Reinsurance : Risk Allocation and Managing Risk

Reinsurance is the condition when one primary insurance company assign or transfer risk to another insurance company (or groups companies). In cases of life insurers, the object that is transferred can be risk of mortality, investment risk, surrender or the combination of those.

The process for reinsurance may occur in several circumstances where the company and/or insurers are facing some limitation. Let say an insurance applicant who has unusual risk condition, or need life insurance policy with higher nominal value (bigger than a retention limit of the insurance company). In this situation, the applicant may get policy but part of the risk is transferred to another company as reinsurer party. The company need to transfer it often because ceding company has to limit the mortality risk of its insured party. In other situation, the company want to determine the risk of group of policies to avoid the variations of claim amounts or perhaps to prevent receiving claims of multiple deaths from one single events.

It is estimated that 88 % of life insurers premiums in the year 2007 were ceded as reinsurance premiums. More than 80 % insurers who paid accident and health premiums, about 80 % ceded as accident and health reinsurance premiums.

Risk Allocation

Insurance companies are adopting reinsurance to spread and disseminates risk of loss between them. Insurance risk can be reduced further if there are more than one reinsurer party involved. Retrocessionaire is the condition where reinsurer then transfer risk to another reinsurer company, again. Single primary insurer cedes business to a single reinsurer, this is the most basic reinsurance arrangement. When both companies are owned by a parent company, this is known as an affiliated company relationship. This absorbed reinsurer risks solely from an affiliated company or group of companies.

The reinsurer in turn may demand to cede at least some of that risk allocation, especially if it is outstandingly large or exceeds the reinsurer’s own retention limitation. Retro ceding or transfer risk from one reinsurer to another, may require similar arrangements. In this situation a reinsurer may retrocede risk to a group of reinsurers, or retrocessionaires.

It is estimated that the total reinsurance in 2007 was $70billion. This amount is an increase of 13 % from previous year. The average annual growth of reinsurance assumed between 1997 and 2007 was 5.5 %. Individual reinsurance premiums as part of accident and health market is grown at responsive pace at a 12 percent annually (between 1996 and 2006). Data for all three markets include retrocessionaires.

Managing Risk

As mentioned above, the main reason for reinsurance is to transfer mortality, investment risk, or surrender between companies engaged in reinsurance. In traditional reinsurance, the company still retains legal obligation of the policy and financial relationship with policyholder. Policyholder may not even be aware that some of the risk on their policies are extended by an reinsurer company. This type of reinsurance is more often called indemnity reinsurance. It is called indemnity insurance because one company indemnifies another company for potential losses which may incurred.

Another type of reinsurance involves the total and permanent transfer of risk from one company to another. In assumption reinsurance, the reinsurer replaces the ceding company in transactions on sections of business, issuing new policyholder certificates. In effect, one company purchases a section of business from another company and becomes directly and legally responsible to the policyholder, while the original company terminates its future obligations. References to reinsurance signify only indemnity reinsurance. It is possible to transfer total and permanent risk from one company to another. In this situation the reinsurer substitutes the ceding company in proceedings transactions on sections of business like writing out certificates for new policyholder. References to reinsurance signify only indemnity reinsurance.

Reinsurance also enables a ceding company to manage its financial position. A reinsurer can provide allowances based on its expectation of future benefits. This will further increases the ceding company’s statutory profits.

If the reinsurer establishes a proportionate share of reserves on its books for policies reinsured, the ceding company is not limited to using that surplus to set up legally required reserves—an option especially valuable when issuing new policies. In this condition the initial cost are higher than premiums received. Likewise, a company can improve its risk-based capital ratio by reinsuring some of its risk.

Companies further look at tax advantages when reflecting reinsurance placements. When the ceding company’s aim is to improve its financial position, transfer risk are known as financial reinsurance. The face amount of life reinsurance assumed decreased 19 % to $1.2 trillion in the year 2007. This decrease was forced back by a 20 % reduction for personal life reinsurance. The number of life policies assumed decreased 25 % in the same year.

In some situation, reinsurance is also benefited you because it allows the assignment of a company to manage your financial situation. A reinsurer can the subsidies on the anticipation of future profits, for the sale of the company and the profit gain during the year.