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REINSURANCE: CREATING VALUE & RISK MANAGEMENT
Introduction The concept of Reinsurance, though known, is still a less popular one in Insurance Industry and even general policy-holders are not very familiar with this term. An insurance company uses this tool to transfer a portion to one or more insurance companies. In a general language, Reinsurance is a process in which an insurer transfers certain percentage of its business risk to another company, which will then reimburse the loss that insurer may face in his business. It makes the risk management process of insurance companies more effective and economical. Reinsurance is a transaction in which one insurer agrees for a premium, to indemnify another insurer against all or part of loss that insurer may sustain under its policy or policies of insurance. The company purchasing the reinsurance is known as the Ceding Insurer (or Primary Insurer) and the company selling reinsurance is known as the Assuming Insurer (or simply Reinsurer). The transaction is also described as "The Insurance of Insurance Companies". It is a risk management tool that spreads the risk so that no single entity has to bear the burden of paying back beyond the limit. Reinsurance companies indemnify a certain percentage of the losses which the primary insurer is unable to pay or the amount of loss is beyond the capacity of the primary insurer. Reinsurance process can be presented diagrammatically as below: -

It is an independent contract between the reinsurer and the primary insurer, and the original insured (A) is not a part of the contract. If the claimant is an individual or even a group of individuals, an insurance company will find it relatively easy to cover the claims. But if there are a huge number of claims at the same time and the loss is massive and widespread, this may not be possible.

A reinsurer enters into a reinsurance agreement for a very specific reason - either the nature of risk insured, or the business strategies of the insurers, or other possible reasons. Reinsurance is an important criterion to determine the success of insurance business. Reinsurance mainly covers catastrophic risks that are not predictable and cause the greatest exposure for the insurance companies. The September 11 attack was a similar situation. A single insurer will not be able to bear such damaging financial impact so the unbearable loss is broken down into bearable units by risk transfer. The amount of risk a company limits depends upon the contract terms as well as factors like worth of assets, trends of inflation in the economy, the price of the insurance products, and the type of risk. Principles of Reinsurance Reinsurance contract basically depends upon three principles: Principle of Utmost Good Faith - Reinsurers maintain utmost faith in underwriters of their company. These underwriters, in turn, maintain utmost good faith in the underwriters of the primary insurance company. Principle of Indemnity - The principle of indemnity of the insured risk applies automatically on reinsurance. A reinsurer automatically follows the legal and technical features of the reinsured in writing and underwriting a risk. The Insurer Must Retain a Part of the Risk Before Reinsuring. Though there cannot be the reinsurance of the complete risk, there can be a complete retention of risk. Those risks that are within the retention capacity of an insurer must be retained completely. How Reinsurance Creates Value to Primary Insurers? Reinsurance benefits primary insurers in following ways: • • • Reduced volatility of underwriting results Capital relief and flexible financing Excess to reinsurer's expertise and services, especially in the fields of product development, pricing and underwriting and claim management.

The above benefits vary in focus for Life and Non-Life Insurance. Non-Life Insurance Non-life insurance buys reinsurance to protect its capital base against large deviations from expected loses. This is most essential in case of catastrophic losses. Reinsurance allows non-life insurers to accept more business with the same amount of capital. By buying reinsurance coverage, insurers transfer risk to reinsurers and do not allocate capital for these risks. Thus primary insurer can spread their overhead cost of distribution network, administration and claim handling over a broad base of business and thereby benefit from economies of scale. Reinsurers play a key role in the assessment and underwriting of risk. They also ensure the continuous supply of insurance coverage to companies in the time of market distress. Reinsures operates in international environment and they have long term experience, which helps in effective claim settlement to the benefit of insurers and policy-holders. Life Insurance Life insurers buy reinsurance to minimize the potentially negative impact of large risks. Life insurers want to limit their exposure to high sum assured for individual risks or to avoid an accumulation of mortality risk in case of group cover schemes. Moreover, long term reinsurance contracts protect insurers against claims variations, for instance, variations in mortality over time. One of the major reasons for entering into reinsurance contract is that reinsurers provide expertise in underwriting and claim management as well as on pricing and product development. Since reinsurers operate globally, they have broad and deep understanding of markets, products and also large data of insured populations. Thus, reinsurer assists primary insurers with high quality underwriting tools, training to insurer's underwriter and other skills. They also help in claim management by providing guidelines on claims assessment and training of insurers and ultimately benefiting policy-holders also. Reinsurers' broad expertise also helps insurers in product development and pricing of new products. Insurers can refine risk into broader classes and can minimize their exposure with the help of innovative products. Since they mainly focus on savings and investment business, life reinsurer allows them to transfer some proportion of mortality and disability risk component. Reinsurance helps to reduce capital strains. By transferring risk, life insurers can reduce their capital requirements and can use the freed-up capital into new lines of business expansion or new geographical areas. As a protection business, they require huge capital and reinsurance helps to ease this strain. Reinsurance as a Risk Management Tool

Reinsurance is used by primary insurers as an effective risk management tool. Primary insurers can use different types of reinsurance products to meet their need of balance sheet protection and capital relief. They draw their reinsurance plan by using all forms and types of reinsurance contracts. The primary insurers use some techniques to transfer their risk to reinsurers and also to analyze what type of contract will be suitable for them according to their risk portfolio or the policies underwritten by them and the terms and conditions mentioned therein. Based on its business needs, an insurer negotiates with reinsurer, directly or through a broker, to determine the terms, conditions and costs of a reinsurance contract. Under this contract, an insurer is indemnified for losses occurring on its insurance policies and covered by reinsurance contract. Traditional Techniques Used by Primary Insurers There are basically two types of reinsurance agreements: 1. Treaty 2. Facultative 1. Treaty Reinsurance Treaties automatically cover all risks written by the insured that fall within their terms, unless they specifically exclude exposures. It does not require to review individual risks, but there should be a careful review of underwriting philosophy, practice, historical experience of the primary insurance company, its attitude towards claim management and engineering control, management's general background, expertise and planned objectives. Treaties are of two types - Proportional and Non-Proportional. Non-Proportional Treaty In this type of treaty, reinsurance cover begins once the amount of the claim exceeds a pre-determined amount. For example, in a contractual language, it is termed as, treaty of Rs. 600 Crores in excess of Rs. 100 Crores, i.e., a Rs. 700 Crores cover with a deductible of Rs. 100 Crores. Now if a loss occurs and if its cost is less than Rs. 100 Crores, then only primary insurer has to consider it. But if the loss is more than Rs. 100 Crores, then liability of primary insurer is up to Rs. 100 Crores, and excess claim should be paid by reinsurance company.

Proportional Treaty

In this type of treaty, the reinsure and the ceding company share the premium proportionally. For example, as per the agreement, if the proportionate share of the premium between both the parties (ceding insurer and reinsurer) is 40% and 60% respectively, then in case of total loss of Rs. 100 Crores, primary insurer will pay Rs. 40 Crores and the reinsurer the remaining Rs. 60 Crores. Each year insurance companies provide their reinsurers with information on intended policies concerning maximum exposures, estimated premium income, classes of business, marketing strategies, etc. Before the start of the year, they finalise treaty conditions depending upon the program and terms negotiated. Facultative Facultative reinsurance contracts cover individual policies and are written on an individual basis. This agreement covers specific risks and requires substantial personnel and technical resources for underwriting individual risk. Since there is a potential loss in these types of agreement, reinsurer must possess necessary knowledge to calculate each risk accurately. These contracts are also used to supplement treaty arrangements, when treaties don't cover any specific risk or exclude that risk. Separate facultative can be used to cover this by entering into agreement with another reinsurer. Retrocession Sometimes reinsurer also may not be able to cover full exposure as per agreements so he again buys its own reinsurance known as retrocessions, to stabilize results and fulfills risk-spreading objectives of reinsurance transactions. Reinsurance agreements range from simple to complex. An insurer may purchase reinsurance cover from a single reinsurer or it can cover the same risk by reinsuring it with many reinsurers. This process is known as Layering. It is again one of the risk management tools of primary insurers. Non Traditional Techniques From past few years, some new risk transfer techniques have been used known as "Alternative Risk Transfer" Techniques like finite reinsurance for both life and non-life reinsurance and multi-year, multi-risk property / casualty contracts. Finite contracts contain major profit (loss) sharing elements, which limit the risk transfer to the reinsurer. Under multi-year, multi-risk property / casualty contracts, reinsurers commit to pay only if the total losses for several different risks over an extended period (often three years) exceed a fairly high threshold. Premiums for these contracts are low, because they are designed to cover only that low frequency, high severity cumulative losses that are unbearable by primary insurers.

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