Reinsurance | Meaning & Definition | Terms | Characteristics, Objectives, Methods

What is Reinsurance?

What is reinsurance

What is reinsurance

When an insurer transfers a part of his risk on a particular insurance by insuring it with another insurer or other insurers, it is called “Re-insurance”.

Reinsurance is insuring the same risk

Reinsurance means insuring again by the insurer of a risk already insured. Every insurer has a limit to the risk that he can bear. If at anytime a profitable venture comes his way, he may insure it even if the risk involved is beyond his capacity which is his retention limit. In such cases, in order to safeguard his interest, he may reinsure the same risk for an amount in excess of his retention limit with other insurers, so that the loss due to risk is spread over many insurers.

Contract between two insurers

Reinsurance is, therefore, a contract between two insurers and the original contract or the insured is not at all affected by it. Now there are two contracts on the subject matter. The first contract is between the original insurer or direct insurer and the owner of the subject matter or the original insured.

The other contract (reinsurance contract) is between the original insurer and the reinsurer. In the case of loss on the subject matter, the original insurer collects the insured sum from the reinsurer and then settles the loss value in full to the original insured.

Example of Reinsurance

An example will make the concept of reinsurance more clear:

Mr. X, a factory owner, approached an insurance company ‘A’ for an insurance of an amount of Rs. 40 crores. Company ‘A’ has two options before it. It can reject the risk or accept the entire risk and share a part of the risk with other insurer.

In case, the company ‘A’ decides to assume the risk, by retaining Rs. 20 crores worth of insurance with it and seeking assistance of other insurer for the excess of his own limit. i.e., for the balance of Rs. 20 crores. The excess for which the company ‘A’ is approaching the other insurer is called “Reinsurance”.

Definition of Reinsurance

Definition by W.A. Dinsdale:

When the amount of any risk or risks from one hazard is such that it is beyond the limits, which it is prudent for one insurer to carry, it is necessary to effect reinsurance.

Definition by Federation of Insurance Institute, Mumbai

Reinsurance is an arrangement whereby an insurer so has accepted all insurance, transfers a part of the risk to another insurer so that his liability on any one risk is limited to a figure proportionate to his financial capacity.

Definitions of Terms used in Reinsurance

Before going deep into the concept of reinsurance, it is necessary to understand the meaning of the various terms used in it.

1. Direct Insurer

An insurance company which accepts the risk from the proposer and which is solely responsible to the policyholder for the obligations undertaken.

2. Reinsurer

The insurance company which provides reinsurance cover to the ceding company is called the Reinsurer. The offer made by the ceding company is accepted by the Reinsurer. The Re-insurer may be

  • a direct insurer, who in addition to accepting direct business, also accepts reinsurance business; or
  • a professional reinsurer who accepts only reinsurance business but does not transact direct business.

3. Ceding company

Insurance company that places reinsurance business of the original risk with a reinsuring company; or the original insurer; the insurer who obtains a guarantee (on fire policy).

4. Cession

This is the amount reinsured with the reinsurance i.e., ceded to the reinsurer.

5. Reinsurance policy

The contract of reinsurance; in fire insurance, it is called guarantee policy.

6. Retention

This is the amount retained by the ceding company for its own account i.e., maximum it is prepared to lose on anyone loss. It is also known as ‘net limit‘ or ‘net holding‘ or ‘net line‘.

7. Surplus

This refers to the difference between the sum insured under the policy issued by the ceding company and its retention.

8. Reinsurance Commission

It refers to the amount paid by the reinsurer to the insurer (ceding office) as a contribution to the acquisition and administration costs. Usually, it is a fixed percentage of premium received by the reinsurer.

Characteristics of Reinsurance

1. Reinsurance is a contract between the two insurance companies.

2. The original insurer agrees to transfer part of his risk to other insurance company on the same terms and conditions.

3. The fundamental principles of insurance such as insurable interest, utmost good faith, indemnity, subrogation and proximate cause also apply to reinsurance.

4. In the event of fire, the insured is entitled to get the amount of claim only from the original insurer and not from reinsurer.

5. Original insurer cannot insure the risk with a re-insurer, more than the sum assured, originally by the insured.

6. The original insurer should intimate to the reinsurer about the alteration, if any, made in terms and conditions with the insured.

Objectives of Reinsurance

The following are the main objectives of reinsurance:

1. Wide distribution of risk to secure the full advantages of the law of averages;

2. Limitation of liability of an amount which is within the financial capacity of the insurers; .

3. Stability in underwriting over a period; and

4. A safeguard against serious effects of conflagrations. Apart from these, sometimes an insurer may undertake the insurance of certain risks at a higher rate of premium and may reinsure part of these or the whole of it with some other insurers at a lower rate with the objective of earning of profit out of it i.e., making profits by way of retaining the difference between the two premiums.

Methods of Reinsurance

Treaty and Facultative Insurance

Treaty and Facultative Insurance

Reinsurance may be effected by two methods. The selection of these methods depends upon the practice of insurers and the scope of their resources. These methods are:

  1. Facultative Reinsurance; and
  2. Treaty Reinsurance.

1. Facultative Reinsurance

This is the oldest method of reinsurance. This method is also known as “Specific reinsurance“. Under this method, each individual risk is submitted by the ceding insurer to the reinsurer who can accept or decline whatever sum they consider appropriate subject to the amount of their acceptance being approved by the ceding insurer.

The reinsurer is offered a copy of proposal form which contains details of risk such as the sum assured, salient features of the risk, perils covered, rate of premium and period of insurance etc. The reinsurer will go through the contents of the proposal form thoroughly and decide whether to accept or reject the risks. If he decides to accept, he should specify the amount for which he would accept the reinsurance. In case, the risk is not fully accepted, the original insurer may again have to approach another insurer for the balance.

For example, ‘X’ insurance company has received a proposal for Rs.1,00,00,000. The retention of the original insurer (i.e. X co) is Rs.50,00,000 and for the balance of Rs.50,00,000, he approaches the insurer ‘A’ who accepts for only Rs.25,00,000. The original insurer may again have to approach insurer ‘B’ for the balance of Rs. 25,00,000.

Any alteration, in the terms and conditions made by the original insurer is to be intimated immediately to the reinsurers. The claim is to be settled according to the ratio of risk accepted by each insurer.

2. Treaty Reinsurance

Treaty reinsurance has been defined as

a formal, legally binding agreement or a treaty (agreement) between the principal and the reinsurer that the reinsurer shall accept without the option of rejecting, a specified proportion of the excess on any risk over the insurer’s limit of retention.

Thus, under this method, there is an agreement between the ceding company and the reinsurance company that amount of every risk over and above the retention shall automatically be transferred to the reinsurance company. As soon as the original insurer accepts the risk, the excess above the retention is automatically reinsured.

For example, if the total sum insured on any risk is Rs.2,00,000 and the retention is Rs.20,000 the balance of Rs.1,80,000 is reinsured. Accordingly premiums are also paid to the reinsurers in the same proportion. In the even of loss, insurers also pay the compensation in the same proportion.

Treaty reinsurance may be

  1. Quota share treaty;
  2. Surplus treaty and
  3. Excess of loss treaty.

1. Quota Share Treaty

Under this method, the ceding company is bound to cede and the reinsurer is bound to accept a fixed share of every risk coming within the scope of the treaty.

This method is especially suitable for an insurer

  • recently established with a small premium income; or
  • entering a new class of business for which it may not have the necessary experience; or
  • to protect a hazardous class of insurance, where selective ceding is difficult.

This method is highly beneficial to the reinsurer. The liability of the reinsurer attaches as soon as the ceding office assumes the risk. Then, the ceding office provides the accepting office with full details of each cession, copies of proposal papers. It does not give the insurer an option of acceptance or rejection.

It enables the reinsurer to consider any marked divergence of underwriting standards and if persistent to its disadvantage, it may indicate the need for revision or cancellation of the treaty in respect of new business.

2. Surplus Treaty

Under this method, the insurers agree to accept the surplus i.e., the difference between ceding insurers’ retention and gross acceptance. Surplus treaties are arranged on the basis of ‘lines’. A ‘line’ is equivalent to the ceding insurer’s retention.

For example, a treaty may be arranged on a ten line basis. Under this arrangement, the insurers will accept automatically upto ten times the retention of ceding insurer.

The following illustration will explain this concept more clearly:

Gross Acceptance Retention Surplus Reinsurance
Rs. 1,00,000 Rs. 1,00,000 Nil
Rs. 2,10,000 Rs. 1,00,000 Rs. 10,000
Rs. 11,00,000 Rs. 1,00,000 Rs. 10,00,000

If the gross acceptance is more than Rs.11,00,000, then the surplus treaty will absorb only Rs.10 lakhs and the balance will have to be reinsured facultatively. It is usual to arrange a second surplus treaty to take care of such excess amount. This method is the most popular and greater part of the reinsurance business is now done under this method, as it does not lay down any right rules.

It is of particular advantage to the ceding office as it saves a lot of time and expenses and simultaneously provides for the reinsurance facility. However, it is not suitable for policies with higher sums insured or where the limit of indemnity is very high.

3. Excess of Loss Treaty

This is a non-proportional method of reinsurance. The reinsurance protection arranged is not linked with the sum insured but comes into operation when the total net loss suffered by the insured due to one event exceeds the figure agreed in the treaty.

Thus, under this method the original insurer has to decide the maximum amount which he can bear on any one loss and seeks reinsurance under which the reinsurer will be responsible for the amount of any losses and above the amount retained by the direct reinsurer. Such a treaty usually contains an upper limit so that the insurer, for instance is content to bear the first Rs.20,000 of any loss, the treaty reinsurers will bear any loss over Rs.20,000 but not exceeding, say Rs.2,00,000

In order to cover the catastrophe risks or risks beyond that maximum limit (Rs.2,00,000 in the above case) an additional second layer ( further excess of loss) treaty may be negotiated. In case, the direct insurer has not made any arrangement to cover the loss over and above Rs.2,00,000, then he will have to bear all possible claims beyond Rs.2,00,000 Sometimes, the insurer may be required to retain part of the cost in excess of the retention.

Thus, to keep the reinsurers directly involved in the cost, the treaty may, for instance, provide that the reinsurer will pay only a part of the excess of Rs.20,000 e.g., 95% of the claims over Rs. 20,000 maybe paid by the reinsurers and the balance of 5% is met by the insured. Generally, the retention is fairly high. In order to get protection under this category, the insurers have to pay an agreed percentage of the annual premium income for that class of risk to the reinsurers.

This method is employed mainly to protect large catastrophic losses such as those caused by Special perils fire insurance i.e. storm, flood, earthquake etc. or where their is an possibility of conflagration in large storage areas or where large marine acceptances are involved in any ship through different sources. It is also applied to protect legal liability classes i.e., motor third party, public liability, products liability and workmen’s compensation risks. For example, a severe mining accident may result in hundred of fatalities to workmen, resulting in a catastrophic loss.