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The Theory of Reinsurance

Larry Schiffer | December 13, 2022

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I have been writing about various aspects of reinsurance in Expert Commentary since 2000, but I have not discussed the theory of reinsurance and why reinsurance is essential to the economy. Well, that time has come.

This commentary will take us back to the purpose and need for reinsurance. 1

What Is Reinsurance?

Many courts and commentators have weighed in on what they believe reinsurance is and how it works. Simply put, reinsurance is merely an extension of the basic theory of insurance: the spreading of risk between multiple insureds to an insurance company. In reinsurance, however, the risk of loss is spread from a single policy-issuing insurance company to other insurance companies. These other insurance companies—reinsurance companies—assume all or, more usually, a portion of the risk from the original insurance company.

Some call reinsurance the insurance of one insurer by another. Others have said reinsurance is like a bookie laying off a bet by having other bookies share some of its exposure. There are elements of truth to both. First, in traditional reinsurance, a reinsurer assumes risk from a ceding insurer and provides the ceding insurer with protection from the risk assumed. Second, the reinsurer is assuming risk where the ultimate loss costs are essentially unknown.

In a sense, the reinsurer is betting that the risk assumed will turn out to be within its estimate of ultimate loss costs, while the ceding insurer is betting that its policies will generate claims as expected. The ceding insurer, having hedged its bet by purchasing reinsurance, nevertheless has the comfort of knowing that if the loss costs rise beyond the estimates, the reinsurer still must indemnify the ceding insurer up to whatever limits the reinsurance contract provides. But don't worry about the reinsurer: the reinsurer will often hedge its bet by ceding a portion of its assumed risk to other reinsurers through a transaction known as retrocessional reinsurance.

Reinsurance, however, is not really insurance of another insurance company because reinsurance is a contract of indemnity, not of liability. The reinsurer assumes a portion of the risk taken on by the ceding insurer and, in most cases, only indemnifies the ceding insurer after the ceding insurer pays an underlying claim and submits a reinsurance billing with proper proof of loss.

What Is the Nature of Reinsurance?

When an insurance company wants to mitigate some of the risk it has assumed under policies of insurance that it issues to its policyholders, it transfers or "cedes" all or a portion of that risk to one or more reinsurers. That risk transfer is accomplished through a reinsurance contract. In exchange for assuming a portion of the risk, the reinsurer receives a portion of the premium obtained by the ceding insurer on the underlying insurance policy.

There are some basic differences between primary insurance and reinsurance. Reinsurance is a contract of indemnity between the ceding insurer and the reinsurer, not one of liability. Ordinarily, a reinsurer is not required to indemnify a ceding insurer for a loss until the underlying claim is actually paid by the ceding insurer and usually after a reinsurance billing with sufficient proof of the loss and payment is submitted. However, depending on the terms of the reinsurance contract, a ceding insurer may have a right of payment from the reinsurer for a loss, even if the ceding insurer has not yet paid the loss on the underlying claim.

The reinsurer's obligation to indemnify runs directly and solely to the ceding insurer. There is no privity between the reinsurer and the policyholder, and, absent a specific provision to the contrary, the reinsurer has no obligation to the policyholder. In general, the reinsurer is not responsible for providing a defense of the underlying claim, investigating the claim, or attempting to control the claim to obtain an early settlement. Instead, the burden typically falls solely on the ceding insurer.

The beauty of reinsurance is that it is flexible and contract-wording dependent. There is no standard reinsurance contract. Each reinsurance contract stands on its own, and its specific terms and conditions must be examined carefully. Assumptions about reinsurance contracts often do not work because contract clauses may be tweaked or changed radically depending on bargaining power, the state of the reinsurance market, and the relationship between the ceding insurer and reinsurer.

The Purpose of Reinsurance

Reinsurance has many purposes and uses, which are far too many to discuss here. Reinsurance is constantly being reinvented by clever underwriters. But there are some basic and longstanding purposes. One purpose is to permit the ceding insurer to mitigate its risk by minimizing its exposure. This is accomplished by traditional reinsurance, where the ceding insurer cedes a large portion of its reinsured portfolio to the reinsurance market.

For example, a ceding insurer may purchase a whole account quota share reinsurance contract that cedes 75 percent of its premium and losses on all its policies written on all lines of business in a given year to its reinsurers. In this reinsurance transaction, the ceding insurer and the reinsurers share premiums and losses proportionally with the ceding insurer, which only retains 25 percent of its total business. This transaction essentially moves 75 percent of its losses off the ceding insurer's balance sheet.

Another purpose is to allow a ceding insurer to reduce the amount of the legally required reserves held for the protection of policyholders and to increase its ability to underwrite other policies or make other investments. This aspect is somewhat technical from a regulatory and accounting perspective, but, simply put, the reinsurance contract is considered an asset on the ceding insurer's financial statement, which lowers the amount of reserves it is required to keep and allows it to underwrite more policies than it otherwise could.

A ceding insurer may use reinsurance to protect itself from catastrophic losses, individual losses, losses by certain policyholders or specific lines of insurance, or financial downturns in the economy. This goes to the flexibility of reinsurance; reinsurance may be used to protect against losses over a certain threshold for a portfolio of business (or attachment point—much like excess insurance) or may be used to protect against the risk of loss from one policy or one underlying insured.

Reinsurance may also help with insurance placement. An insurer that is not licensed to issue policies in a state may arrange with an insurer licensed in that state to issue policies on its behalf. The unlicensed insurer will then assume 100 percent of the policies written by the licensed insurer, creating what is known as a fronting arrangement. Fronting is also used when the credit rating of one insurer is not acceptable to the policyholder. Having the lower-rated insurer reinsure 100 percent of the underlying policy issued by the higher-rated insurance company creates the fronting relationship.

Policyholders can also use reinsurance to reduce their insurance costs through the creation of a "captive" insurer owned by the policyholder. A captive insurer typically reinsures 100 percent of the policy liability or may keep a modest retention depending on the policyholder's risk appetite.

How Reinsurance Affects the Economy

The effect of reinsurance on the economy is best understood through an example: A company owns a business that has various risks of loss. It wants to buy insurance to protect against losses that might arise out of the operations of the business. So, it buys a comprehensive package policy covering property, liability, and auto risks. The insurance company that issues the insurance policy has now assumed a portion of that company's risk of loss from multiple perils. That insurance company also insures hundreds, if not thousands, of similar companies under similar package policies. That's a lot of risk being assumed by that insurance company.

The insurance company turns around and buys reinsurance to help reduce its risk of loss from the risks it has assumed under its policies issued to its policyholders. That allows the insurance company to stay economically viable while at the same time allowing each of its policyholders to conduct their businesses. This is because they have mitigated their risk of loss through their business operations by purchasing insurance at a reasonable price.

This scenario repeats itself millions of times a day as businesses, schools, municipalities, and individuals can take risks and run their operations and lives because they have insurance. Insurance companies can provide that insurance protection because they are supported by the reinsurance market, which assumes portions of the ceding insurers' risks and spreads those risks further through the reinsurance market. And reinsurers can enter into reinsurance contracts with ceding insurers because they, in turn, cede portions of their assumed risks to other reinsurers, known as retrocessionaires, through retrocessional reinsurance. Thus, the risks assumed from businesses and individuals are often spread across multiple insurance and reinsurance companies, often across the globe.

Insurance enables businesses of all kinds to open their doors and thrive. Most businesses cannot lease a building or take out a loan if they do not have insurance. No business with trucks or cars can function without insurance. No companies that transport oil, natural gas, or other necessary chemicals can do so without insurance. And very little of that necessary insurance can be written without reinsurance behind the insurance policies to help spread the risk.

It has been said that insurance also spurs innovation. Many risky projects and businesses would not exist without insurance behind the scenes. And, without reinsurance, the insurance that supports innovation would likely not exist.

For example, satellite and space launches would not exist without insurance. Without reinsurance, the primary and excess insurers that support innovations like space flight would not be able to insure those launches. That takes us back to the beginning, which is that the theory of insurance is the spreading of risk throughout society. Reinsurance makes that risk spreading a reality by assuming pools of risk and spreading that risk of loss further, thereby diluting the risk and making insurance premiums affordable.

Conclusion

Reinsurance plays an essential role in the insurance marketplace and, more importantly, in the global economy. Without reinsurance, insurance companies would not be able to provide the level of insurance necessary for the operation, innovation, and expansion of businesses around the world.


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.


Footnotes

1 Some of the materials in this Expert Commentary are derived from my chapter on reinsurance found in Insurance Law Practice (Third Edition), Chapter 15, published by the New York State Bar Association and edited by my former colleague John Nonna. Look for the Fourth Edition in 2023.