Risk Management and Insurance Department of Management

CHAPTER SEVEN
REINSURANCE

7.1. Meaning of Reinsurance

Reinsurance is the shifting of part or all of the insurance originally written by one insurer to
another insurer. The insurer initially writes the business is called the ceding company. The
insurer that accepts part or all of the insurance from the ceding company is called the reinsurer.
The amount of insurance retained by the ceding company for its own account is called the net
retention or retention limit. The amount of the insurance ceded to the reinsurer is known as the
cession. Finally, the reinsurer in turn may obtain reinsurance from another insurer. The process
by which a reinsurer passes on risks to another reinsurer is known as retrocession.

7.2. Reasons for Reinsurance

One may wonder why an insurer that has gone to all the expenses and difficulty of security
business would voluntarily transfer some of it to third party. There are several reasons for this,
the main one being that the primary insurer is often asked to assume liability for loss in excess of
the amount that its financial capacity would permit. Instead of accepting only a portion of the
risk and thus causing inconvenience and even ill will of its customer, the company accepts all the
risk, knowing that it can pass on to the re-insurer the part that it does not care to bear. The
policyholder is thus shared the necessity of negotiating with many companies and can place
insurance with little delay. Using a single insurer with a single premium also simplifies insurance
management procedures. The policy coverage is not only more uniform and easier to
comprehend, but the added guaranty of re-insurer also makes it much safer.

Reinsurance had a very simple beginning. When a risk that was too large for the company to
handle safely was presented to an insurer, it began to shop around from another insurance
company that was willing to take a portion of the risk in return for a portion of the premium. A
few current reinsurance operations are still conducted in this manner, but the ever-present danger
that a devastating loss might occur before the reinsurance become effective led to the
development of modern reinsurance treaties.

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Risk Management and Insurance Department of Management

Reinsurance is also used to allow for a reduction in the level of unearned premium reserve
requirements. For new, small companies especially, one of the limiting factors in the rate growth
is the legal requirement that the company set aside premiums received as unearned premium
reserves for policyholders. Since no allowance is made in these requirements for expenses
incurred, the insurer must pay for producers’ commissions and for other expenses out of surplus.
As the premiums are earned over the life of the policy these amounts are restored to surplus.
Finally, reinsurance may be used to retire from business or to terminate the underwriting on a
given type of insurance. If a firm wishes to liquidate its business, it could conceivably cancel all
its policies that are subject to cancellation and return the unearned premiums to the
policyholders. However, this would be quite unusual in actual practice because of the necessity
of sacrificing the profit that would normally be earned on such business. It would probably be
impossible to recover in full the amount of expense that had been incurred in putting the business
on the books.

7.3. Types of Reinsurance Agreements

Organizations for reinsurance are found in many forms. It ranges from individual contractual
arrangements with re-insurers to pools whereby a number of primary insurers agree to accept
certain types of insurance on some pre-arranged basis.
1. Facultative Reinsurance: - is an optional, case-by-case method that is used when the
ceding company receives an application from insurance that exceeds its retention limit.
Before the policy is issued, the primary insurer shops around for reinsurance and contacts
several reinsurers. A life insurer, for example, may receive an application for birr 1 million
of life insurance on a single life. Not wishing to reject this business but still unwilling to
accept the entire risk, the primary insurer communicates full details on this application to
another insurer with whom it has done business in the past. The other insurer may agree to
assume 40 percent of any loss for a corresponding percentage of the premium. The primary
insurer is under no obligation to cede insurance, and the reinsurer is under no obligation to
accept the insurance. But if a willing reinsurer can be found, the primary insurer and
reinsurer can then enter into a valid contract.

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Risk Management and Insurance Department of Management

Facultative reinsurance is frequently used when a large amount of insurance is desired.

Before the application is accepted, the primary insurer determines if reinsurance can be
obtained. If available, the policy can then be written.

Facultative reinsurance has the advantage of flexibility, since a reinsurance contract can be
arranged to fit any kind of case. It can increase the insurer’s capacity to write large amounts
of insurance. The reinsurance tends to stabilize the insurer’s operations by shifting large
losses to the reinsurer.

The major disadvantage of facultative reinsurance is that it is uncertain. The ceding

reinsurer does not know in advance if a reinsurer will accept any part of the insurance.
There is also a further disadvantage of delay, since the policy will not be issued until
reinsurance is obtained.

2. Treaty Reinsurance:- it is also called automatic treaty means the primary insurer has
agreed to cede insurance to the reinsurer, and the reinsurer has agreed to accept the
business. All business that falls within the scope of the agreement is automatically
reinsured according to the terms of the treaty. Under automatic treaty reinsurance the
ceding insurer agrees to pass on to the reinsurer all business included within the scope of
the treaty, the reinsurer agrees to accept this business, and the terms-e.g., the premium
rates and the method of sharing the insurance and the losses-of the agreement.

Treaty reinsurance has several advantages to the primary insurer. It is automatic, and no
uncertainty or delay is involved. It is also economical, since it is not necessary to shop
around for reinsurance before the policy is written.

Treaty reinsurance could be unprofitable to the reinsurer. The reinsurer generally has no
knowledge about the individual applicant and must rely on the underwriting judgment of
the primary insurer. The primary insurer may write bad business and then reinsure it.
Also, the premium received by the reinsurer may be inadequate. Thus, if the primary
insurer has a poor selection of risks or charges inadequate. Thus, if the primary insurer
has a poor selection of risks or charges inadequate rates, the reinsurer could incur a loss.

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There are several types of reinsurance treaties and arrangements, including the
following:
 Quota-share treaty
Under this treaty, the ceding insurer and reinsurer agree to share premium and losses
based on some proportion. The ceding insurer’s retention limit is stated as a percentage
rather than as a birr amount. The insurance and the loss are shared according to some
pre agreed percentage. For example, if a birr 100000 policy is written and the agreed split
is 50-50, the reinsurer assumes one-half of the liability, the insurer and the reinsurer each
pay one-half on any loss. For smaller insurers and other insurers that wish to reduce a
surplus drain, a quota-share treaty can be especially effective. The principal disadvantage
is that a large shares or potentially profitable business is ceded to the reinsurer.
 Surplus-share treaty.
Under this treaty, the reinsurer agrees to accept insurance in excess of the ceding
insurer’s retention limit, up to some maximum amount. The retention limit is referred to
as a line and is stated as a birr amount. Under surplus share treaty the ceding company
decides what its net retention will be for each class of business. The reinsurer does not
participate unless the policy amount exceeds this net retention. If the amount of insurance
on a given policy exceeds the retention limit, the excess insurance is ceded to the
reinsurer up to some maximum limit. The primary insurer and reinsurer then share
premiums and losses based on the fraction of total insurance retained by each party. The
principal advantage of this treaty is that the primary insurer’s underwriting capacity is
increased. The major disadvantage is the increase in administrative expenses. It is more
complex and requires greater record keeping.
 Excess-of-loss treaty
It is designed largely from catastrophic protection. Losses in excess of the retention limit
are paid by the reinsurer up to some maximum limit. The excess-of-loss treaty can be
written to cover (1) a single exposure, (2) a single occurrence, such as a catastrophic loss
from a windstorm, or (3) excess losses when the primary insurer’s cumulative losses
exceed a certain amount during some stated time period, such as a year. The reinsurer
agrees to be liable for all losses exceeding a certain amount on a given class of business
during a specific period.

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Risk Management and Insurance Department of Management

Example:
1. An insurer wishes to enter in to one of the following reinsurance arrangements;
I. A quota-share arrangement with the ceding insurer retaining 60
percent of any loss.
II. A surplus-share arrangement, under which the ceding insurer will
retain policy, amounts up to birr 100,000.
III. An excess-loss arrangement, under which the ceding insurer will retain
all losses under birr 100,000
How much will the reinsurer pay under each of these arrangements if
the loss is?
a. Birr 40,000 under a birr 80,000 policy
b. Birr 40.000 under a birr 200,000 policy
c. Birr 150,000 under a birr 200,000 policy

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