Reinsurance is insurance of insurance, where one or more insurance companies agree to indemnify the risk, partially or altogether, for the policy issued by another one or more insurance companies.
Reinsurance indicates the process where the original insurer accepted the risk from the original insured gets the risk covered by another insurer or reinsurer for the same reason the original insured got protection.
Before proceeding to the study of reinsurance, the students must understand the meaning of certain terminologies commonly used in the reinsurance business transaction.
In the absence of such understanding, the student is likely to get confused, and the study might mean obsolete to him.
The terminologies are:
What is Reinsurance or Reassurance?
This means insurance of insurance. The original insurer gets the risk, assumed from the original insured (primary insured), and covered (reinsured) with another insurer (known as reinsurer) for the same reason as the primary insured does.
The primary insurer, here, in fact, becomes the insured (known as reinsured), and the person or body or company giving him the protection becomes the insurer (known as reinsurer).
Definition of Reinsurer or Reassurer
Meaning the person, body, or company giving reinsurance cover. They protect the insurer’s interest in case of loss/damage of the property or subject matter insured and for which the insurer is liable under the policy of insurance.
Definition of Reinsured / Reassured /Ceding Company / Direct Co-primary or original Insurer
All these terms relate to, indicate, or identify the insurer who primarily assumes the primary insured’s risk and then gets the same reinsured according to need.
When an insurer reinsures the risk, he becomes known as reinsured/reassured/ceding company/direct company/original or primary insurer.
Related: Importance of Reinsurance Industry
What is a Ceding Company
The company ceding the risk, i.e., getting the risk reinsured, and has already been discussed.
What is Cession?
This means the amount of risk ceded for reinsurance, i.e., the amount reinsured.
What is Retrocession?
Means reinsurance of reinsurance. A reinsurer may like to get his interest protected by further reinsurance and so on.
What is Retention?
This refers to the amount of risk retained by the ceding company. The balance is usually reinsured. The amount of retention is dependent on the financial strength of the ceding company for that class of business. It is the refined figure of another term known as LIMIT.
Normally “Limit1’ is a rough guide of the ceding company, and depending on the quality and nature of the risk, the ceding co. may decide to enhance or reduce the limit for actual retention.
What is Line?
A line is equivalent to retention, i.e., the amount retained by the ceding co… A reinsurance arrangement is usually expressed in terms of “line,” meaning that if a ceding company has a ten-line or twelve-line reinsurance arrangement (TREATY), it can automatically cede reinsure up to ten times or twelve times of the amount retained.
Who is a Primary Insured / Assured?
This refers to the primary insured (assured) originally insuring the risk at the first instance. He is one of the parties to the insurance contract and not in the reinsurance contract.
What is Reciprocity?
This is a widely used term in the transaction of the reinsurance business, indicating a situation involving the desire for the satisfaction of mutual interest.
Normally, the direct insurers do transact reinsurance business in addition to the insurance business at one time or the other.
When they cede reinsurance business as such to another company, they also expect that at different times that company also would cede reinsurance business to them. This understanding of looking after each other’s interests is expressed by the term ’’Reciprocity”.
Broadly, speaking reinsurance is insurance for insurance. This means that the original insurer (who originally accepted the risk from the original insured) gets the risk covered with another (Reinsurer) for the same reason the original insured got protection for.
Many risks in almost all business classes may be too big for an insurer to digest or bear on his own account.
The insurer’s financial strength on that account may not be potent enough to bear a loss if it at all takes place.
Moreover, there is the question of big catastrophe losses, which might cripple down the insurer financially and force him to disown any liability to the insured simply because of the inability to honor a claim.
Whilst this possibility is very much there, on the other hand, the insured is also most reluctant to go from insurer to insurer and to place only that amount of business to each, as each would be able to bear.
It is indeed amidst these two extremes that we see the development of a system wherein the insured goes to one insurer which usually takes the whole risk and reinsures any balance beyond his retention capacity (i. e., beyond which he cannot consume from the viewpoint of financial strength for that class of business) with the reinsurers.
Reinsurance, like insurance in general, has the element of chance involved. The reinsurer hopes that his premiums will take care of his losses and that he will obtain a profit in the course of events.
When an insurer accepts risk for a huge amount of one event, although he may be in a position to make a reasonable gain, yet indeed he has subjected himself to serious possible liabilities.
Under such circumstances, he may desire to reinsure a part or all of the risk with some other company or insurer. Reinsurance steps in as a method whereby the insurer may receive indemnity from his reinsurer in the event of reinsured’s liability to the original insured.
Some examples may be considered at this stage.
In life insurance, the actuary can predict with some certainty as to how many lives of a given age will die within a certain period. What he cannot forecast is which of the named persons will exactly die.
This ignorance or limitation of knowledge, in fact, has aggravated the necessity of reinsurance further.
If a life company has 100000 lives all aged 20 and each insured for $10,000, and if this company now gets a fresh proposal from a managed 20, but for an amount of $30,000, then a problem would arise since the company shall have to run the risk of an additional amount of $20000 which will definitely imbalance the account if simply the new entrant dies first. Therefore, this company shall feel the necessity of getting its load ( $20000 in this case) reinsured with another company.
A general insurance company may have the capacity to bear up to $100000 for any property insurance or liability insurance.
If a risk is placed for $300000 by the insured, the insurer shall have to reinsure $200000.
In the case of assuming unlimited liabilities, the extent of loss may sometimes be considerable and, therefore, in all fairness, should have reinsurance arrangements beyond capacity.
After seeing the terms related to Re-Insurance and examples, let us look at the various definitions given in the following paragraphs.
By a reinsurance agreement, the reinsurer may undertake to reinsure the assured (i.e., the reinsured or reassured), considering the assured paying him a portion of the premium the assured receives against the proportionate amount of all assured’s losses arising from insurances along a certain line.
This arrangement could not constitute a partnership but would, in fact, be a contract of reinsurance (English Insurance VS. National Benefit Insurance (1929), A. C. 114 ). This definition understandably refers to a treaty agreement discussed later.
Reinsurance is an agreement to indemnify the assured (meaning reassured), partially or altogether, against a risk assumed by it in a policy issued to a third party.
– (Friend Bros V. Seaboard Surety Co, 56 N. E. 2d 6).
A direct company may find that it has placed itself under liability to many policy-holders. It may consider that it has undertaken more than it can safely carry.
Therefore the company, because of its outstanding contractual obligations, may desire to protect itself. It may seek to lessen its burden by getting some other company to assume a part of its liability in case of a loss.
The ORIGINAL OR PRIMITIVE OR DIRECT insurer, as is often called to represent the direct-writing company, may transfer or cede the whole or part of a risk to another company.
The first insurer or cedar, in turn, enters into a contractual relationship with the second company, which is called the REINSURER. The original or the primary insurer is obligated directly to his insured or the policy-holder. The reinsurer is obligated to the ceding company.
The original insurer has to account for its original assured in case of loss under a primary policy.
The direct company, known as the reinsured, by its contract may obtain the power to collect from the reinsurer because of the loss suffered by the original assured under the terms of the original policy. There may arise a contract of reinsurance from the business relationship established between the reinsurer and the reinsured.
The students should appreciate that the risk assumed in reinsurance is necessary to be determined by examining the parties’ intention to reinsurance contract itself, since it may so happen that the risk covered by the reinsurance contract is not the same as that covered by the original, policy.
A reinsurance transaction is a relationship of utmost good faith, established between two parties, which is based primarily on contract or understanding whereby one party, called the reinsurer, in consideration of a premium paid by the reassured agrees to indemnify under certain terms and conditions, another party, the reassured, against a risk previously assured by the latter, the direct writer, in its primary insurance covering the original assured.
“Reinsurance is a contract which one insurer makes with another to protect the first insurer from risk already assumed” (Bethke Vs. Cosmopolitan Life Insurance Co., 262, APP 586).
“It involves the principle of indemnity” ( Union Central Life Insurance Co. Vs. Lowe, 182 N. E. 611).
The contract of reinsurance was also defined in the American case of Stickel Vs. Excess Insurance Co. of America, Ohio Supreme Court; Nov. 22, 1939, 23 N. E. ( 2nd) 839 as “A contract whereby one, for a consideration, agrees to indemnify another wholly or partially against loss or liability because of a risk the latter has assumed under a separate and distinct contract as insurer of a third party.”
The students should recall that the primary concept of insurance is to spread the risk or loss of one onto many’s shoulders.
Whilst it becomes unbearable for a man alone to bear the load of a loss, it becomes quite easier when a group collectively shares the same. In reinsurance also the same principle or concept is involved. It is indeed sharing and re-sharing of risks or spreading and further spreading of risks.
The necessity emerges out of the same need as is felt by the original assured.
Reinsurance is not double insurance or coinsurance since in such contracts, unlike reinsurance, there is a direct contractual relationship between the insured and insurer or co-insurer.
The students should get acquainted with a widespread term, known as retrocession, widely used in reinsurance transactions. This virtually means reinsurance of reinsurance.
The students should appreciate that reinsurance enjoys no immunity from the operation of the principles governing sound practice for insurers.
The reinsurer must also avoid a concentration in conflagration areas or catastrophe situations and maintain a wide distribution of its risks assumed from the ceding company.
The reinsurer may probably have sufficient amounts ceded from several different sources, and unfortunately, the cession may relate to the same risk.
To relieve itself from this undesirable accumulation, the reinsurer would itself have to resort to reinsurance. This act of reinsuring any part of reinsurance is termed as retrocession and comes within the same reinsurance study.
To sum up, therefore, it may be said that:
- To secure a large number of similar risks to permitting the prediction of losses with a reasonable degree of certainty, insurance companies have devised the practice of reinsurance.
- Reinsurance is the transfer of insurance business from one insurer to another. Its purpose is to shift risks from an insurer, whose financial security may be threatened by retaining too large an amount of risk, to other reinsurers who will share in the risk of large losses.
- Reinsurance tends to stabilize profits and losses and permits more rapid growth.
- The entire area of reinsurance and retrocession is an example of the essential need for a spread of risk among many risk bearers. Much of the process goes on without the policy-holder being aware of its existence since he is not a party to the reinsurance arrangement.
- Reinsurance enables a risk to be scattered over a much wider area, which is the primary concept of the whole business of insurance.
- The need for reinsurance arises in the same way as an original insured needs insurance protection.
- The original insured is not a party to the reinsurance contract.
Types of Reinsurance
Having completed the various types of reinsurance arrangements, discussions will now be made regarding the forms they usually take. There are two forms of reinsurance, irrespective of the type of reinsurance discussed so far. These are;
- PARTICIPATING OR PRO-RATA: Where the proportion of amounts payable by the insurer and the reinsurers regarding a loss is determined and agreed beforehand, i.e., before a loss. Here, the insurer’s premium is also distributed between himself and the reinsurers in the same proportion. Examples are facultative, quota share, surplus, or pool.
- NON-PROPORTIONAL: The reinsurance is on different terms, and the reinsurers do not stand to be proportionately liable for a loss. Therefore, the premium received by the insurer is also not required to be proportionately distributed to the reinsurers. Examples are an excess of loss treaty, stop loss treaty, etc.
11 Legal Considerations of Reinsurance
In the reinsurance business, 11 legal aspects should be considered for comprehensively dealing with the complex matters in reinsurance.
The students should appreciate that the business of reinsurance is very much within the four walls of the business of insurance, and
As applicable to the business of insurance, most of the legal considerations will also equally hold good in so far as the reinsurance business is concerned.
The students should also appreciate that it is not possible to deal comprehensively with the vast legal matters surrounding reinsurance in a few pages.
Nor is it the intention either. Only those very vital matters would be indicated here which a student of insurance, particularly at this stage, should ordinarily know.
The important legal considerations are summarized below in stratum.
- As a general rule, reinsurance is a contract between the direct insurer and the reinsurer. The original assured is not a party and does not obligate the reinsurer to the assured. (Baltica Insurance Co. V. Carr, 330 ). If the reinsurers fail to meet their liability, the direct insurer would still be liable for the policyholder’s whole loss. The policy holder’s redress lies with the insurer and not the reinsurer.
- Contracts of reinsurance require Utmost Good Faith on the part of the insurer. Generally, the same rules regarding misrepresentation and non-disclosure that apply in connection with ordinary insurance contracts apply in cases of reinsurance contracts.
Whereas an assured may not be under an obligation to describe his own bad character to his insurer, yet the insurer seeking reinsurance may be under the duty to disclose what he knows about the assured. ( loonies V. Pender (1874) L. R. 9 0. B. 531).
- The contract of reinsurance is equally subjected to the requirement of Insurable Interest. It is a legal financial.
- The interest entitles the insured or the insurer to insure or reinsure. Insurers have an insurable interest against the policy they have issued because of a loss’s possible financial involvement. This justifies the existence of insurable interest, thereby validating reinsurance contracts.
- Reinsurance is an agreement to indemnify the direct insurer, partially or altogether, against a risk assumed by him in a policy issued to a third party. (Friend Bros. V. Seaboard Surety Co. 56N, E. ALR 962). Reinsurance is a contract, which involves the principle of indemnification (Union Central Life Ins. Co. V. Lowe, 182 N.E. 611).
- The reinsurer is obligated to the ceding company. The direct company, known as the reinsured, obtains the power to collect from the reinsurers because of the loss suffered by the original insured by its contract with the reinsurers.
- There may arise a contract of reinsurance from the business relationship established between the reinsurer and the reinsured. The risk assumed in reinsurance must be determined by examining the contract of reinsurance. It cannot be taken for granted that the reinsurance contract’s risk is the same as that covered by the original Policy written by the direct insurer.
- Reinsurance does not mean double insurance. Double insurance exists where there are two policies in force covering the same insured’s same interest on hazards that are identically the same and involving the same subject- matter. In reinsurance, different interests and different parts are involved. Whereas in double insurance, the original insured has a direct contractual relationship with the insurer, in the reinsurance contract, he holds no contractual relationship.
- Reinsurance does not mean coinsurance for the same reason as explained under double insurance. Whereas in coinsurance, the insured is contractually linked up with the various co-insurers directly to the extent of respective shares assumed by them. In reinsurance, he (insured) is not a party at all.
- Usually, reinsurers are liable as per the liability of the original insurer. Therefore, when the original insurers, on different considerations, make exgratia payments without admitting liability under an insurance policy, they cannot claim recovery from their reinsurers.
- When after making a claim, the insurers make any recovery from the liable third party as per policy terms and conditions, the reinsurers become entitled to such recovery proportionately. This means that the principle of subrogation applies. The insurer cannot make a profit by recovering from all the sources.
As reinsurance contracts are contracts of indemnity, the principle of contribution also equally applies to reinsurance contracts. By affecting the reinsurance contracts, the ceding company cannot recover from each reinsurer’s full amount of loss independently.
Importance of Reinsurance Business
The main reason for the practice of reinsurance that it enables a risk to be scattered over a much wider area and the principle of insurance is taken well care of.
From what has been said so far, the students should be able to grasp the reason as to why reinsurance is resorted to. However, to sum up, in a systematic, disciplined way, the reasons can be grouped as under:-
- Risk Minimization by Spreading.
- Risk Transfer.
- Prediction for Rating.
- New Insurer.
Risk Minimization by Spreading
The fundamental concept of insurance is to spread the risk over as wider an area as possible to reduce the burden of loss at each stage.
To an insurer, the need for reinsurance protection arises in the same way as the insured needs insurance protection.
But for reinsurance, the business of insurance would not have developed to the extent of the present-day growth.
In the absence of reinsurance, insurers would have been bound to limit their acceptance of risk only up to such an amount that they could digest.
In other words, the insurers would have been unable to accept a risk beyond their financial strength or resources for that class of business. Consequently, insurers’ service to the public would also have been limited.
Reinsurance gives insurers flexibility by creating a condition that enables them to accept a risk beyond their financial capacity or resources.
The insuring community is also left care-free about various risks to which they are subjected, irrespective of whatever may be the value per single risk.
Reinsurance reduces the possibility of getting involved in an undesirable additional risk-load, which is otherwise eminent from the accumulation of risks from different sources.
Examples of such accumulation are,
(a) Heavy commitment on the cargoes of the same vessel,
(b) Heavy commitment on the cargoes lying in the same port possibly because of the arrival of all vessels at the same time and,
(c) The heavy commitment of an insurer on the property of a particular hazardous locality from the viewpoint of fire or conflagration fire.
It is possible that the various branches of an insurer, without knowing each other’s position, may commit individually, thereby giving rise to a situation of heavy unbearable commitment as mentioned in (a) (b) or (c) above.
Reinsurance reduces such worries of insurers and keeps down the pressure of accumulation to a sustainable limit.
An insurance company’s growth is particularly dependent on sound financial standing, which is primarily based on the stability of profit and loss. Profit cannot be expected if there is an untoward charge on the fund through a claim that it cannot sustain or for which there is no provision.
Reinsurance tends to stabilize profits and losses and permits more rapid growth of an insurance company.
Prediction for Rating
An insurer needs to have many similar cases in his book to predict an accurate rating structure.
But assuming a large number of similar risks is in itself undesirable unless some precautionary measure is taken.
It may not also be possible to get many similar cases by an insurer because of the operation of numbers of insurers in the market. Whatever it is, reinsurance takes care of such a situation in both ways.
On the one hand, it protects the insurer by providing unsustainable losses, and on the other creates a forum for getting a large number of similar cases through reciprocity.
A new insurer who has recently started transacting an insurance business cannot certainly develop and possibly cannot survive in the absence of reinsurance protection.