Selecting Insurance exists to meet a widespread need for protection against potential financial losses. It works by pooling many similar individual risks into categories. However, sometimes the potential loss is too large for a single entity to cover, even if the likelihood of the event is well understood. For instance, one insurance company might not be able to handle catastrophic risks, such as epidemics or war damage, because such events could affect a vast number of policyholders simultaneously.
Reinsurance is, in simple terms, the process of transferring liability from the primary insurer—the company that issued the policy—to another company, the reinsurer. The insurance business that is transferred is called a cession, essentially the insurance of an insurance company. The reinsurer may also transfer part of this risk to yet another reinsurer, called a retrocession, and the company assuming this secondary risk is the retrocessionaire.
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Reinsurance agreements occur between Selecting Insurance(or reinsurance) companies, whereas insurance contracts exist between insurers and individuals or non-insurance organizations. Therefore, a reinsurance contract deals solely with the original insured risk, and the reinsurer is accountable only to the ceding company. Policyholders have no direct claim against the reinsurer, even though they are often the ultimate beneficiaries of the arrangement.
What Is the Role of Reinsurance?
No single Selecting Insurance company can provide unlimited coverage for all contracts in any line of business. Likewise, insurers have limits on the maximum risk they can safely assume. When a risk is too large for one insurer, it can be shared across multiple companies through a process called coinsurance.
Reciprocity refers to a mutual cession arrangement between two primary insurers, where each exchanges a portion of its business with the other to maintain similar premium volumes while spreading risk more widely.
Reinsurance, however, is usually a more cost-effective and efficient method to distribute risk among several companies. Insurers also buy reinsurance for reasons including financial support, capacity expansion, smoothing loss fluctuations, catastrophe protection, and assistance in underwriting.
Financing
An insurer’s limit on premium volume is tied to its surplus. Since collected premiums are initially considered unearned, companies must hold an unearned premium reserve. Reinsurance allows insurers to boost their surplus by reducing this reserve, which is especially helpful for new or expanding insurers or established companies entering new underwriting areas.
Capacity
In insurance terms, capacity is a company’s ability to provide coverage for large individual risks or a large number of contracts within a particular line. Reinsurance helps companies underwrite risks that exceed their capital or that their management deems too risky.
Stabilizing Loss Experience
Like any business, insurers prefer stable year-to-year results. Underwriting losses can vary significantly due to economic, environmental, or diversification issues. Reinsurance allows companies to reduce these fluctuations. It is sometimes likened to a banking system where insurers “borrow” from the reinsurer in poor years and repay during profitable ones.
Catastrophe Protection
Catastrophic events, such as natural disasters or industrial accidents, can severely impact an insurer’s expected losses. Reinsurance helps protect the company from financial ruin in these situations.
Underwriting Assistance
Reinsurers gather extensive data and experience in risk assessment, rating, and claims management. This knowledge can be invaluable to insurers entering new markets, offering new products, or discontinuing certain lines or regions.
Traditional Reinsurance Methods
Reinsurance contracts are typically divided into facultative and treaty arrangements.
Facultative Reinsurance involves negotiating coverage for individual policies. It is useful for very large risks or unusual exposures, especially when the primary insurer lacks experience with the risk. While expensive and limited to few policies, it provides underwriting guidance to the ceding insurer.
Treaty Reinsurance is a pre-agreed arrangement covering a class of business under specified terms. This method offers a more stable, long-term relationship between insurer and reinsurer. The reinsurer accepts all risks within the treaty without individually reviewing each policy. Treaty reinsurance is cheaper, easier to administer, and preferred when dealing with a single line of business. Adverse selection is less of a concern in long-term treaties.
Reinsurance contracts can also be classified as proportional (pro-rata) or non-proportional (excess).
Proportional Reinsurance: The insurer cedes a fixed portion of every policy to the reinsurer, who then receives a corresponding share of premiums and pays the same percentage of claims. Quota-share contracts for Selecting Insurance are common here, particularly in property and liability insurance. They are easy to manage and reduce unearned premium reserves for smaller insurers or reciprocal arrangements between companies.
Non-proportional Reinsurance: Coverage is provided for risks exceeding a certain threshold (risk excess), catastrophic events (catastrophe excess), or aggregate losses (stop-loss).
Surplus-share contracts, like quota-share agreements, are a type of proportional reinsurance. The key difference lies for Selecting Insurance in how the retention is specified. In a surplus-share contract, retention is expressed as a monetary amount rather than a fixed percentage. Consequently, in a surplus treaty, the ceded portion varies depending on the size of the insured exposure and the limit the reinsurer sets on the maximum risk it will assume.
This reinsurance limit is commonly described as an “n-line surplus treaty,” indicating that the reinsurer will cover up to n times the retention amount. The surplus risk may be divided among multiple reinsurers. For instance, consider a surplus-share treaty with a retention of 50,000 monetary units for Selecting Insurance and a reinsurance limit of 500,000—this would be termed a “10-line surplus treaty.”
| Size of Loss Exposure | Cedent’s Retention | Surplus Cession (%) |
| 50,000 or less | 50,000 | 0 |
| 80,000 | 50,000 | 30,000 (37.5%) |
| 160,000 | 50,000 | 110,000 (68.7%) |
| 400,000 | 50,000 | 350,000 (87.5%) |
The reinsurer pays losses in proportion to the share of premiums it receives. Surplus treaties are particularly suited for large commercial or industrial risks, providing higher line capacity than quota-share contracts. They also allow the primary insurer to retain smaller, manageable risks. However, they do not offer unearned premium relief for Selecting Insurance, which small insurers might require.
In surplus contracts, only the portion of risk above the insurer’s retention is reinsured, resulting in a more uniform portfolio. The primary insurer keeps more profitable policies, while the reinsurer assumes a larger share of higher-risk exposures. Commissions to the ceding company are lower than in quota-share treaties, and administrative costs are higher.
Excess-Loss Contracts
Excess-loss (XL) contracts differ from proportional arrangements because the cedent and reinsurer do not share premiums and losses in the same ratio. No part of the insurance coverage is ceded. The reinsurer only pays when losses exceed an agreed retention level. Typically, the cedent pays a premium based on the risk assumed by the reinsurer, without commissions. This is known as the burning-cost system, where the premium is calculated by dividing total losses above the retention point by premiums for the same period for Selecting Insurance. A deposit premium is paid initially, and the final premium is adjusted at the end of the year.
Per-Risk Excess Contracts
In per-risk contracts, retention is expressed as a specific monetary amount per loss. The reinsurer covers losses exceeding this deductible, often up to a defined limit—for example, $200,000 in excess of $50,000. Multiple layers of excess-loss treaties can be applied sequentially, as long as they do not overlap as Selecting Insurance.
$200,000 in excess of $50,000
$500,000 in excess of $200,000
$1,000,000 in excess of $500,000
Loss payments would be distributed as follows:
| Loss Amount | Cedent Retention | First Layer | Second Layer | Third Layer |
| 50,000 | 50,000 | 0 | 0 | 0 |
| 100,000 | 50,000 | 50,000 | 0 | 0 |
| 300,000 | 50,000 | 200,000 | 50,000 | 0 |
| 900,000 | 50,000 | 200,000 | 500,000 | 150,000 |
Per-risk excess treaties are effective for providing large line capacity and stabilizing loss experience. They may even temporarily improve results for unprofitable lines, but reinsurers may increase future premiums or refuse renewal. In health insurance, per-risk coverage can apply to expensive treatments, though defining a claim is challenging due to ongoing conditions. Coverage is often measured on a calendar-year basis.
Per-Occurrence Excess Contracts
Property insurers face the risk of multiple claims from a single event, such as a hurricane or earthquake. Individual claims may be small, but their total can threaten the company. Per-occurrence contracts, or catastrophe treaties, protect against such accumulation. Like per-risk contracts, the insurer’s retention is specified in monetary terms, but all losses from one event are summed to determine the reinsurer’s liability. Defining a single occurrence is critical but complex in health insurance. Per-occurrence treaties are often combined with per-risk contracts to protect the insurer’s retention capacity.
Aggregate-Excess or Stop-Loss Contracts
Aggregate-excess treaties activate once the cedent’s losses during a defined period (usually a year) exceed a pre-set retention. Retention can be expressed as a monetary amount, a loss ratio percentage, or both. Aggregate-excess contracts are highly effective in stabilizing underwriting results by capping the cedent’s losses or loss ratio. However, limits are never set so high that the cedent is guaranteed a profit; otherwise, the insurer could take excessive risks without financial consequence, creating a high risk of adverse selection for the reinsurer.
Contracts often include a coinsurance factor. For example, in health insurance, the loss ratio—losses over earned premiums—might be calculated using the company’s experience over the previous five years.
Assuming that a loss ratio of 81 percent results in a break-even underwriting outcome for a line of business (after deducting operating expenses), a stop-loss treaty might be structured as follows: “The reinsurer will cover 90 percent of the amount by which the ceding company’s loss ratio exceeds 81 percent, with the total recoverable amount capped at $1,000,000.”
Because the balance between premiums collected and claims paid is often unfavorable for the reinsurer, stop-loss coverage is frequently combined with a quota-share treaty and sometimes with excess-loss protection for specific risks.
What Is Nontraditional (Financial) Reinsurance?
Rather than relying solely on traditional methods of taking on and financing individual risks, reinsurers have developed financial products that combine aspects of reinsurance, insurance, and capital markets. These solutions, known as alternative risk transfer (ART) products, provide more comprehensive, longer-term coverage, with the primary aim of protecting the overall financial resources of a company (balance-sheet protection) rather than just covering individual events.
Types of Contracts
A reinsurance agreement can be prospective, retroactive, or a combination of both.
- In a prospective contract, the ceding company pays a premium to the reinsurer in exchange for coverage against losses or liabilities arising from events occurring after the contract’s start date.
- In a retroactive contract, the ceding company pays the reinsurer to cover losses or liabilities from events that have already occurred. This approach is called loss-portfolio transfer and has gained popularity.
By definition, insurance risk involves uncertainty regarding the total amount of claims (underwriting risk) and the timing of those claims (timing risk). A reinsurance contract transfers some or all of this risk from the ceding company to the reinsurer. Contracts that do not transfer underwriting risk are typically considered financial arrangements or financial reinsurance.
Historically, financial reinsurance focused on retrospective coverage for past losses and catastrophes. Today, the emphasis is on prospective products, which blend banking and reinsurance features. Key characteristics include limited risk assumed by the reinsurer, multi-line and multi-year coverage, profit-sharing with the ceding company, and the inclusion of anticipated investment income in pricing.
ART solutions are designed to help insurers with long-term planning and to balance cash flow and resources. Coverage is usually limited across the treaty’s multi-year term, with timing risk (when payments are made) being more significant than the actual transfer of risk.
Finite-Risk Reinsurance
Finite-risk reinsurance (FR), a type of financial reinsurance, protects the primary insurer from the volatility of underwriting results over the contract period. It combines risk transfer with profit-sharing between reinsurer and client.
Finite-risk arrangements involve limited risk transfer, since the client essentially funds most of the losses through premiums and investment income. The reinsurer’s primary exposure is timing risk—the possibility of paying claims sooner than expected. Multi-year contracts allow the reinsurer to use the time value of money and spread losses over several years. Essentially, the client exchanges current underwriting income for future investment returns.
Under finite-risk contracts, insurers receive a substantial portion of profits accrued over multiple years. Coverage is generally broad, without the extensive exclusions found in traditional policies. Popular forms of ART in this category include finite quota-share treaties, which cover both current and future underwriting years, and spread-loss treaties, which manage financial risks associated with the timing of claim payments.
Prospective aggregate stop-loss contracts are increasingly used as a type of finite-risk reinsurance to protect against low-probability, high-severity events. For potential catastrophes, part of the excess-loss risk is retained by the reinsurer, while the remainder is transferred to the capital markets through securitization via event-linked bonds or derivatives. Capital market participants are attracted to these insurance risks because they are uncorrelated with traditional stock and bond market movements.