Chapter eight
Reinsurance
1. Definition of Reinsurance
Reinsurance may be defined as the shifting by a primary insurer, called the ceding company
of a part of the risk it assumes to another company, called the re-insurer.
That portion of the risk kept by the ceding company is known as the line, or retention, and
varies with the financial position of the insurer and the nature of the exposure.
When a re-insurer passes on risks to another reinsurer, the process in known as retrocession.
It is not good business to refuse to write insurance in excess of the retention amount, imaging
the displeasure of the applicant and particularly of the producer when the application is
rejected or accepted in part.
For these and other reasons insures commonly insure that portion of their liability under
their contracts in excess of their retention with one or more insurers.
This process is called reinsurance, the originating insurer is the ‘primary insurer’ or ‘direct
insurer’, and the accepting insurer is the ‘reinsurer’.
7.1. Methods of Reinsurance
There are two main methods in which risks can be shared: facultative reinsurance and automatic
treaty.
1. Facultative Reinsurance
Facultative reinsurance is reinsurance on an optional basis.
There is no advance agreement between the ceding company and the re-insurer regarding
the sharing of risks and premiums.
Under this arrangement a primary insurer, in considering the acceptance of a certain risk,
shops around of reinsurance on it, attempting to negotiate coverage specifically on this
particular contract.
Each risk, which is offered, is described and this is shown to the prospective re-insurers
who are free to accept or decline as they see fit.
A life insurer, for example, may receive an application for birr 1 million of life insurance
on a single life.
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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 past.
The other insurer may agree to assume 40% of any loss for a corresponding percentage of
the premium. The primary insurer then puts the contract in force.
The reinsurance agreement does not affect the insured in any way.
The insured is generally not aware of the reinsurance process and the primary insurer
remains fully liable to the insured in event of loss.
As stated earlier the insurer retains the right to decide whether and how much of his risk
to submit for reinsurance.
The re-insurer also retains the right to accept or reject any business offered by the insurer.
2. Automatic Treaty
Under an automatic reinsurance treaty, the ceding insurer agrees to pass on to the re-
insurer all business included within the scope of the treaty and the re-insurer agrees to
accept this business, and the terms.
Example: the premium rates and the method of sharing the insurance and the losses of the
agreement are set. The ceding company is required to cede some certain amounts of business,
and the re-insurer is required to accept them. The ceding company known in advance that it will
be able to obtain reinsurance for all exposures that meet the conditions specified in the treaty.
The amount that the ceding company keeps for its own account is known as its retention, and
the amount ceded to others is known as cession.
7.2. Types of Reinsurance
The most important types of reinsurance treaties include:
1) Quota-share reinsurance
2) Surplus-share reinsurance
3) Excess of loss reinsurance
1) Quota-share Reinsurance
Under a quota share split, the insurance and the loss are shared according to some pre-
agreed percentage. For example, if a 100,000-birr policy is written and the agreed split is
50-50, the insurer and re-insurer each pay one-half on any loss.
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The method is not greatly favored because, it means paying away a proportion of the
premium income where the direct office might safely retain the whole of a risk.
It is, however, a useful method for small offices or those starting up a new class of
business where in the early days one or two heavy losses could swallow up all the
income.
The method is sometimes also used between parent and subsidiary companies.
2) Surplus Share Reinsurance
Under surplus share reinsurance the ceding company decides what its net retention will
be for each class of business.
The direct office cedes to the re-insurer only those amounts, which it does not wish to
hold for its own account-the surplus of its retention.
The re-insurer does not participate unless the policy amount exceeds this net retention.
This retention is known also as a “line” and reinsures have a maximum capacity of so
many lines, or so many times the direct office’s retention.
For example, if the agreement calls for cession of up to “ten lines” and the direct office retain
25,000 birr, then ten times this amount can be ceded to the re-insurer, i.e., 250,000 birr: in this
way sums insured up to 275,000 birr can be accepted by the direct insurer knowing that he
automatically has the reinsurance he requires. It is of course not necessary (or possible) to fill the
whole capacity of the reinsurance treaty on each individual acceptance: sometimes the
acceptance will be entirely within the direct insurer’s retention and the treaty will not be
interested at all, and on other occasion the treaty underwriters will only be ceded a limited
amount which they divide equally between them.
Using the earlier example of a ten-line reinsurance treaty the position of the treaty (reinsures) in
different circumstances would be as follows:
300,000 25,000
Original sum Direct insurer’s
Insured Retention
Br 25,000 Br. 25,000
50,000 25,000
100,000 25,000
275,000 25,000
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Br. 25,000 50%
Ceded to Treaty 75,000 Proportion to Treaty 75%
(reinsure) 250,000 (reinsure) 90.9%
Nil 275,000 Nil 83.3%
N.B:The balance of birr 25,000 would have to be reinsured facultative of under a second
reinsurance treaty.
3) Excess of loss Reinsurance:
In this form of reinsurance, the direct insurer decides the maximum loss arising from any
event or series of events he is prepared to bear, and then arranges with re-insures for them
to pay the excess of that amount up to an upper limit.
The re-insurers agree to be liable for all losses exceeding a certain amount on a given
class of business during a specific period.
For example, the primary insurer may be prepared to pay up to 50,000 birr any one loss and he
secures reinsurance for the excess of 50,000 birr up to a further 200,000. The way in which
various losses are divided is shown below:
Loss Direct insurer Excess treaty
(Re-insurer)
Br. 10,000 Br. 10,000 Nil
50,000 50,000 Nil
70,000 50,000 Br. 20,000
100,000 50,000 50,000
250,000 50,000 200,000
300,000 50,000 200,000
NB: The balance birr 50,000
(in excess of this treaty) needs
to be reinsured under the
second reinsurance agreement
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