If you are in or around the reinsurance business,
your ears must be burning. Articles, blogs, letters to the editor, tweets, and
unsolicited commentary are replete with attacks on the reinsurance industry.
It's the greedy reinsurers that are causing insurance premiums to go up, so
they say. Reinsurers, especially offshore reinsurers, are reaping big profits
while the policyholders still have to pay large premiums for homeowners' insurance
in coastal areas even though there were no hurricanes this year, according to
these pundits. Reinsurance is being described by some as a sham.
Perhaps, in the face of this current accusatory atmosphere, we need to go
back and consider what reinsurance is and what reinsurers do.
The Nature of Reinsurance
Earlier Commentaries discussed why reinsurance
matters (March 2000) and the reinsurance
relationship (December 2000). We even commented on the effect of having
the government act as a reinsurer (June
2007), and the changing
reinsurance marketplace (August 2008). Now let's talk about what reinsurance
is and does, at least from one commentator's perspective.
Reinsurance, at its essence, is a risk transfer and risk spreading mechanism
that is consistent with and further supports the basic theory of insurance.
Insurance is about spreading of risk. Insurance works only because many policyholders
pool their risks of loss and transfer portions of those risks to an insurance
company. The insurance company, having accepted potential losses from many policyholders,
is able to charge an affordable premium to each policyholder based on the probability
that only a few of the potential losses will actually occur and have to be paid.
Thus, by pooling risks together through an insurance company, insureds are able
to insure their risks at a reasonable price, which would otherwise not be possible
if the risks of all insureds had not been pooled together through an insurance
Spreading Risk through Reinsurance
Just as policyholders spread their risks of loss by purchasing insurance
from a company that collects premiums from many policyholders, an insurance
company spreads its risk of loss—the risks it assumed from its policyholders—to
other insurance companies—reinsurers—in exchange for a share of the premium
received by the insurance company from its policyholders. In other words, the
same risks that were pooled together through the insurance company get spread
further through the distribution of those risks to many other insurance companies,
called reinsurers. The reinsurers aggregate the pooled risks assumed by many
insurance companies just like the insurance companies aggregate the pooled risks
of the policyholders.
Let's consider an example. You own a factory. There is a risk that your factory
might burn down from a fire. You purchase property insurance to protect against
that risk of a fire loss and, in essence, transfer the risk that your factory
might burn down to your insurance company in exchange for a premium. Your insurance
company writes hundreds of property insurance policies like yours and has determined
the probability that only a few of its insureds will suffer property damage
losses in any given year and at varying degrees of severity. But to protect
against the insurance company's accumulation of so much property damage and
fire risk, it purchases reinsurance, further spreading your fire damage risk
to other insurance companies. If your factory burns down and you file a claim,
your insurance company will be able to recover a portion of its payment of your
claim back from its reinsurers after it has paid your claim.
In the traditional reinsurance setting, the obligation to pay a loss suffered
by a policyholder rests and remains with the insurance company that issued the
insurance policy to the policyholder. A policyholder that suffers a loss must
notify its insurance company, not the reinsurer (which it is unlikely to know
about), and the insurance company is generally obligated to address the claim.
The reinsurance company has no direct contractual or other relationship with
the original insured and, generally, only pays the insurance company after the
insurance company has paid the underlying policyholder and has submitted a reinsurance
claim for indemnification. If, in the example, your insurance company, for whatever
reason, fails to pay your fire loss claim, generally you would have no direct
right of action against the reinsurance company because there is no contractual
privity between you as the original policyholder and the reinsurer. The contractual
relationship in the reinsurance context is only between the insurance company
and the reinsurer, and that is a separate contract of indemnity.
Reinsurance as a Financial Tool
Reinsurance is also used for other purposes, often for financial or regulatory
reasons, none of which are mutually exclusive. On the financial side, reinsurance
is often described as a transaction where the reinsurer lends its capital to
the reinsured. Insurance laws and rules generally regulate how much insurance
risk an insurance company can underwrite based on its financial condition. These
rules are in place to prevent an insurance company from becoming insolvent because
of an overextension of its business. Reinsurance can be used to mitigate this
risk by transferring (ceding) some of the liabilities on the books of the insurance
company (risks assumed under policies it wrote for its policyholders) to the
reinsurer. The obligation of the reinsurer to assume those ceded risks becomes
an asset on the financial statement of the insurance company assuming it meets
all the statutory and regulatory requirements.
For life and health insurance, reinsurance is often used much more as a financial
tool than as a device to spread risk, although it often has both features. Because
of the nature of life and health insurance and related products, a great deal
of capital must be allocated to required reserves. Reinsurance provides a mechanism
for infusing capital into an insurer by ceding blocks of life and health insurance
policies to the reinsurer in exchange for that capital.
Using Reinsurance To Protect against Catastrophic Loss
Reinsurance is also used by many insurance companies to protect against catastrophic
loss. An insurance company may have plenty of capital to pay the losses it anticipates
from the insurance policies it writes, but may be concerned about losses it
does not anticipate. Using the property insurance example again, the insurance
company that writes your factory's fire insurance policy may wish to protect
itself from a massive fire that burns down many of its insureds' properties
in a concentrated factory district. In the homeowners' situation, insurance
companies that write property insurance on the coast are always concerned about
the losses they will sustain in the event of a serious hurricane that destroys
hundreds or thousands of homes.
Various types of reinsurance are available to protect an insurance company
for these catastrophic losses. Insurance companies may buy excess-of-loss reinsurance,
which is reinsurance that responds when a specific loss exceeds a certain dollar
figure. Insurance companies also may purchase aggregate excess-of-loss reinsurance,
which is reinsurance that responds based on the aggregate losses paid by an
insurance company within a period of time. Property catastrophe reinsurance
is what companies purchase to protect themselves against large losses arising
out of a large event like a hurricane. This type of reinsurance may respond
based on the aggregated loss payments made by the specific insurer arising from
one storm or based on the total value of all losses suffered industry wide for
Reinsurance and Premiums
Insurance companies that use reinsurance to spread their risk of loss or
to protect themselves from catastrophic risk will factor the cost of reinsurance
into the premiums charged to their policyholders. If the cost of reinsurance
goes up, the premiums charged to policyholders likely will go up also. But the
cost of reinsurance is only one of many factors that affect the cost of insurance,
which also includes interest rates, taxes and fees, the cost of running the
insurance operation, and the cost of acquiring the policyholders' business.
Determining the price a reinsurer will charge is a complicated exercise often
based on actuarial models. Typically, insurance and reinsurance companies look
to past experience to predict the cost of future losses so that a proper premium
can be determined. Those predictions are never perfect, but over the long term,
should follow the ultimate loss costs reasonably well.
Predicting future losses in property catastrophe reinsurance for coastal
homeowners insurance is very difficult. We have now seen a few years with very
few hurricanes. This followed a few years with some of the most catastrophic
storms in history. The probabilities are that hurricanes will strike again,
and insurance and reinsurance companies are trying to match premiums to reflect
Life without Reinsurance
So what happens if we cut out the reinsurers and save on that cost? Certainly,
extremely well-capitalized direct writers of insurance may not need to purchase
traditional reinsurance. These companies may only purchase catastrophe reinsurance
or go into the capital markets and obtain other catastrophe loss protection
like cat bonds or loss warranties. But the reality is that most insurers have
reinsurance programs because reinsurance is a significant tool used by insurers
to manage their business and their overall risk exposure.
Without reinsurance, an insurance company will have to shoulder all the risks
of loss it has assumed from all of its policyholders. Unlike its policyholders,
it will not have the advantage of spreading its risk of loss to other companies
and policyholders. Should it accumulate too much business in a particular geographic
location or in a particular line of insurance, it may find that its capital
will be severely strained. By using reinsurance, accumulation risk, catastrophic
risk, and overall risk are lessened.
Moreover, most insurance companies are not large mega-companies. There are
literally thousands of small, regional insurers that are crucial to the existence
and well-being of local businesses and coastal communities. These smaller companies
necessarily rely more on reinsurance to spread their risk of loss and to avoid
accumulation and catastrophic exposures. These companies also often rely on
the underwriting and claims expertise of their reinsurers to improve their products
and better serve their insureds. Without strong reinsurance relationships, these
smaller and regional insurers likely would not exist.
While reinsurance bashing has seemingly taken over for insurance bashing,
it is important to put in perspective the reasons why reinsurance exists and
the importance of reinsurance to the economy. Reinsurance is the backbone of
insurance because it enables risks of loss to be spread more widely across companies
and borders. Without the spreading of risks of loss through reinsurance, policyholders
would find it even more difficult to obtain affordable insurance.