Solvency Series: Reinsurance
September 22, 2021
The foundation of maintaining solvency and financial stability for insurance carriers – and, by extension, the entire industry – is maintained through many levels of safeguards, not least of which is reinsurance.
Like it sounds, reinsurance is insurance for insurers. Insurance carriers buy reinsurance policies to pool risk even more than just among the policyholders who pay premiums to the carrier. By making sure they have a backup, carriers then have a way to redistribute the risks in case a single event has a concentrated impact on a carrier or even a group of carriers.
How reinsurance lowers risk concentration
Insurance carriers sell their policies to consumers for a certain premium and then may find a reinsurer whose underwriters have found a way to offer coverage for a lower premium. They’re passing this risk on to the reinsurer, and so, in many cases, this allows the original insurance carrier to either write policies that offer better benefits or allows them to keep less cash on hand to pay out policies.
Before we get too far into the weeds of how reinsurance policies work, let’s drill down into why insurance carriers may want reinsurance in the first place. After all, don’t underwriters determine the risk of writing certain policies, and that should be that? Yes and no. Reinsurance first became common in the oldest insurance industry: maritime insurance.
So, to use that as our case in point: Say you are writing insurance for ships. You’ve calculated the general risk of a ship being tossed in a freak storm or taken by pirates. Your insurance company covers most of the boats in a certain harbor, and all the ships’ owners are pooling their risks. Their premium payments are designed to cover the inevitable accident or freak happenstance.
But what about a hurricane that rips through the harbor? If most of the boats there need to be replaced or repaired, you’re probably not going to have the cash on hand to make that happen.
If you had reinsurance, your insurance company would have been pooling risk by paying premiums alongside insurers across the country, or across the globe. So, even if a hurricane hits your state and causes problems for you to pay out your covered claims, it’s unlikely that an insurer on the other side of the country or on another continent would be suffering similar losses; their premium payments can go to help you cover your claims.
This helps all insurance carriers maintain solvency, pass on extreme risks, and provide coverage even to higher-risk individuals or market sectors, or conversely provide even higher limits to relatively banal coverage cases.
The two-by-two basics of reinsurance contracts
Like regular insurance, reinsurance is hardly straightforward. An insurance carrier can possess various kinds of contracts – let’s look at the basics:
Treaty vs. facultative
Treaty reinsurance is basically a reinsurance contract that covers all of the current (and presumptively future) coverage and policies. For instance, an insurance carrier (also called the “ceding” insurer (because they’re ceding risk (do you like our parentheses?))) writing policies for personal homeowner, auto, and life insurance may reinsure their homeowner policies on a treaty contract. Essentially, the reinsurer in this case is agreeing to cover all the homeowner policies exactly the way the original insurer did. Each new policyholder is assumed into the treaty.
In juxtaposition, facultative reinsurance is more specific, isolated coverage written on a one-off basis. For instance, say a business with a fleet of vehicles wants to include hospital coverage in its auto policy – uncommon, but terribly expensive if necessary. Before agreeing to the contract, the insurer might first secure a facultative reinsurance agreement specifically to cover this singular event for this singular client.
So, for a reinsurance treaty, the reinsurer is chiefly concerned about a carrier’s policies and underwriting practices; specific clients with standard policies aren’t subject to scrutiny. With facultative reinsurance, however, the reinsurer(s) – it may take more than one to completely cover particularly outsized benefits – are underwriting specific contracts and contract holders.
Proportional vs. nonproportional (aka excess-of-loss)
Both treaty and facultative reinsurance contracts can be proportional or non-proportional.
Proportional coverage, sometimes known as pro rata coverage, means the reinsurer and the insurance carrier are sharing the costs of insuring coverage proportionally. Both benefit in the same proportion from premiums, and both will pay out in the event of a claim.
Nonproportional coverage, known as excess-of-loss coverage, is basically a contract where the insurer handles a basic claim but pays a fee to maintain the reinsurer for excess, unanticipated claims. Nonproportional reinsurance is essentially the backup in case of catastrophic claims filings.
Reinsurers and regulations
You likely recognize the names of the major insurance providers.The biggest ones spend millions on cavemen and ducks to become household names. But most outside of (or even inside) the insurance industry may not recognize common reinsurers. They’re the thing behind the thing – they aren’t looking for public recognition.
Like insurance carriers, reinsurers have to follow the regulations of the states they operate in, and, because of the nature of risk pooling that they follow, they are likely to operate in multiple states. In fact, having reinsurers follow the patchwork of state regulations gets a little tricky because not only are they better off operating in multiple states, most of the big reinsurers operate internationally.
Because most reinsurers are foreign, or alien, the vetting process gets tricksome. For instance, one major stumbling block was that states typically require foreign insurers to hold 100 percent of collateral for state-based claims locally. Put another way, if you’re an insurer with a home office in France, and you’re insuring $150 million in Utah, you’ll need to own $150 million of something – cash, real estate, investments – in Utah.
For foreign-based reinsurers, this rule makes it difficult to operate across the states (although, as discussed previously, reinsurance is most effective when spread across a broad spectrum of locations and lines of authority). Unfortunately, this has had a secondary effect of insurers being reinsured by unauthorized reinsurers. Some states have options for how insurers can prove coverage in these nebulous situations, but across the broader insurance industry this remains a somewhat gray area.
The National Association of Insurance Commissioners has recognized this is an area where disparity serves no one, and has model legislation to address it. Essentially, the Credit for Reinsurance Model Law and Credit for Reinsurance Model Legislation set standards for how foreign reinsurers can establish credit, as well as giving parameters for ways certain jurisdictions (specifically those in the European Union) can become “reciprocal” with those of the states.
Although the model legislation doesn’t have widespread adoption, it’s a step forward in giving insurers a way to back up their book of business and benefits.
Limitations of reinsurance
While reinsurance is meant to serve as a safety net for insurers by limiting their losses in case of catastrophic events, it doesn’t necessarily benefit them in the case of state audits.
Reinsurance can increase an insurance carrier’s underwriting capacity (the number of policies they can issue for a specific, underwritten risk profile), but it also signals that the insurer likely can’t cover all claims on its own. While it’s unlikely that an insurer will fail, and unlikely that a reinsurer will fail, it can and does happen on occasion.
The Insurance Information Institute reminds us that no one can predict the future:
“After Hurricane Andrew hit Southern Florida in 1992, causing $15.5 billion in insured losses at the time, it became clear that U.S. insurers had seriously underestimated the extent of their liability for property losses in a megadisaster. Until Hurricane Andrew, the industry had thought $8 billion was the largest possible catastrophe loss.”
Reinsurers’ role in the insurance industry is predicated on the idea that not everyone will be affected by a catastrophe. Yet, COVID-19 has certainly strained that assumption as nearly every market sector has increased the number of claims.
Reinsurers are also canaries in the coal mine for how to cover flood, fire, and other property and casualty claims as they see the effects of climate change stressing their ability to provide backup coverage. Again, the strength of reinsurance lies in being able to pool the risks for events that are likely to be limited by geography or market sector.
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While reinsurer failure can and does happen, both reinsurers and insurance carriers have the option to issue what are called catastrophe bonds, which allow them to use investor funds to pay claims and issue bonds as a debt instrument. In this scenario, investors front the money for claims, and the insurer or reinsurer will pay the investors back plus interest over an agreed-upon schedule. Catastrophe bonds, or cat bonds, are an increasing market, with both reinsurers and insurers publicly financing their debt obligations with more frequency after catastrophic events.
Most states include a clause in their guaranty association documentation that they retain any reinsurance contracts for the life of any associated policies. So, in short, they sure are.
No, although reinsurers can coinsure. Coinsurance is another insurance solvency mechanism. If you have a sizeable asset to insure, or you want to insure something like a hospital, or an industrial farm, you may have more than one insurer providing sometimes overlapping coverage. You and the insurance carriers would want to clearly coordinate coverage, but the advantage is that neither insurance carrier is solely responsible for any claim. Similarly, if an insurance carrier is interested in covering a particularly large anything, say a $500 million contract, they may be best served by not covering all of that by themselves or even through a single reinsurer. The insurer might cover $350 million, and then pay a share of premiums to one reinsurer for $100 million, and another for $50 million. The insured then has coverage for all of the $500 million, but no single insurer or reinsurer is strapped for that collateral.