The road to security and ex pansion

A company will wish to ensure its long-term survival so it can offer security to its own policyholders. In order to do this a company needs to protect itself from exceptionally large losses or accumulations of losses.

The company's management may wish to further stabilise its claims cost so that annual underwriting results fluctuate within an acceptable range. Reinsurance will enable a company to underwrite larger risks and participate in business that may be affected by the same event or occurrence. It can also be used to help finance growth in underwriting, particularly in new territories or for new lines of business.

The chart (above right) shows the main types of reinsurance. Conventional reinsurance can be classified as either proportional or non-proportional. Under a proportional reinsurance, the reinsurer accepts a fixed share of each risk assumed by an insurer in return for a fixed share of the original premium.

Under a non-proportional reinsurance, the reinsurer becomes liable to pay only if the claims incurred by the insurer exceed a predetermined amount, so the reinsurance is provided in excess of a certain point. Broadly, proportional reinsurance is linked to the sums insured of risks within a portfolio whilst excess of loss is linked to the losses incurred.

Important factors
A distinction is also drawn between facultative and treaty reinsurance. Facultative is used to refer to single risk reinsurance which is negotiated individually and can be written either on a proportional or non-proportional basis. A treaty is an agreement between a ceding company and its reinsurers to cede individual reinsurances. The reinsurer does not have the right to accept or reject each individual risk.

Quota share and surplus reinsurances are arranged on a treaty basis. There is no treaty agreement with excess of loss reinsurance so, strictly speaking, this is not treaty reinsurance, although it is quite common to refer to an excess of loss treaty.

The following analysis will discuss the important factors affecting reinsurance. Both facultative proportional and facultative excess of loss have been omitted. Facultative reinsurance is used to access capacity for large single risks or when a specialist risk falls outside a company's proportional treaties. The following analysis concentrates on reinsurances that provide cover across a portfolio of a company's business.

The simplest form of proportional reinsurance, a quota share, is an obligatory ceding treaty. In this, a formal agreement exists between the reinsured and reinsurer, under which the reinsured is obliged to cede a fixed percentage of all business covered by the treaty and the reinsurer is obliged to accept all cessions. The negotiation between reinsured and reinsurer focuses on the commissions allowed under the treaty. There are no pricing issues.

A quota share may be the most appropriate form of reinsurance for classes of business where the definition of a single risk or single event is difficult. The partnership structure of a quota share treaty as an agreement between two parties often suits the underwriting of a new class of business, with both taking a pro rata share of each risk.

It is an ideal form of reinsurance if a company is ceding a large volume of premium. If a company has insufficient capital for the account it is underwriting, a quota share will reduce its net income. In the long term the company will need to raise capital but this takes time and costs money. The company can be provided with temporary relief from `soft capital' in the form of a quota share.

This form of reinsurance can be applied to in-force business as well as an account as it is underwritten.

Like quota share reinsurance, a surplus is an agreement under which the reinsured cedes reinsurance to a reinsurer. However, unlike a quota share, where a fixed percentage is agreed in advance, the reinsured company only cedes that part of each risk that is surplus to its net retention. So, as a company's net retention varies, so will the percentage cession to the surplus reinsurer. Surplus was the most common form of reinsurance in the 1970s before it was overtaken by excess of loss.

The main advantage of a surplus over quota share is its flexibility. It can be used to correct imbalances in a reinsured's account or provide capacity for larger risks. For example, a reinsured might retain smaller risks for its net account and cede a proportion of larger risks to a surplus, reducing the volatility or range of possible outcomes for its net account.

However, although a surplus can reduce a company's exposure to large losses, whether from single risks or from an accumulation of losses from a single event, it is not the most efficient way of addressing these problems. For this, companies increasingly turn to excess of loss reinsurance.

Excess of loss, or non-proportional, reinsurance is designed specifically to provide cover for large losses (see chart below right). It normally allows the reinsured to retain most of its gross premium. The reinsured is covered against the balance of any loss occurring on the reinsured portfolio in excess of an agreed amount. Cover is usually placed in layers with specified monetary limits.

Administration costs associated with this form of reinsurance are comparatively low. Excess of loss reinsurance covers a company's account net of pro rata reinsurance. A minimum and deposit premium is paid up front by the reinsured company, so this type of reinsurance has important cash flow implications.

Catastrophe deductible
Within the excess of loss category, risk excess of loss gives a company cover for large losses from individual risks within a portfolio. A risk excess will reduce a company's loss from an accumulation of losses from a single event or over a period, but it will provide only limited cover for this type of event.

Also in this category, occurrence or event excess of loss specifically provides cover for a company's aggregate loss from a large single event excess of a catastrophe deductible. For a property account this type of cover is referred to as catastrophe excess of loss. Normally, there is no cover for large individual risk losses and, frequently, it is subject to a two-risk warranty which makes this restriction explicit. For this type of cover, definition of a loss occurrence can cause problems, in particular, the difficulty of defining what constitutes a single event. Typically a contract will have an hours clause, setting a time limit for single events, nevertheless, this area can still cause problems as the recent terrorist losses in the US demonstrate.

A stop loss provides a company with cover for its aggregate net retained loss for a period in excess of a deductible, expressed either as a monetary amount or, more often, as a percentage net loss ratio. A stop loss will usually provide cover after a company has made recoveries from all its other reinsurances, including catastrophe excess of loss reinsurance. It provides no cover for individual risk losses, although individual losses contribute to a company's net retained loss over a period.

An important issue to remember with excess of loss reinsurance is that it is normally a limited form of cover. The excess of loss contract will have a limit for each and every loss occurrence and will be subject to a reinstatement clause limiting cover to a certain number of full limits. For example, it is common for catastrophe reinsurances to have one reinstatement. What this means is that there is unlimited cover for partial losses within the contract limit, subject to an overall ceiling on the aggregate losses collectable in a year to twice the occurrence limit. A pre-agreed additional premium will be payable to reinstate the limit and this is usually pro rata as to the amount of the loss, but 100% as to time, regardless of when the loss occurs.

For risk excess of loss the number of reinstatements will vary depending on the type of portfolio that is being covered. If the portfolios loss experience is stable and predictable it may be possible to obtain unlimited reinstatements. In reinsurance market jargon, this provides unlimited sideways or horizontal protection. Even if a risk excess of loss reinsurance for a property account has multiple reinstatements, it is usual for there to be a limit to the number of reinstatements for catastrophic losses.

Reinsurer security
Of course, however comprehensive a company's reinsurance programme appears to be it can prove valueless if the security of the reinsurers used is inadequate. In the London Market, recent years have brought problems, such as asbestos and pollution, and large catastrophe losses including, most recently, the WTC loss in the US. All these problems have served to heighten the importance of reinsurer financial strength.

Rating agencies have an important role to play here. Most managers of insurance companies pay attention to financial strength ratings as a clear indication of the quality and reliability of reinsurance recoverables.

Reinsurance plays an essential role in the risk spreading process and provides insurers, with varying degrees of financial stability. AM Best evaluates a company's reinsurance programme to determine its appropriateness and credit quality. A company's reinsurance programme should be appropriate relative to its policy limits, underwriting risks and catastrophe. Particular attention is given to the monetary level of a company's retention per risk relative to its gross premium income for each class of business.

Shock losses
To be considered adequate, a company's catastrophe reinsurance must protect a company's solvency against shock losses. While many other exposures can affect solvency, no single exposure can have an impact on policyholder security more instantaneously than catastrophes. Immediately following the WTC losses in the US a number of companies had to cease trading as a result of the impact the loss had on solvency.

This concern is reflected in the Best capital adequacy model. Each company's BCAR (Best's capital adequacy ratio) is directly adjusted to reflect a company's worst case loss scenario. This is taken as the higher of either a 100-year wind net PML or a 250-year earthquake net PML. The model also takes account of the quality of a company's reinsurance asset, allocating differential capital charges depending on the AM Best rating of each reinsurer from which recoveries are anticipated.

A company's ability to meet its financial obligations can become overly dependent upon the performance of its reinsurers. As a result, the company may become heavily exposed to the state of the reinsurance markets in general. This can become a problem if an important reinsurer to a company becomes insolvent or disputes coverage for a claim. It can also become a problem if reinsurance rates, capacity, terms and conditions change dramatically following an industry event. The more dependent a company is on reinsurance, the more vulnerable its underwriting capacity is to changes in the reinsurance market.

The table below shows the level of reinsurance ceded as a percentage of gross premium written for the 40 largest UK general insurers. A high level of reinsurance ceded will signal high dependence to AM Best, although further investigation will be required. For example, a large volume of business may be ceded between subsidiaries with common ownership within a large insurance group. Used in this way, reinsurance may be a means of allocating capital within the group. It is also common for insurers that specialise in highly volatile lines, that are prone to catastrophic loss, to place more reinsurance. Many insurers that operate in the London Market buy reinsurance in this way.

At the other end of the scale a company that places very little reinsurance may be missing opportunities that the reinsurance market offers to reduce volatility in its performance and protect against catastrophic loss. Alternatively, a company may not need to buy a great deal of reinsurance if it writes a stable book of small risks that has no significant catastrophe exposure. For example, it would be possible to write some personal lines business with very low reinsurance requirements.

Reinsurance poses a number of complex problems for credit analysts. AM Best addresses these problems in a structured fashion, incorporating reinsurance analysis into its models. However, as with all areas of credit analysis judgment must be applied to arrive at reliable conclusions.