MGAs and Reinsurance: What Every Prudent Agent Needs To Know

July 2002

In today's market, it is critical that those involved in the independent wholesale distribution segment of the industry understand the role of reinsurance. New AAMGA President Robert Giles explains.

by Robert S. Giles, CIW
American Association of Managing General Agents

The effect of September 11 on the reinsurance industry has been the focus of attention virtually since September 12. Suddenly, there is strong interest in some of the previously little known and perhaps misunderstood ramifications of reinsurance from all quarters of the insurance industry.

All things considered, reinsurance isn't that old. While forms of insurance and reinsurance can be found throughout recorded history, the first American reinsurance company, First Reinsurance Co. of Hartford, began operation in 1912. Eighty years later, reinsurance is written and used throughout the world to cover virtually every kind of basic insurance, including marine, aviation, auto, property, casualty, workers compensation, warranty, surety, fidelity, credit, and many, many others.

At its heart, reinsurance provides indemnification and reimbursement for payments already made. Because it is a keystone element of any insuring organization's strategy to minimize risk and maximize value, reinsurance is important to every level of insurance distribution.

In today's hard market environment, where prudence is the watchword, it is critical that those in the independent wholesale distribution segment of the industry, and those who do business with independent wholesalers, understand the role of reinsurance. Even for agents and others who do not deal with reinsurers on a daily basis, it is critical to understand the function of reinsurance and the role of any coverage or program in which reinsurance is involved.

In the wake of September 11 and with the continuation of a market that was hardening even before then, it is useful to understand the relationship between reinsurance and a cedent -- the term that describes a company or other entity, including a managing general agency, that transfers risk to a reinsurer. Such understanding can serve as a guide to the kinds of issues to consider, and the kinds of questions to ask, when placing coverage.

Functions of Reinsurance

Reinsurance has four main functions:

Like insurance at the wholesale and retail level, reinsurance can be placed through the broker market or by direct writers.

Forms of Reinsurance

Two forms of reinsurance include pro rata and excess of loss. With pro rata reinsurance, the level of a reinsurers' participation is predetermined. There is proportional sharing of the premium and losses and first-dollar recovery. The rate is a proportional share of the premium, less the ceding commission. Portfolio capacity is provided and adjustment expenses are shared accordingly. Under the quota share version of pro rata reinsurance, the reinsurer's percent of participation is the same for each risk assumed. Under surplus share, the reinsurer's percent of participation varies by size of risk.

With excess-of-loss reinsurance, the reinsurers' participation depends on size of loss and/or time element. There is a nonproportional sharing of premium and losses and recovery excess retention. The rate is negotiated based on expected exposure. It provides per-risk capacity and stability. Adjustment expenses are shared by formula.

When using per-risk excess-of-loss reinsurance, a limit applies to each risk, regardless of how many risks are involved in a single occurrence. If calculated per occurrence, the limit applies to all losses that arise out of one event or occurrence. When using aggregate excess-of-loss reinsurance, the reinsurer participates over an aggregate limit for a specified period of time.

MGAs and Reinsurers

Managing general agents are well known for their ability to provide retailers a broader range of coverage options for their customers, as well as issuing coverage themselves. They frequently offer coverage options that can't be found elsewhere, such as for the taste buds of the Edy's chief ice cream tester or a retail customer's antique car collection.

Accordingly, MGAs work both indirectly and directly with reinsurers. Indirectly, they will be concerned about the reinsurance held by a market for which they place coverage, particularly for specialty or excess and surplus lines coverage.

But MGAs also work directly with reinsurers in developing programs. This may take many forms. An MGA may have a program with a market that is exiting the business and is looking for a way to continue writing that program. In these cases, the MGA will try to find a company to write the program. It is sometimes easier to do this if the MGA has reinsurance support for the program already in place. Often, reinsurers and reinsurance brokers will help the MGA find an issuing company to be the insurer for the program.

Another example is if the MGA recognizes a niche in the marketplace where there are few or no insurers interested in writing a specific line of business. The MGA in those cases will structure a reinsurance program where it is possible to generate an underwriting profit. Then the MGA will sell the program to potential issuing companies.

In still other cases, some insurance companies do not have the capacity to offer the limits needed for a particular risk. Here, the MGA would try to place facultative reinsurance on the portion of the risk that the insurance company is not willing to write.

Reinsurance in the Cedent Business Plan

Reinsurance is an integral part of an insurance company's or wholesaler's strategy to effectively manage the business. The company must first analyze its operating philosophy and business objectives, determine its level of growth and profitability, and consider its direction and other major goals. It must assess its book of business and its financial position.

A reinsurance program can have a number of different effects. Any of these effects, or outcomes, may influence the effectiveness of the program for the ultimate customer. Accordingly, cedents and reinsurers are partners who should act in good faith and who should expect the same from the other party so that the chance of any negative effects is minimized.

For example, among many other roles, reinsurance can remove unearned premium from the balance sheet by removing risk. It can improve ratios (decrease net premium written, decrease unearned premium, "increase" policyholders' surplus), allowing the company to write more business and grow its market share. Ceding commissions from ceded premium come back to the company and are immediately recorded as income.

What the Retailer Should Look for

Retail agents working with MGAs should look closely at the issuing company paper. In most cases, a strong insurance company will only accept reinsurance from an A.M. Best's rated A XII company. Many companies that "sell" or "front" their paper have reinsurance placed by the program manager or the MGA. The ability of these companies to pay claims is directly tied to the quality of the reinsurance behind the program. There have been a number of these companies that have not survived in the recent past largely due to uncollectable reinsurance.

The MGA must perform due diligence if he is doing business with a new market. What is the issuing company's Best or Standard & Poor's rating? How much reinsurance does the company purchase and what is the quality of that reinsurance? This information can easily be found in the insurance company's annual report statement.

What a Cedent Is Looking for

Choosing the right reinsurer is critical to the success of a cedent's relationship with that reinsurer. Retail agents, risk managers and others can benefit from being aware of what their markets and their MGAs look for when selecting a reinsurer.

Many of the principles are the same as those in selecting any market. Avoid companies that will not be around to pay your claims. Don't use companies that will not support you. Stay away from companies that are difficult to deal with or are not responsive to your needs. Forget about companies that will not honor their obligations to you.

Cedents will look first for financial stability and continuity of operations. The reinsurer should have a record of long-term relationships and a willingness to remain on program, even following a period of poor financial results

The right reinsurer will offer flexibility. It will have an open mind toward new approaches, an ability to create custom or tailor-made products, expertise and imagination in solving problems, and an overall program that meets specific needs with the least amount of effort and expense.

The right reinsurer will provide the desired level of service, while offering adequate staff to provide prompt payment of losses and expertise in loss evaluation and claims handling. It will maintain a confidential relationship, both in terms of business plans and marketing strategy, as well as problems that relate to loss, extra contractual obligation or bad faith.

The Reinsurer's Needs

Likewise, the reinsurer has high expectations of a ceding company, and by extension others involved in the distribution chain. Reinsurers expect timely reporting and payments regarding premiums, claims, and losses. Information must be accurate and complete and reported in a clear, consistent, and professional manner.

Cedents should provide thorough summaries that include loss details and relevant facts as well as coverage level, name of claimant, liability, and damages. Their management of cases should represent the company's best thinking. They should show an action plan to conclude each case. Reinsurers will favor cedents who demonstrate an attempt to protect reinsurer interests, as well as the interests of others, so that a fair and judicious resolution is reached.

Minor disputes between cedents and reinsurers may involve individual claims or contracts, intent or notice issues, and negotiation or arbitration. Major disputes typically involve whole books of business, disagreement over management of fiduciary responsibility, and accountability and litigation. The stakes, of course, can be very high. Serious attention to the details is a must so that steps to resolution are clear and so that disputes can be minimized, or avoided entirely.

The Bottom Line

Last but not least, never forget that developments in the reinsurance marketplace are important at every level because in many cases, reinsurance pricing drives the market pricing. On the surface, there may be no apparent connection between a terrorist attack on New York skyscrapers and the important insurance needs of a small business in a rural area elsewhere in the country. In fact, the events of September 11 at least indirectly affect virtually every insurance policy in the nation.

Over the past several years, reinsurance companies have shown very poor results, somewhere in the 140 percent combined ratio range. No one can afford to lose 40 cents on the dollar. As a result, a number of reinsurers have exited the marketplace, putting pressure on those remaining to fill the gap.

Remaining companies have increased prices substantially and decreased commissions in an attempt to generate an underwriting profit. Those price increases are passed onto the issuing companies who in turn pass on these restrictive terms to their insureds.

Knowing what is happening in the reinsurance market can help a retail agent prepare his insureds for what his insurance terms will be in the future. Understanding the reinsurance market can help risk managers prepare their executives for the realities of insurance costs now and for the foreseeable future.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.