Having paid these excess claims, the reinsurer adjusts the reinsurance

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premium so that the amount of claims paid in that year plus 20 percent is

collected from the primary insurer over the ensuing five years. The net

result has been to spread these abnormally high claims over several years.

We can summarize these three types of non-proportional reinsurance as

shown in the graphic representation below:

Non-proportional reinsurance

Non-proportional reinsurance used in the life insurance industry generally

assumes three forms: stop-loss, catastrophe and spread loss.

Life Insurance Non-Proportional Reinsurance

Stop Loss

Supplemental

Losses exceeding

normal mortality

Catastrophe

Stop loss for

accidental death

Extraordinary

losses fromsingle cause, e.g.

a plane crash

Spread Loss

Spreads

large one year

losses over a

longer period

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Chapter Three

Purposes of Reinsurance

Why Insurers Choose to Reinsure

To this point we have considered how the various types of reinsurance

arrangements operate to meet the objectives of primary insurers, both life

insurance and property & casualty insurance companies. What we havent

yet done is considerwhy an insurer would choose to reinsure, other than for

the obvious reason of risk reduction.

As we continue our examination of reinsurance, we will see that reinsurance

is generally used by a primary insurer for one of two reasons:

To transfer to another company some or all of a

primary insurers liabilities; or

To accomplish one or more broad managerial

objectives

When reinsurance is used for the first purpose, it is generally referred to as

portfolio or assumption reinsurance; when used for the second purpose, it is

called indemnity reinsurance.

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Assumption Reinsurance

Through assumption reinsurance, a primary insurer transfers some or all of

its liabilities to a reinsurer. This type of reinsurance is always tailored to the

particular requirements of the situation and its parties. For that reason,

assumption reinsurance does not lend itself to broad generalizations.

However, it is a fairly simple matter to identify several uses to which

assumption reinsurance has been put.

The traditional uses of assumption reinsurance include:

Assisting insurance companies during a period of financial

distress

Financing mergers between and acquisitions of insurance

companies

and

Facilitating restructuring

A traditional method of bailing out troubled insurers has been through the

use of assumption reinsurance. A number of life insurance companies have

found themselves forced to liquidate because they encountered severe

financial problems, including such companies as:

Executive Life

Confederation Life

and

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Mutual Benefit Life

In each of these cases, it mighthave been possible for the insurer to avoid

liquidation by reinsuring, if a reinsurance company was willing to assume

the risks involved.

It is not unusual in cases like these for two companies to implement a plan

whereby a solvent insurer will agree to assume the liabilities of the

distressed company. Not unexpectedly, the white knight will also gain

something in the transaction. In return for assuming the distressed insurersliabilities, the reinsurer will generally obtain the assets underlying the

liabilities as well as the right to receive future premiums under the policies.

Sometimes, of course, the assets are insufficient to offset the liabilities. In

fact, this is a fairly likely scenario in a financially failing insurer. In such a

case, the reinsurer will normally place a lien against the cash values of the

ceded policies until the deficiency can be liquidated through the companys

earnings on the policies. When a lien is placed on the failing insurers

policies, policyowners are restricted in their access to cash in their policies

a situation that Executive Life policyowners encountered.

Many other dynamics are occurring in the life insurance industry that call for

the likely use of assumption reinsurance. Some of those changes are:

Demutualization

Mutual holding company formation

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and

Mergers and acquisitions

Insurance companies face significant challenges. Among those challenges

are the enormous costs involved in maintaining cutting-edge technology and

sustaining new product development initiatives. As insurers address the

important issues of identifying and returning to core competencies and

establishing critical mass levels, many of them have identified their ability to

raise capital as essential to their survival.

At one time, most of the insurance giants were mutual companies, owned by

and operated for the benefit of their policyowners. They had no

stockholders and were largely unable to raise capital. Because of that

inability, many of those companies considered demutualizing, forming

mutual holding companies, entering into strategic alliances and merging

with or acquiring other companies. Each of these alternatives that are

designed to help insurers raise capital involves a change in organizational

structure.

When insurers restructure, they often employ reinsurance to enable them to

cede business that isnt core to their business strategy. For example, an

acquiring company will often cede much of the business of an acquired

insurer in order to divest itself of less profitable policies. Additionally,

restructuring insurers will often attempt to carve out mortality risks during

the demutualization process or during the formation of a mutual holding

company.

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Sometimes, when mergers and acquisitions are being contemplated,

reinsurers may be asked to assume a portion of the transaction in order to

provide a certain amount of financing. Depending on the cost to borrow

money, financing through reinsurers may be less expensive.

Assumption reinsurance may involve only a portion of a ceding companys

book of business. A prime example of that can be found in the home service

side of the life insurance business. Some of the largest life insurers in the

United States were initially in the home servicealso known as the debit

business, a business involving the sale of relatively small policies by an

agent who operates within an assigned geographical area selling and

servicing policies. While these companies may owe their current stature to

this type of business, many companies are leaving the debit business in

pursuit of more upscale clientele capable of purchasing larger policies. In so

doing, they may choose to identify such business as marginally profitable

and cede all of itthrough assumption reinsuranceto another company.

In other situations, assumption reinsurance may be employed to enable an

insurer to withdraw from a particular state or region. Rather than being

required to continue to service insurance contracts in areas from which it had

withdrawn, an insurer may choose to cede the business to another insurer

that has continued to operate in the area. In such a case, everybodys

interestthe policyowners, the ceding insurers and the reinsurersis

usually served through the reinsuring of this business.

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As we can readily see, assumption reinsurance must be individually

designed for each situation in order that the primary reinsurers objective can

be met.

Indemnity Reinsurance

Indemnity reinsurance is generally used by a primary insurer to transfer its

liability with respect to individual policies to its reinsurer. The transfer of

liability may involve all of the primary insurers liability under the life

insurance policy, or it may be a transfer of only a portion of it.

The use of indemnity reinsurance is widespread, and a primary insurer may

choose to use it for many reasons. Among the primary reasons for the use of

indemnity reinsurance are:

Limiting the amount of insurance held on a single life

Stabilizing the primary insurers mortality experience

Reducing the insurers drain on surplus

Gaining access to the reinsurers product development and

underwriting expertise

and

Transferring liability under substandard insurance contracts

Of all the important reasons given for the use of indemnity reinsurance, its

most prevalent use is to enable the primary insurer to avoid too heavy a

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concentration of risk on the life of a single policyowner. Almost all

companies choose to limit the amount of life insurance that they will retain

on the life of a policyowner. The amount limit is generally referred to as the

insurers retention limit. Although the actual amount may differ from

insurer to insurer, life insurance companies generally limit their retention to

no more than 1 percent of capital and surplus. It should come as no surprise,

therefore, that insurers with larger assets will generally have greater net

retention limits.

In addition to the amount of surplus that impacts an insurers retention level,

it will also be affected by the amount of insurance that the company has in

force and managements confidence level in the companys underwriting

ability. As a result of these considerations, a companys retention limit may

be as low as $10,000 for a small, relatively young company to $30 million or

more for one of the giants.

Insurance companies may also have retention limits that differ based on

several factors. Some of the factors that might affect a companys retention

for a particular risk are:

The life insurance productwhether term insurance or

permanent insurance is being applied for

The proposed insureds age

and

The proposed insureds underwriting classification

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Normally, those products that entail a higher degree of mortality risk, such

as term life insurance or insurance that is issued on a rated or substandard

basis, will have lower retention limits that apply. Additionally, many

companies will retain lower amounts for very young and very old insureds.

There is little question but that it is generally in an insurers interest to retain

as much of its business as it can prudently manage. As a result of that

general principle, insurers usually increase their retention limits as their

book of in-force business increases and their surplus funds grow.

In addition to limiting an insurers exposure to significant liability on a

single life, indemnity reinsurance is often used to stabilize the insurers

mortality experience. Typically, insurers will use stop-loss, catastrophe and

spread-loss arrangements to reduce their exposure to unwanted risk

concentrations as a means of stabilizing experience. It is these first two uses

of reinsurance that are most obvious. However, there are other reasons for

reinsurance that may be equally as important but far less obvious: surplus

management and reinsurer expertise.

Surplus in a life insurance company can be equated to retained earnings in

any other corporation. And, it is through its retained earnings that most

companies fuel their growth. Surplus serves the same purpose in a life

insurance company.

Surplus and the management of surplus are important issues in all life

insurance companies. In the small and medium size life insurance company,

it is critical. The reasons for that importance are:

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Although gain from operations is the principal source of surplus for

insurance companies, a second source of surplus comes from traditional

capital markets. In other words, insurance companies that are organized as

stock companies can issue stock.

Since generating surplus through the issuing of stock is an alternative

available only to insurance companies that are organized as stock

companies, mutual companies are at a significant disadvantage. Over the

last decade, this mutual company disadvantage has led many of the largest

mutual life insurance companies to elect to change their organizational

structure from a mutual company to a stock company; in other words, to

demutualize.

It is easy to see the beneficial results of demutualization in terms of surplus

creation by looking at the first financially healthy mutual insurance company

to demutualize in the United States. In 1986, a company then known as

Union Mutual changed its organizational structure to a stock company and

raised $580 million in its initial public offering of stock. It also doubled its

surplus.

We have looked at gain from operations and demutualization as ways in

which surplus can be created for an insurer, and we have left a major source

of surplus to the last: reinsurance. Reinsurance can serve as a major capital

source in the insurance industry. In a certain sense, a primary insurer that

purchases reinsurance can be seen as borrowing the reinsurers capital.

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When the use of proportional reinsurance was examined in the life insurance

industry, we considered two major forms: coinsurance and modified

coinsurance. In both cases, a reinsurer paid the primary insurer a ceding

commission based on the amount of reinsured life insurance. That ceding

commission included an allowance for:

Commissions paid by the primary insurer to its agent

Premium taxes and

A portion of the primary insurers overhead expenses

The reinsurer, by paying the primary insurer a ceding commission that may

be greater than an annual premium is, in fact, financing the primary insurers

ability to put additional business on its books. Through its commission

payment, the reinsurer is reducing the primary insurers surplus drain that

was caused by the writing of new insurance business.

Although the financial aspect of reinsurance is critical to many primary

insurers, it isnt only the financial aspect of reinsurance that plays an

important role. Another important reinsurance use concerns the primary

insurers borrowing of the reinsurers expertise. This reinsurer expertise is

often used by primary insurers in two areas:

Entering new lines of business

and

Underwriting substandard risks

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Lets briefly consider each of these uses.

Entering New Lines of Business

It shouldnt be surprising that when a primary insurernormally a

particularly conservative organizationdecides to add to its product line

there is a felt need to tap into available experience. That experience often

comes from reinsurers.

Consider, for example, the movement of a number of smaller life insurance

companies in the late 1970s and early 1980s to enter or expand their

marketing efforts in the disability income insurance line of business. While

offering what appeared to be a substantial source of profit, disability

coverageat least in terms of its new forms and cutting edge featureswas

new ground and needed to be developed and marketed cautiously.

A concern shared by many of these companies was that a noncancellable,

guaranteed renewable disability income policy with an own occupation

definition of disability could result in many millions of dollars in claims

over its life. For that reason, they turned to reinsurers that had a wealth of

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accumulated disability income knowledge and experience in underwriting

disability income insurance.

Through the efforts of these reinsurers, many smaller life insurance

companies successfully entered the disability income business at a level that

would enable them to compete with other primary insurers having far greater

disability underwriting experience. Although many of these primary

insurers have since returned to marketing only their core life insurance

products and have sold their book of disability business to other companies,

they were able to enter the disability business only because of these

reinsurance companies.

Underwriting Impaired Risks

Another area in which primary insurers use the expertise of reinsurance

companies to significant advantage is in the area of impaired risks. Many of

these impairments are seen by underwriters on such an infrequent basis that

even the largest primary insurers have little experience in underwriting them.

Not unexpectedly, an underwriter faced with an impairment that may be

encountered once or twice in an entire career is justifiably concerned about

his or her ability to properly underwrite the risk.

In such a case, underwriters for primary insurers are likely to look for a

reinsurer that possesses the needed expertise. This type of knowledgehow

best to select impaired risksis a special service that reinsurers offer to their

primary insurer customers.

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Even though a particular impairment may be fairly common, primary insurer

underwriters will typically submit the risk to one or more reinsurers with

whom they have agreements. While they may want to solicit the best offer

from the reinsurer, primary insurers also have another objective in sending

the case to several reinsurance companies: it demonstrates to the soliciting

agent that everything has been done to ensure that his or her client has

received the most favorable underwriting decision.

Sometimes a primary insurer will want to transfer all of its substandard

policies to a reinsurer. This type of transfer occurs most frequently in those

situations in which a primary insurer writes no substandard business on any

basis. However, in order to provide a more complete range of products and

services to its agents, the primary insurer may arrange to channel all of its

substandard risk applications to a reinsurer with both the interest in writing

the business and an expertise in doing so.

As an alternative to the complete transfer of all substandard risks to a

reinsurer, a primary insurer may elect to transfer only those substandard

risks that represent a particular multiple of standard mortality or morbidity.

For example, a primary insurer might want to reinsure any application for

life insurance in which the proposed insured falls into a mortality class that

is 150 percent or more than standard mortality.

At this point, it should be clear that the uses of reinsurance are far broader

than the simple risk spreading would seem to suggest. As we have seen, it is

often used to attain management objectives that have little to do with

underwriting any particular risk.

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Chapter Four

Reinsurance Agreements

Reinsurance Agreements

Since primary insurers may reinsurer their business to achieve a wide range

of objectives, it ought not to be surprising that there are various types of

agreements. We noted at the outset of this course that there are two basic

types of reinsurance agreements and that these agreements are known as:

Facultative agreements

and

Treaty agreements

Thus far, the basic types of reinsurance have been examined along with their

uses. It is time to consider the agreements under which primary insurers and

reinsurers are bound.

The Facultative Agreement

In a facultative agreement, the reinsurer has the facultyanother word for

the powerto accept or reject any risk that is brought to it by the primary

insurer. As a result of this reinsurer ability to select risks on a case-by-case

basis, the agreement must establish a procedure that the primary insurer uses

to offer risks to the reinsurer.

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The fundamental characteristic of a facultative reinsurance agreement is that

neither the reinsurer nor the primary insurer is required to offer or accept any

particular risk. Both insurers have complete freedom of action to consider

the risks on their own merits.

In a reinsurance arrangement using a facultative agreement, a primary

insurer will submit a copy of the application for the risk that it is interested

in reinsuring. In addition, it will normally include all of the supporting

documents that it has received from its agent, such as:

Attending physicians statements

A heart chart

Avocation forms

and

Financial statements

and any other material that bears on the appropriate underwriting of the

particular risk.

Additionally, the primary insurer will also submit a form to the reinsurer on

which it specifies the basis on which it is requesting reinsurance and the

amount of the risk that it proposes to retain. It is this form that is the offer

for reinsurance. As the offer, the form and its attachments supply all of the

information concerning the risk in the possession of the primary insurer and

typically requests that the reinsurer telephone, e-mail, fax or telegram

notification of its acceptance or rejection of the risk.

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Whether the risk is a property & casualty risk or a life insurance risk,

facultative reinsurance is normally used in those cases where:

The value to be insured is unusually high

or

The risk is deemed to be substantially greater than normal

The Treaty Agreement

While the facultative reinsurance agreement provides the maximum freedom

to both the primary insurer and reinsurer to undertake any particular risk, the

treaty agreement severely limits that freedom. Unlike the arrangement in a

facultative reinsurance agreement, the treaty agreementremember, it is

also known as automatic reinsurancerequires that the primary insurer

offer to reinsure every risk that falls within the provisions of the reinsurance

agreement. Furthermore, the reinsurance company must accept every risk

that is envisioned in the agreement.

The treaty agreement contains a schedule of retention limits that apply to the

primary insurer. Whenever the primary insurer issues a policy exceeding the

limits, the excess amounts must be automatically reinsured. Since the

reinsurance applies automatically, the procedure used in the facultative

agreement wouldnt make much sense. Because of its automatic application,

the primary insurer typically sends no copies of the application or supporting

documents to the reinsurer under a treaty agreement.

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The amount of reinsurance to which the reinsurer agrees to be bounda

subject covered in the treaty agreementgenerally depends upon the

reinsurers assessment of the primary insurers underwriting ability. Based

on the reinsurers level of confidence in the expertise of the primary

insurers underwriting staff and the primary insurers retention limits, it is

not uncommon for the reinsurer to agree to its automatic risk acceptance of

up to four or five times the primary insurers retention limits. For a primary

insurer with retention limits of $250,000, a reinsurer may agree to

automatically accept an additional $1.25 million in risk.

Of course, if the primary insurers retention limits are unusually high, a

reinsurer may reduce its automatic acceptance of risks so that it will only

accept risks no greater than an amount equal to the primary insurers

retention. For example, a primary insurer with a retention limit of $10

million may find it difficult to find a reinsurer that will agree to treaty

reinsurance at a level of greater than an additional $10 million.

The reinsurer under an automatic or treaty agreement must be able to rely

completely on the underwriting of the primary insurer. To be able to

confidently rely on that underwriting expertise, a reinsurer may require that

the primary insurer retain an amount of risk equal to its retention limit. If

the primary insurer seeks to remove itself from the risk by reinsuring its

portion of the liability under the risk through facultative reinsurance, the

automatic reinsurer is relieved of its obligation to accept the risk on an

automatic basis. In such a case, the entire risk is typically handled on a

facultative reinsurance basis.

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Even under treaty agreements, there are certain cases in which the reinsurer

is not required to automatically assume liability. This special handling

normally applies to jumbo cases, defined as cases in which the total

insurance amount on the proposed insureds life in all companies, including

the amount applied for, is greater than the amount recited in the reinsurance

agreement. When situations like that occur, the automatic agreement no

longer applies, and the case is handled completely on a facultative basis.

The Cession Form

The contract between the primary insurer and the reinsurer is known as the

cession form. Irrespective of whether the agreement under which a primary

insurer and reinsurer are operating is of the facultative or treaty variety, it

provides that the primary insurer must prepare a formal cession of

reinsurance. This occurs only after the primary insurers agent has delivered

the policy to the policyowner and collected the first policy premium.

The cession form, in addition to incorporating the reinsurance agreement by

reference, contains several important elements, including:

The details of the risk

A schedule of reinsurance premiums

and

A schedule of ceding commissions, if any

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A copy of the cession form is sent to the reinsurer, and a duplicate copy is

retained by the primary insurer. It will describe the reinsurance arrangement

and whether it is of the yearly renewable term insurance, coinsurance or

modified coinsurance type. It also makes provision for premium payments

from the primary insurer to the reinsurer and for ceding commissions to be

paid by the reinsurer if a coinsurance or modified coinsurance arrangement

is in force.

Reinsurance premiums paid by the primary insurer are normally on an

annual basis. Usually, the reinsurer will bill the primary insurer on a

monthly basis for the annual premium for all reinsured policies with

anniversaries on that month.

As each of the forms of reinsurance has been discussed, reference was made

to the portion of the risk for which the primary insurer is responsible and the

portion for which the reinsurer is responsible. Although that language is

sufficiently descriptive to apportion liability between the parties to the

agreement, it may be somewhat misleading.

It is important to remember that the primary insurer is responsible to the

policyowner for meeting all of the policys terms and providing all of its

benefits, irrespective of any reinsurance agreement. The reinsurance

agreement does not make the reinsurer responsible to the policyowner.

Instead, the parties to the reinsurance agreement are only the primary insurer

and the reinsurer, so that the reinsurance agreement makes the reinsurer

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liable to the primary insurer only. The policyowner is not a party to the

agreement.

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Chapter Five

Reinsurance in Operation

Claims

Insurance is generally purchased because of the policyowners need to be

assured that a payment will be made if and when a claim is presented. So,

this is a reasonable place to begin a discussion of how reinsurance works in

the primary insurers day-to-day operations.

We observed, earlier, that a policyowner is not a party to a reinsurance

agreement. Often, the policyowner isnt even aware that reinsurance is in

effect on his or her policy. Instead, the policyowner looks to the insurer that

issued the policy, i.e. the primary insurer, to pay any benefits due under it.

Because the policyowner expects claims payment from the primary insurer,

the reinsurance agreement provides that any settlement of the claim made by

the primary insurer is binding on the reinsurance company. That provision

applies irrespective of the type of reinsurance agreement in force. Even

though a primary insurer can bind its reinsurer to its claim decisions,

primary insurers often consult with reinsurers in situations involving

doubtful claims.

In settling policy claims, the reinsurer can be seen as an extension of the

primary insurer. To the extent that a claim is settled for less, the reinsurer

participates in the savings. Or, if legal costs are incurred in order to contest

a claim, the reinsurer must bear its part.

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Normally, when a policy has been reinsured, the reinsurer is legally

obligated for the life of the policy. However, there are two exceptions to the

general rule:

When the amount of coverage in force has declined

and

When the primary insurer increases its retention limits

Change in Reinsurance Amounts

The total amount of coverage in force may decline because certain coverage

has expired according to the policys terms. For example, a non-renewable,

non-convertible term insurance policy might expire because the insured

lived to the end of the specified term. Or, the policyowner may have lapsed

a policy by not paying its premiums when due.

Regardless of the cause of the decline in coverage, the amount reinsured

changes. There are generally two approaches for making the reduction in

the amount reinsured:

An off the top reduction in reinsurance

or

A pro rata reduction

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In the case of a reinsurance agreement that calls for an off the top reduction

in reinsurance, the total amount of the reduction in coverage comes solely

out of the sum reinsured, up to the total sum reinsured. For example,

suppose that the primary insurer retained $1 million of coverage in a total $5

million insurance portfolio. In an off the top arrangement, a reduction in

coverage of $500,000 would leave the retained amount unaffected but would

reduce the reinsured amount from $4 million to $3.5 million.

In a reinsurance agreement that provides for a pro rata reduction, the amount

retained and the amount reinsured would be reduced as a result of the

coverage reduction. In the example above of a $5 million insurance

portfolio that was reduced by $500,000, a reinsurance agreement calling for

a pro rata reduction would reduce the $1 million retained by $100,000 and

the $4 million reinsured by $400,000. The result would be a retention of

$900,000 and a reinsured amount of $3.6 million.

The other exception to the general rule of the reinsurer being at risk for the

duration of the coverage applies when the primary insurer increases its

retention limits. This increase in retention limits normally occurs as a

reinsurers small client insurers grow their assets and increase their

insurance in force. Often, in such a case, they will choose to increase their

retention and hold onto more of their risk exposure and their premiums.

In such a case, reinsurance agreements normally permit a recapturing of

the primary insurers reinsured business. Under the recapture provision of

many reinsurance agreements, a primary insurer that increases its retention

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8/8/2019 Rajesh 100 Marks 6t

rajesh 100 marks 6th semester

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