Economical Sciencies/3. Financial relations

Z. Biblyi

National University of Food Technology

Mechanism of Reinsurance Risks in General Insurance

Reinsurance is insurance that is purchased by an insurance company (the "ceding company" or "cedant" or "cedent" under the arrangement) from one or more other insurance companies (the "reinsurer") as a means of risk management, sometimes in practice including tax mitigation and other reasons described below. The ceding company and the reinsurer enter into a reinsurance agreement which details the conditions upon which the reinsurer would pay a share of the claims incurred by the ceding company. The reinsurer is paid a "reinsurance premium" by the ceding company, which issues insurance policies to its own policyholders.

There are two basic methods of reinsurance:

1. Facultative Reinsurance, which is negotiated separately for each insurance contract that is reinsured. Facultative reinsurance is normally purchased by ceding companies for individual risks not covered, or insufficiently covered, by their reinsurance treaties, for amounts in excess of the monetary limits of their reinsurance treaties and for unusual risks. Underwriting expenses, and in particular personnel costs, are higher for such business because each risk is individually underwritten and administered. However as they can separately evaluate each risk reinsured, the reinsurer's underwriter can price the contract to more accurately reflect the risks involved.

2. Treaty Reinsurance means that the ceding company and the reinsurer negotiate and execute a reinsurance contract. The reinsurer then covers the specified share of all the insurance policies issued by the ceding company which come within the scope of that contract. The reinsurance contract may oblige the reinsurer to accept reinsurance of all contracts within the scope (known as "obligatory" reinsurance), or it may require the insurer to give the reinsurer the option to reinsure each such contract (known as "facultative-obligatory" or "fac oblig" reinsurance).

Reinsurance occurs when multiple insurance companies share risk by purchasing insurance policies from other insurers to limit the total loss the original insurer would experience in case of disaster. By spreading risk, an individual insurance company can take on clients whose coverage would be too great of a burden for the single insurance company to handle alone. When reinsurance occurs, the premium paid by the insured is typically shared by all of the insurance companies involved.
Reinsurance can help a company by providing:

1. Risk Transfer - Companies can share or transfer of specific risks with other companies

2. Arbitrage - Additional profits can be garnered by purchasing insurance elsewhere for less than the premium the company collects from policyholders.

3. Capital Management - Companies can avoid having to absorb large losses by passing risk; this frees up additional capital.

4. Solvency Margins - The purchase of surplus relief insurance allows companies to accept new clients and avoid the need to raise additional capital.

5. Expertise - The expertise of another insurer can help a company obtain a proper rating and premium.

Reinsurance is a contract under which a company, the reinsurer, agrees to indemnify an insurance company, the ceding company, against all or part of the primary insurance risks underwritten by the ceding company under one or more insurance contracts.

Reinsurance differs from insurance primarily in terms of its inherent complexity, which is linked to its broader range of activities and  international nature. Reinsurance can provide a ceding company with several benefits, including a reduction in net liability on individual risks and catastrophe protection from large or multiple losses. Reinsurance also provides ceding companies with the necessary capacity to increase their underwriting capabilities, in terms of both the number and size of risks. Reinsurance does not, however, discharge the ceding company from its liability to policyholders. Reinsurers themselves may feel the need to transfer some of the risks involved to other reinsurers (known as retrocessionnaires).

Reinsurance provides three essential functions:

- it offers the direct insurer greater security for its equity and solvency, as well as stable results when unusual and major events occur, by covering the direct insurer above certain ceilings or against accumulated individual commitments;

- it allows insurers to increase their available capacity - i.e. the maximum amount they can insure for a given loss or category of losses, by enabling them to underwrite policies covering a larger number of risks, or larger risks, without excessively raising their administrative costs and their need to cover their solvency margin and, therefore, their shareholders' equity;

- it makes substantial liquid assets available to insurers in the event of exceptional losses.

In addition, reinsurers also provide advisory services to ceding companies by:

· defining their reinsurance needs and devising the most effective reinsurance program to better plan their capital needs and solvency margin;

· supplying a wide array of support services, specifically in terms of technical training, organisation, accounting and information technology;

· providing expertise in certain highly specialised areas such as the analysis of complex risks and risk pricing;

· enabling ceding companies to build up their business even if they are temporarily under-capitalised, particularly in order to launch new products requiring heavy investment.

REFERENCES

1. Centeno, M. L. Measuring the effect of reinsurance by the adjustment coefficient in the Sparre Andersen model // Insurance: Mathematics and Economics – 2012 – 30, 37–50.

2. Centeno, M. L. (2011) Retention and reinsurance programmes // Encyclopedia of Actuarial Science – John Wiley & Sons – Chichester, 2011.