REINSURANCE CHAPTER 1 INTRODUCTION TO REINSURANCE INTRODUCTION The term ‘Reinsurance, also termed as insurance of insurance’. Means that an insurer who has assumed a large risk may arrange with another insurer to insure a proportion of the insured risk. In other words, in the event of loss, if it would be beyond the capacity of the insurer than this reinsurance process is restored to. In reinsurance, therefore, one insurer insures the risk which has been undertaken by another insurer. The original insurer who transfers a part of the insurance contract is called the reinsured and the second insurer is called the reinsurer. Of course the reinsurance has to pay reinsurance premium for risk shifted. For example, a man wishing to insure his premium for 10 lakhs goes to an insurance company, which will accept the risk if it is satisfied as to the condition of the property. But if it its own LALA LAJPATRAI COLLAGE OF COMMERCE & ECONOMICS 1
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REINSURANCE
CHAPTER 1
INTRODUCTION TO REINSURANCE
INTRODUCTION
The term ‘Reinsurance, also termed as insurance of insurance’. Means
that an insurer who has assumed a large risk may arrange with another
insurer to insure a proportion of the insured risk. In other words, in the event
of loss, if it would be beyond the capacity of the insurer than this reinsurance
process is restored to. In reinsurance, therefore, one insurer insures the risk
which has been undertaken by another insurer. The original insurer who
transfers a part of the insurance contract is called the reinsured and the
second insurer is called the reinsurer. Of course the reinsurance has to pay
reinsurance premium for risk shifted. For example, a man wishing to insure
his premium for 10 lakhs goes to an insurance company, which will accept
the risk if it is satisfied as to the condition of the property. But if it its own
limit is probably Rs 5 lakhs, it will arrange with another company to reinsure
or to take up so much of the risk as exceeds its limits, i.e. Rs 5 lakhs, so that
if the house is burnt down the original insurer would pay the owner Rs 10
lakhs. But they would be recouped 5 lakhs, by the reinsurance offices.
To be effective, the reinsurance policy must be formulated after
carefully considering all aspects of the situation to which it is to be applied.
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DEFINITION
Reinsurance is a transaction in which one insurer agrees, for a
premium, to indemnify another insurer against all are part of the loss that
insurer may sustain under its policy or policy or policies of insurance. The
company purchasing reinsurance is known as the ceding insurer: the
company selling reinsurance is known as the assuming insurer, or, more
simply, the reinsurer. Reinsurer can also be described as the “insurance of
insurance companies”
Reinsurance provides reimbursement to the ceding insurer for lasses
covered by the reinsurance agreement. It enhances the fundamental
objectives of insurance to spread the risk so that no single entity finds itself
saddled with a final burden beyond its ability to pay. Reinsurance can be
acquired directly from a reinsurance intermediary.
OBJECTIVES OF REINSURANCE
Insurer purchases reinsurance for essentially four reasons:
1) To limit liabilities on specific risks
2) To stabilize loss expanses
3) To protect against catastrophes; and
4) To increase capacity.
Different types of reinsurance contract are available in the market
commensurate with the ceding company’s goals.
1. Limiting liability:
By providing a mechanism in which companies limit loss exposure to
levels commensurate with net asset, reinsurance companies allows
insurance companies to offer coverage limits considerably higher then
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they could otherwise provide. This function of reinsurance is crucial
because they allow all companies, large and small, to offer coverage
limits to meet their policyholders’ needs. In this manner, reinsurance
provides an avenue for small-to-medium size companies to compete with
industry giants. In calculating an appropriate level of reinsurance, a
company takes in to account the amount of its available surplus and
determines its retention based on the amt of loss it cam absorb
financially. Surplus, sometime referred to as policyholders surplus, in the
amount by which the asset of an insurance exceeds its liabilities
A company’s retention may range from a few lakhs rupees o thousand
of crores. The reinsurer indemnifies the loss exposure above the
retention, up to the policy limits of the reinsurance contract. Reinsurance
helps to stabilize loss experience on individual risks, as well as an
accumulated loss under many policies occurring during a specified
period.
2. Stabilization:
Insurance often seeks to reduce the wide swing in profit and loss
margins inherent to the insurance business. These fluctuations result, in
part, from the unique nature of insurance, which involves pricing a
product whose actual cost will not be known until sometime in the future.
Though reinsurance, insurance can reduce these fluctuations in loss
experience, thus stabilizing the company overall operating result.
3. Catastrophe protection:
Reinsurance provides protection against catastrophe loss in much the
same way it helps stabilize an insurer’s loss experience. Insurer uses
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reinsurance to protect against catastrophes in two ways. The first is to
protect against catastrophic loss resulting from a single event, such as the
total fire loss of large manufacturing plant. However, an insurer also
seeks reinsurance to protect against the aggregation of many smaller
claims, which could result from a single event affecting many
policyholders simultaneously, such as an earthquake as a major
hurricane. Financially, the insurer is able to pay losses individually, but
when the losses are aggregated, the total may be more than the insurer
wishes to retain.
Though the careful use of reinsurance, the descriptive effect
catastrophes have on an insurer’s loss experience can be reduced
dramatically. The decision a company makes when purchasing
catastrophe coverage are unique to each individual company and vary
widely depending on the type and size of the company purchasing the
reinsurance and the risk to be reinsured.
4. Increased capacity:
Capacity measures the rupee amount of risk an insurer can assume
based on its surplus and the nature of the business written. When an
insurance company issues a policy, the expenses associated with issuing
that policy-taxes, agents commissions, administrative expenses-are
changed immediately against the company’s income, resulting in a
decrease in surplus, while the premium collected must be set aside in an
unearned premium reserved to be recognized as income over a period of
time. While this accounting procedure allows for strong solvency
regulation, it ultimately leads to decreased capacity because the more
business an insurance company writes, the more expenses that must be
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paid from surplus, thus reducing the company’s ability to write additional
business.
PURPOSES OF REINSURANCE
"Reinsurance achieves to the utmost extent the technical ideal of
every branch of insurance, which is actually to effect
(1) The atomization,
(2) The distribution and
(3) The homogeneity of risk. Reinsurance is becoming more and
more the essential element of each of the related insurance
branches. It spreads risks so widely and effectively that even
the largest risk can be accommodated without unduly burdening
any individual."
ORIGIN AND DEVELOPMENT OF REINSURANCE
In the years 1871 to 1873, no less than twelve independent
reinsurance institutions were founded in Germany, of which very few
survive today. The pressure of competition led to unwholesome practices,
and soon many of these newly formed companies found themselves in dire
straits. In branches of insurance, other than fire insurance, we find no
definite tendency in the '70's toward the establishment of separate
reinsurance facilities in Germany. Ernst Albert Masius, in his "Rundschau"
in 1846, deplored the lack of reinsurance facilities in hail insurance. Even at
the present time, this branch of the business lacks adequate reinsurance
service.
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Fundamentals
In the most widely accepted sense, reinsurance is understood to be
that practice where an original insurer, for a definite premium, contracts with
another insurer (or insurers) to carry a part or the whole of a risk assumed by
the original insurer. By insurers we mean all persons, partnerships,
corporations, associations, and societies, associations operating as Lloyd's,
inter-insurers or individual underwriters authorized by law to make contracts
of insurance. We may define insurance as an agreement by which one party,
for a consideration, promises to pay money or its equivalent, or to do an act
valuable to the insured, upon the happening of a certain event or upon the
destruction, loss or injury of something in which the other party has an
interest. The insurance business is the business of making and administering
contracts of insurance. Insurance contracts are of two types those which
engage merely to pay a sum of money on the happening of an event, or
merely to begin a series of payments on or after the happening of a certain
event, are contracts of investment. Contracts of insurance which engage to
pay money or its equivalent, or the doing of acts valuable to the insured,
upon destruction, loss or injury involving things, are contracts of indemnity.
And so, reinsurance may be second insurance of
(a) Contracts of investment and/or
(b) Contracts of indemnity.
There may exist, therefore, two types of insurance business,
depending upon which of these two organic contracts the business engages
to administer.
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Risks carried by the insurer
The need for reinsurance arises out of the fact that a first or primitive
insurer bears two distinctly different major risks:
(1) The risk that the events insured against will happen among a
number of homogeneous risks;
(2) The risk that certain events insured against will happen among a
heterogeneous group of risk to one or several insured entitled by contract to
an exceptional payment in money or its equivalent, or entitled to
exceptional, costly service.
Case 1:
An insurer contracts to pay $10,000 to the beneficiary of each of 806
persons insured by him at 21 years of age, in event of the death of the
insured during the contract year. This group is homogeneous in respect to
amount insured and class of risk. He charges a net premium of 1.22 per
cent., or $98,332 to meet the expected claims in that year of age.
Case 2:
Assume, however, that the insurer has accepted, as a second instance,
a heterogeneous group composed of 805 risks at $10,000 each and one risk
at $100,000. This produces $99,430 in premiums.
If in Case 1, only 8 deaths actually occur with a uniform coverage of
$I0, 000 each, the premiums are $98,332 and the claims $80,000, leaving an
underwriting profit of $18,332. If in Case 2, the $100,000 policyholder and
seven $10,000 policyholders die, the premiums are $99,430, and the claims
$170,000, or an underwriting loss of $70,570. We had in the first case the
carrier of a group of primary, homogeneous risks, with only a slight hazard
to him that the number of actual claims would exceed the expected. Against
this slight hazard the insurer is supposed to hold paid-in capital and surplus
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(or "guarantee capital" in case he was a mutual underwriter). Slightly
exceptional losses above the expected are to be made up by slightly
favorable underwriting profits in the long run of the business. In the second
case, the insurer is not only carrying a group of primary, homogeneous risks
but also the secondary risk of selective loss through the death of the
$100,000 policyholder. The quality of the second group of risks is
heterogeneous with respect to the carrier's interests. Insurers have
historically met the second risk through the practice of two varieties of
coinsurance:
(1) External or true coinsurance or
(2) Internal coinsurance or reinsurance.
HISTORY OF REINSURANCE
Reinsurance has a rather illustrious history eating back 10 the
fourteenth century. Even though there is no authentic information of the
first reinsurance contract, it is widely recognized that Lombardians beggar
Develop the concept of reinsurance in circa 1200 AD and from whence the
concept of reinsurance took ground.
1200-1600 AD
The emergence of the reinsurance concept and its slow pace of
expansion was one of the remarkable features of this time. Marine business
was one of the earliest fields that recognized the need of reinsurance to
protect its business from the dangers and rakes of marine transport.
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1600-1850AD
Though marine insurance nourished during this period in Europe, it
suffered a set back in UK, where it went largely unrecognized except when
the insurer became insolvent or went bankrupt or died. This ban lasted till
1864 and as such there was no recorded reinsurance business in England.
After the great fire of London in 1666, an interest to insure against fire suit
faced and regulators soon made modifications to reduce their losses. In the
year 1776 royal concession was granted to the Royal Chartered Fire
insurance Company of Copenhagen to undertake fire insurance one of the
earliest recorded fire reinsurance transactions place in 1813 when the Eagle
hire Insurance Company of New York assumed all of the outstanding rim
the Union Insurance Company, but it really executed, as the insurer did not
avail this facility and after this the earliest recorded fire insurance then
which was executed dates back to the year I821 between the National
Assurance Company, Paris, France and the assuming reinsurer the United
Proprietors of Belgium.
Validation of the reinsurance contract by the Supreme Court of New
York boosted a number o\ reinsurance contracts contracted. In l883 the
Supreme Court gave its consent in the case between New York Browery
Insurance Company, the cedent, and the New York Fire Insurance Company,
the reinsurer. This case acted as a catalyst for the emergence of reinsurance
companies and thus began a new era in the reinsurance sector and in \S4A
the current system of life reinsurance took seed. The first life treaty as such
dates back to 1858.
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From 1850 onwards
By he mid nineteenth century there was a boom in the European
reinsurance business and Germany became the hotbed for reinsurance
activity. Many German reinsurance companies undertook business of; large
scale and new reinsurance companies flourished. But the after-effects of the
two world wars spilled over to the reinsurance markets leading to the
emergence of London as a strong player in the reinsurance sector. One of
the pioneers of the insurance industry, Lloyd's of London, began its
operations in the year 1688. It initially ventured into life insurance only and
because of the ban imposed on marine insurance they could not make much
headway. Once the ban was lifted it opened its business in all the spheres of
insurance activity and with the introduction of excess of loss reinsurance it
aggressively jumped into the fray and became one of the strongest players
in the industry.
THE FIRST INDEPENDENT REINSURANCE COMPANY
In 1846, the first independent reinsurance company was founded in
Germany, the Cologne Reinsurance Company. This was the idea of
Mevissen. He held that an independent reinsurance company would be no
competitor of the direct-writing companies and that it was certain to be
welcomed by and to receive a good volume of business from those
companies. Mevissen's idea of 1846 did not mature, however. For various
reasons the company did not begin business until 1852, and then only with
the assistance of considerable French capital. This marked the establishment
of reinsurance as a specific, independent branch of the business. Out of
small beginnings, this company began to prosper and its example began to
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attract other enterprising persons. During the first three years of its business
life the Cologne Reinsurance Company extended its operations in Germany,
Austria, Switzerland, Belgium, Holland and France, and then tried to arrange
treaty contracts with English companies. It seems that domestic English
reinsurance business, at that time, was quite unprofitable to the reinsures and
the Manager of the Cologne was obliged to keep out Of the English market.
On June 24, 1853, a fire treaty was concluded between the Aachen and
Munchener Fire Insurance Company and its subsidiary, the Aachener
Reinsurance Company. This was an early example of a true "first surplus"
treaty under which the reinsurer was allotted one-tenth of every surplus risk,
with certain modifications in respect to various classes of risk enumerated in
the contract. It is interesting to note that the Aachen - Munchener Company
had an earlier arrangement with L' Urbaine, Paris.
FIRST RECORDED REINSURANCE CONTRACT
The first reinsurance contract on record relates to the year 1370, when
an underwriter named Guilano Grillo contracted with Goffredo Benaira and
Martino Saceo to reinsure a ship on part of the voyage from Genoa to the
harbor of Bruges.
As early as the twelfth century, marine insurance began to be
transacted through the so-called "Chambers or Exchanges of Insurance,"
which had for their object, first, the promotion of the marine insurance
business on a solid basis and, second, the settling of disputes arising among
merchants and others concerned in bottomry and respondentia contracts. In
later years, these Chambers or Exchanges of Insurance became corporate
bodiesand instead of remaining confined to the original function of
regulating and registering insurance made by others, actually undertook an
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insurance business themselves. With the establishment and functioning of
Lloyd's in 1710, there was a marked decline in the transaction of insurance
business through these Chambers or Exchanges. There is a suggestion of
reinsurance practice in the "Antwerp Customs" of 1609. Some mention of
reinsurance practice is to be found also in the "Guidon de la Mer," a code of
sea laws in use in France from a very early date. These marine regulations
were consolidated and published at Bordeaux in 1647 and at Rouen in 1671.
The author of the consolidations was said to have been Cleirac. With the
shift of centers of commerce from the south, southwest and west of Europe
to the north, England's foreign trade grew. Marine insurance followed in its
wake. Some underwriters found they could affect reinsurance with others.
Underwriters were accustomed to assign parts of risks to others at lower
rates, and these reinsures had hopes of finding other persons who would take
parts of these risks at still lower rates. This traffic in premium differences
was so greatly abused that in 1746 it was forbidden. (19 Geo. II, c 37,
Section 4). Under this statute, reinsurance was permitted only if the party
whose risk was reinsured was insolvent, bankrupt or in debt and if the
transaction was expressed in the policy to be a reinsurance. The statute was
more or less of a dead letter and was repealed by 27 and 28 Vict.c 56,
Section I on July 25, 1864
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CHAPTER 2
PRINCIPLES OF REINSURANCE
WHAT IS REINSURANCE?
Insurers take out their own insurance - this is called reinsurance.
When you look at the risks that insurers take on, it is not surprising
that they themselves might want to have insurance. When insurers insure a
risk again, it is called reinsurance.
Reinsurance is an extension of the concept of insurance, in that it
passes on part of the risk for which the original insurer is liable. Reinsurance
contracts are slightly more specialists than insurance contracts but for most
part they work in exactly the same way – it is just that the ‘insured’ is
another insurer, known as the ‘reinsured’ (See the Basics of Insurance for an
explanation of how insurance contracts work).
A contract of reinsurance is between the insurer and reinsurer only
and legally there is no direct link between the original insured and any
reinsurer. The original insurer is still the one who must pay any claim from
the insured – the insurer must then make its own separate claim against the
reinsurer.
Reinsurance is important for a number of reasons, including:
1) To protect against large claims. For example, in the case of a fire in a
large oil refinery or a large city hit by an earthquake, insurers will
spread the risk by reinsuring part of what they have agreed to insure
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with other reinsures so that the loss is not so severe for any one
insurer.
2) To avoid undue fluctuations in underwriting results. Insurers want to
ensure a balanced set of results each year without ‘peaks and troughs’.
They can therefore get reinsurance which will cover them against any
unusually large losses. This keeps a cap on the claims the insurer is
exposed to having to pay it.
3) To obtain an international spread of risk. This is important when a
country is vulnerable to natural disasters and an insurer is heavily
committed in that country. Insurance may be reinsured to spread the
risk outside the country.
4) To increase the capacity of the direct insurer. Sometimes insurers
want to insure a risk but are not able to do so their own. By using
reinsurance, the insurer is able to accept the risk by insuring the whole
risk and then reinsuring the part it cannot keep for itself to other
reinsures.
Like the direct insurance market, reinsurance usually involves
specialist brokers who have expert knowledge of the market and access to
reinsurance underwriters on behalf of their clients.
REINSURANCE IN INDIA
Reinsurance in India dated back to the 1960’s. After independence
there was rapid development of the insurance business. With various sectors
growing in the post independence era the need for reinsuring the
development work was also felt. Since reinsurance industry has negligible
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presence in India after independence, the domestic requirement of
reinsurance was netted from mostly was foreign markets mainly British and
continental. For undertaking reinsurance by Indian entities meant drain of
precious foreign exchanged earned by the country. To prevent the outflow of
foreign exchange, in year 1956 Indian Reinsurance Corporation, a
professional reinsurance company was formed by some general insurance
companies. This company started receiving the voluntary quote share
cession from member companies.
Selection of Customers:
In the reinsurance industry business is acquired in two ways. One is
when a customer directly approaches the reinsurance for ceding their claims
and the other method is when the reinsurer gets their business from the
reinsurance broker appointed by he customer. In certain parts of the world,
reinsurance accepts business routed only through a reinsurance broker. The
important thing to be noted here is that it is not the quantum of business
generated by the reinsurer but the customer for whom they are undertaking
the business. Some go that extra mile by going to their business and
accordingly tailor their policies to fit their needs and business. The more the
reinsurance knows about the business nature of their clients, they can serve
them.
The Quality of Service:
The quality of services offered by the reinsurer to their customers
matter a lot in the reinsurance industry. Most customers go for reinsurance
for extra benefits like expertise, experience, and the advisory role of the
insurer. If these services cannot meet customers, expectations, then
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reinsurance can accepts a rundown of their businesses which the customer
shifting base to the other players providing better services. It is to be
remembered that the reinsurance industry is a highly competitive market and
hence the reinsurance needs to carefully grade its customer.
The Skill Set:
The skill set of the reinsurance is the most important aspect of a
contract to the customer. It matters a lot to a reinsurance too because a skill
set represent the basic amour which it can showcase to its costume. The skill
set generally refers to the underwriting, financial, actuarial, claims
management and last but not the least management skills which it can serve
its clients. Hence the reinsurance gives due consideration to its available
skill set and sees how best it can serve the client with such skills.
Thus reinsurer who takes risk in the hope of gaining the premium volume
ceded to him, as part of a contract, would like to reap the benefits over a
period of time and hope for a long-term relation with its customers.
WHY REINSURANCE?
Risk managers and other buyers of insurance rarely think about how
reinsurance affects their company or the insurance they purchase for their
company. Insurance buyers mainly focus on the direct insurers – the
primary, excess, and umbrella carriers that provide the coverage. Smart
insurance buyers look for A--rated or better insurance companies with long
histories. Other buyers rely on their brokers to put together the best quality
insurance program with the best insurance security available. After all, the
insured must rely on the insurance policy issued by the direct insurer.
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But what stands behind the A--rated carrier or the high quality
program for a complex risk? The answer is “Reinsurance”. Commercial
insurance cannot exist without reinsurance. The quality of the reinsurance
security purchased by the direct insurer is what helps to insure that loss will
be paid. Quality reinsurer provides special expertise to their direct insurer
client and assists the direct insurer in providing the best possible protection
and risk management for the direct insurer’s own client. Some large
professionals reinsure help small insurance companies expand into new
areas and provide them with technical, actuarial, and claims expertise and
training
FUNCTIONS OF REINSURANCE
There are many reasons why an insurance company would choose to
reinsure as part of its responsibility to manage a portfolio of risks for the
benefit of its policyholders and investors :
1. Risk transfer
The main use of any insurer that might practice reinsurance is to allow
the company to assume greater individual risks than its size would otherwise
allow, and to protect a company against losses. Reinsurance allows an
insurance company to offer higher limits of protection to a policyholder than
its own assets would allow. For example, if the principal insurance company
can write only $10 million in limits on any given policy, it can reinsure (or
cede) the amount of the limits in excess of $10 million.
Reinsurance’s highly refined uses in recent years include applications
where reinsurance was used as part of a carefully planned hedge strategy.