Spreading insurance risk through REINSURANCE

Some policy holders do not know anything about reinsurance. They have probably not heard the word before. In truth, they do not really have any business or interaction with reinsurance, so you can excuse them if they are ignorant of reinsurance. Insurance is a risk transfer mechanism as well as a tool for spreading of risks. For a consideration, which is the premium, the insurance company takes over the risk of the policy holder. Now after taking over the risk, the insurance company looks at its capacity and retention limit. It asks itself, if there were to be a partial or total loss on this risk, can I pay the claim alone or I need to share the payment of the loss with others?

The other entities insurance companies share (transfer) parts of their assumed risks with are reinsurance companies and the process is called reinsurance, our topic today. Wikipedia defines reinsurance as “insurance that is purchased by an insurance company, in which some part of its own insurance liabilities is passed on (‘ceded’) to another insurance company.” In a reinsurance arrangement, the insurance company is referred to as the ceding company or cedant, while the reinsurance company is referred to as reinsurer. The cedant and the reinsurer are the only parties to a reinsurance contract. Individual policy holders are not party to a reinsurance contract, even though it is their risks that are being reinsured. Consequently, they cannot sue the reinsurer or join the reinsurer in a suit should a dispute arise. Individual policy holders’ recourse to legal action ends with the insurance company they placed their business with.

How does reinsurance work? When an insurance company gets a business (risks), it takes the portion it can accommodate based on certain parameters and transfers (cedes) the balance to reinsurers, again based on the kind of reinsurance arrangement (Treaty). It pays the reinsurance part of the premium it collected. The reinsurer now assumes that proportion of the risk. If there is a claim, the reinsurer pays its proportion of the claim. Let me quickly add that it is not every claim that the reinsurer participates in. It depends on the kind of reinsurance arrangement and we shall get to that shortly.

But before then, let us add here that even reinsurance companies have their limit of retention. Beyond their limit, they retrocede portions of the risks they have assumed to other reinsurance companies. The process is called retrocession. A reinsurer, which reinsures other reinsurance companies, is called retrocessionaire. You will be surprised that reinsurance companies in Africa, Europe and Japan participate in payment of large claims that arose as a result of a cyclone in America. Some of these far-flung reinsurers assumed the risks by way of retrocession.

There are various reasons why insurance companies reinsure risks they assume. The first reason, which readily comes to mind, is that insurance business involves spread of risks. By reinsuring they are only being typical of an insurance establishment. Two, reinsurance makes it possible for insurance companies to punch above their weight. Without reinsurance, an insurance company will only accept risks within its retention capacity. But due to reinsurance, insurance companies are able to accept risks larger than they can accommodate. They simply take the portion or percentage within their capacity and reinsure the balance. Three, insurance companies use reinsurance to protect themselves. Minus the reinsurance protection, a single major loss or a series of losses can send an insurance company out of business.

Four, reinsurance helps to reduce fluctuation in the technical results of insurance companies. Facultative and Stop Loss Reinsurances are particularly suited for this purpose. Five, reinsurance companies offer technical support and training for insurance companies. Some of these reinsurance companies have been around for a long time and have unbelievable body of knowledge and expertise which they make available to insurance companies. Six, insurance companies may be motivated by arbitrage (“arbitrage is the practice of taking advantage of a price difference between two or more markets striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices”) in purchasing reinsurance coverage at a lower rate than they charge the insured for the underlying risk, whatever the class of insurance.

Seven, by regulation, all insurance companies operating in Nigeria must have a Reinsurance Treaty arrangement in place and submit a copy of the treaty to the National Insurance Commission, the insurance industry regulator.

There are various types of reinsurance arrangements tailored to suit different classes of insurance and specific situations. We have Facultative Reinsurance, which is the oldest form of reinsurance. Here each reinsurance cover protects the cedant for an individual risk. It is a one off contract. Each risk the cedant wants to place with the reinsurer is presented separately. The reinsurer assesses and decides to accept or decline. Where the reinsurer accepts, it states its conditions and the portion it is taking.

The second type of reinsurance is called Treaty Reinsurance. Here, there is a prior agreement between the ceding company and the reinsurer, where the ceding company agrees to cede and the reinsurer agrees to accept all risks within the agreement (treaty) over a stipulated period. Treaty Reinsurance is divided into two: Proportional Treaty and Non-Proportional Treaty. Under Proportional Treaties, we have the Quota Share Treaties and the Surplus Treaties. Under Non-Proportional Treaties, we have Excess of Loss Ratio also known as Stop Loss, Catastrophe Excess of Loss and Working Excess of Loss, among others. We do not need to go into details of how each works. All we need to know here is that under Proportional Treaties, losses are shared in fixed proportion between the cedant and the reinsurer, while that is not the case with Non-Proportional. Sometimes, the reinsurer does not even participate in claims payment unless the loss is in excess of the amount fixed (retention limit) by the ceding company.

If policy holders are not privy to a reinsurance contract, why bother them with the topic? One, we just want to give policy holders an idea of the extent insurance has gone to ensure they are protected come what may. Two, your broker might not bother you, but brokers are always interested in the reinsurance arrangements insurance companies have in place before placing business with them. This is especially so with large businesses and highly technical risks where reinsurance is inevitable. A broker might not bother asking for reinsurance arrangement while placing a motor business with a sum insured of N2 million. This is because the risk is small and the insurance company will likely retain it 100 percent. But if the risk runs into billions of naira, the broker knows the insurance company will not retain the risk 100 percent and so is interested in the insurance company’s reinsurance arrangement.

Another way to place large risks is through co-insurance (placing it with more than one insurance company in agreed proportions).