Reinsurance: how and why

Reinsurance: how and why

Reinsurance: how and why 520 265 Rupert Swallow

Behind the scenes, reinsurance is critical to almost every insurance policy sold. This insurance-for-insurers provides standby capital for the insurance companies named on the policy, and therefore protects them from severe financial losses arising from large claims, or from clusters of losses caused by made catastrophes. Reinsurance therefore allows insurers to take on more and greater risks, and thus is a crucial part of the insurance value chain.

Traditional reinsurance comes in two types:

  1. facultative, which transfers a portion of reinsured losses arising under a single insurance contract, and
  2. treaty, which does the same for a specific portfolio of policies.

Both types of reinsurance can be proportional, when the reinsurer provides indemnity for a set proportion of all claims, or excess of loss, which covers the part of any claims which exceed a certain threshold.

Reinsurance spreads risks. Facultative contracts let insurance companies underwrite individual risks like factory fires and construction projects which are greater than they may be able to bear on their own. Proportional treaty reinsurance allows insurers to sell many more policies of a specific type – motor, for example – than their own capital otherwise allows. Excess of loss reinsurance protects insurers from accumulations of losses, such as the geographical bunching of homeowners’ claims which often follows a significant storm.

A different and increasingly important area of reinsurance is the backing of managing general agents (MGAs). These are intermediaries with authority to price and accept risks against their reinsurer’s capital, and sometimes to issue policies in the name of their reinsurer. Such relationships are mutually beneficial: the reinsurer gains access to speciality risks that they wouldn’t otherwise see, while the expertise of the reinsurer is deployed through MGAs to help them introduce targeted new products designed specifically to support their distribution strengths.

Such knowledge-sharing is an important benefit of reinsurance. Through reinsurers, expertise normally located in London can be deployed anywhere. In addition, reinsurance brokers have advanced analysis tools to help insurers evaluate individual risks, and to construct a diversified and balanced book of business, which lets them maximise returns on capital.

Currently world-wide reinsurance prices are low, and levels of competition between reinsurers are high. Competition leads to innovation in distribution and product design, and supports the growth of MGAs, which give reinsurers inexpensive access to attractive risks. Current reinsurance market conditions also benefit ultimate insureds: low prices trickle down to the cost of underlying policies, making each policy sold less expensive.