INSURANCE

DETAILED EXPLANATION OF REINSURANCE

MEANING OF REINSURANCE

This refers to an arrangement whereby an insurer, having accepted risk beyond his financial capacity, cedes part of the risk to another insurer. There are two parties involved in reinsurance: the ceding company and reinsurer. The ceding company is the original direct insurance company which has accepted the risk from the original insured and cedes or transfers part of the risk to another party. The reinsurer is another direct insurance company or a professional reinsurance company which accepts that part of the risk which is ceded or transferred.

This arrangement is possible because the original insurer (the ceding company) has an insurable interest in the contract which creates a relationship that will make the insurer suffer some loss in the damage of the subject matter of the insurance.

Reinsurance increases the ability of an insurer to accept large amount of risk. Any amount of risk accepted but which he cannot retain in his account will be transferred to the reinsurer.

The primary objective of the reinsurer is protecting the primary insurer from being crippled by large losses beyond its financial capacity. It is important to know that in the event of loss, the insured’s claim for the full amount is against the ceding company and has no business with the relationship between the ceding company and the reinsurer. For an insurer to select reinsurance, he must ensure that the reinsurer’s financial security is good and that the reinsurer is in a position to settle claims promptly.

It is important to note the following because of separate contracts:

  1. The original policy holder (the insured) has no right against the reinsurer.
  2. The insolvency of the reinsurer does not affect the entitlement of the insured from the insurer.
  3. The insolvency of the ceding company does not affect the liability of the reinsurer to the ceding company.
  4. The reinsurer has no right against any wrong doing of the original policy holder.
  5. The insured and all party to contract of insurance enjoys better security as a result of protection enjoyed in the fund of the organization.

 

FUNCTIONS OF REINSURANCE

  1. Spread of risk: The incident of risk is spread over a wide area in the contract of reinsurance.
  2. Reinsurance makes it possible for the direct insurer to handle larger risks than he would have accepted.
  3. Reinsurance also helps the direct insurer to stabilize his loss level by removing some of the uncertainties.
  4. Reinsurance helps in catastrophe situations, by reducing the net cost of acceptable level,as some reinsurance pays claims in excess of a stated figure as agreed.
  5. An insurer gains and enjoys confidence in the existence of reinsurance as a result of availability of reinsurance cover.
  6. It also helps the insurer to grow in size.

 

DIFFERENCE BETWEEN REINSURANCE AND CO-INSURANCE

Two separate arrangements exist: One between the insured and insurer and the other between the insurer and the reinsurance. Two or more insurance companies can come together to undertake a common risk.

The original insured maintains contract with the insurer only. The insured maintains contract with all the insurers involved in the time of loss, the insured claims from his insurer. In the time of loss, the insured claims from each of the participating insurers.

The insured has no right to fight against the reinsurer. The insured has right to fight each of the participating insurers since he has contract with each of them.

 

FORMS OF REINSURANCE

There are basically four types of reinsurance, which are:

A) Facultative reinsurance: This method of reinsurance involves the assessment of every risk individually. The insurer will present the details of the risk on a reinsurance slip to the reinsurer. The reinsurer will then appraise the risk and decide whether to accept the risk or to reject it or state the condition upon which the risk would be accepted. The reinsurer has the freedom of choice of how much of the risk should be re-insured and at what premium rate. If the risk is not accepted by the reinsurer, it throws it back to the ceding company who has to seek other reinsurer to place the risk.

 

Disadvantages of facultative method

  1. The nature of risk offered under this method together with high administration cost makes this method very expensive.
  2. It is cumbersome and time consuming.
  3. The insurer has no guarantee that reinsurance will be available. It may lead to the insurer declining the risk offered.

This method is still widely used despite the popularity of other forms. The situations where facultative form is still used are:

  1. Suitable for reinsuring risks that fall outside ceding company’s treaty limit.
  2. Useful where the sum insured exceeds the treaty limit.
  3. Suitable for risk of catastrophic nature.

 

B) Treaty Reinsurance: In this method of reinsurance, there is an agreement between the ceding company and the reinsurer. The ceding company agrees to cede and reinsurer agrees to accept all reinsurance offered within the limit of the treaty. In essence, the ceding company is bound to cede and the reinsurer is bound to accept. Under this form of reinsurance, the nature of the limits could be monetary, geographical, branch, section, class, and so on. This implies that there is automatic protection within the treaty by the reinsurer.

A treaty could either be “open treaty or blind treaty” It is an open treaty where the details of the risk ceded is sent to the reinsurer on a document called bordereaux on monthly or quarterly basis. This document contains details of ceded risk such as;

  1. The insured name.
  2. Premium rate.
  3. Retention of the ceding company.
  4. Amount reinsured.
  5. Period of insurance.

 

In a blind treaty, only the amount stated is forwarded to the reinsurer. This contains only shares of premium and losses by each party (the insurer and the reinsurer). The absence of prior knowledge of what is insured is experienced by the reinsurer in this case.

 

Forms of treaty

Treaty reinsurance could be grouped into two categories, namely:

Proportional treaty and non-proportional treaty

1) Proportional treaty: This is the form of treaty in which a proportional agreement has been reached to which any risk that falls within the terms and conditions of the treaty will be shared.

The premium will also be shared in such proportion and the claim settlement also follows the agreed proportion.

For example, if a ceding company cedes 65% of a risk, he will remit 65% of the premium to the reinsurer. The reinsurer also accepts 65% of the risk and will settle claims up to the time at 65%.

A proportional treaty is further grouped into two, namely:

  • Quota share treaty.
  • Surplus Treaty.

 

i) Quota Share Treaty: Under this treaty, the reinsurer takes a certain percentage of all the risks written by insurer. They will receive same percentage of premium and same percentage of all claims that arise.

For example, if the agreement between the ceding company and the reinsurer is 75% to the reinsurer and 25% to the ceding company, the reinsurer will accept 75% of each risk, 75% of premium and 75% of all claims that might arise. The ceding company will accept 25% of risk, 25% of premium and 25% of each claim that might arise.

 

Advantages of Quota share treaty

  • It is simple and easy to handle.
  • It serves as a means of saving cost (Administrative cost).
  • It is suitable for a young company that needs full reinsurance protection.

 

Disadvantages of Quota share treaty

Premium is paid away on small risk instead of retaining the whole for insurer’s own account.

There is no risk of selection against the insurer as they set an equitable share of good and bad risks.

 

ii) The surplus treaty: This is the most common form of proportional treaty. Under this, only the surplus above the ceding company’s retention of each risk is passed to treaty reinsurer. The capacity of the treaty is defined in line and the line is equal to the retention limit of the ceding company. For example, if there are 10 line treaties, and the retention limit of the ceding company is N2m, the ceding company has the capacity of accepting risk up to N2m. This implies that any case above N2m will be covered under additional surplus treaty which could be 2nd, 3rd or 4th surplus treaty contract. The insurer can only cede when the risk is above his retention limit. If a direct insurer has 10 lines treaty, this means that they could accept risk from the public up to 11 times their retention. The ceding company (direct insurer) will retain 1 line and cede the remaining lines toa reinsurance company.

For example: Let us assume that Olumide Insurance Company has entered into surplus treaty arrangement with some reinsurance companies. Under the treaty he has a retention limit of N200,000. If he has 10-line treaty reinsurance on a policy with sum of N1,400,000, the arrangement will be as follow:

Retention = N200,000

Surplus = 6 lines = 6 x 200,000 = N1,200,000

Total = N1,400,000

In an event of N1,500,000 loss, claim settlement will be:

 

At times the sum insured could be large to the extent they will make the available treaty inadequate, i.e. both the insurer’s retention and the reinsurance arrangement will not be adequate to absorb the entire sum insured. The remaining one would be reinsured under another surplus treaty or by facultative arrangement.

Also, it is possible for the insurer to go into negotiation, asking for increment in the retention to be able to absorb more risk. This is subject to approval of the reinsurer.

 

Advantages of surplus treaty

  1. The ceding company can retain substantial premium within its retention.
  2. It allows the ceding company to decide upon its retention on each individual risk separately.

 

Disadvantages of surplus treaty

  1. The administrative cost is high because each risk must be apportioned between the ceding company and reinsurance.
  2. There is selection against the reinsurer.

 

B) Non-Proportional Treaty: This is the form of reinsurance where there is no correlation between the premium received by the reinsurer and the claim payable by him. If at all premium received and claim payable are the same, it is just coincidence. Under this term of reinsurance, the reinsurer is required to pay the balance of the claims only if the claim exceeds a specific amount as agreed. There are two categories of nonproportional treaty namely: Excess of loss and Stop loss. Let us examine these categories one after the other.

Excess of loss: Under excess of loss, the ceding company and the reinsurer do not share loss in a fixed percentage. The ceding company is allowed to select the maximum amount it can conveniently bear in case of loss and the reinsurer undertakes to pay all loses above this amount.

This treaty is usually suitable for situation where large loses could be sustained. Example is the liability insurance. The reinsurance is not based on the sum insured in this case but only based on the cost of individual claims. Retention under excess of loss is usually high and any excess above the retention is recoverable from the reinsurer. For this protection, the insurer pays the reinsurer an agreed percentage of the annual premium income for that class of business.

For example

A reinsurer may agreed to pay N400,000 in excess of N150,000. This implies that in the event of a loss, the reinsurer could be committed with N400,000. If the loss of N500,000 occurs, the ceding company (the insurer) pays N150,000 and the remaining N350,000 is paid by the reinsurer. But if the loss is N600,000 the reinsurer only pays N400,000 and the ceding company pays its N150,000 and the ceding company will also have to bear the loss above its limit in addition to N150,000 i.e. the N50,000 balance with have to be paid by the ceding company.

 

Illustration:

God’s Own Fire Insurance Plc has an excess of loss treaty with Omega Reinsurance Company Ltd. The reinsurance company arranged to cover N200,000 in excess of ?50,000 arising out of one event. The following losses were recorded-N22,000, N30,000, N75,000 and N260,000.

This loss would be shared as follow:

In the event of the last claim, after the reinsurer (Omega Reinsurance Company Ltd) has paid its own part of the loss, there is still balance of N10,000 left. The amount would have to be paid by the insurer (God’s Own Fire Insurance Plc).

In order to protect itself against anticipated losses in excess of the reinsurance facility it has arranged, it can negotiate a second excess of loss treaty.

Some insurers arrange up to three or four excesses of loss cover and the cover are expressed in layer. The layer can be:

  • Catastrophe layer, or
  • Working layer.

 

1) Catastrophe Excess: This protects the ceding company’s net account against the risk of accumulation in the event of one catastrophe or disaster which could result in series of losses. This form of protection is principally against disaster arising out of flood, earthquake, windstorm, explosion and so on.

The catastrophe excess of loss is to limit the company’s loss (the ceding company) to an agreed figure which the company feels it could afford without any challenge to its financial stability. An event could result to series of losses. For instance, earthquake can result to destruction of buildings and its contents, machinery, and loss of lives. The insurer can estimate in this regard that it can afford N200, 000 in any one event and arrange with the reinsurer for the excess above retention of N500,000 in excess of N200, 000. If the loss exceeds the points, the insurer can negotiate for further layer of cover for adequate protection.

 

2) Working layer: In working layer, cover is arranged against losses on per risk basis, not like the catastrophe that is on per event basis. The excess point is fixed at a very much lower level unlike the catastrophe excess of loss where the cover is per event basis.

Let us look at the example below to throw more light on the difference between the catastrophe excess of loss and the working excess of loss.

Union Insurance Company has an excess of loss with Trade Reinsurance Company covering its fire and special perils (including flood, windstorm, and earthquake). A business of N1,200,000 excess of N20,000 at any one event only. A windstorm occurred, damaging four buildings. The cost of repairs are N25,000, N75,000, N30,000 and N120,000 (for the first, second, third and fourth buildings).

Since the same event caused damage to the four buildings and the total loss for the event is N250,000 and the cover is “any one event” basis, the reinsurer (Trade Reinsurance Company Limited) will pay N50,000 which is the amount on excess of N200,000. But on the other hand, if the cover was arranged on “per risk” basis, since none of the risks in the illustration above is above the excess point, the reinsurer pays nothing.

 

Stop Loss Treaty

This form of non-proportional reinsurance is similar to excess of loss as it does not concern itself with individual claim but with total loss cost, if it does not exceed a percentage of the annual premium in a particular class of business. This reinsurer is not liable for any loss until the loss ratio exceeds the agreed percentage of the premium for the year. For example, it may be that the reinsurance will only apply if the claim on a particular class of insurance exceeds the ratio of 80% of premium income for the year.

 

Illustration 1:

G.B Insurance has arranged a stop loss reinsurance to cover any excess of 85% of the company premium income of motor insurance, the premium income of N8m. The amount to be paid by the insurer is subject to 90% of the excess.

Solution

The payment position will be:

Premium income = N8m

 

Illustration 2:

LACO Insurance Plc has arranged a stop loss cover with NITEL Reinsurance Plc for 90% of any excess of ratio of 70%. (Bearing 10% itself).

In the event of claim amounting to N1,500,000 compared with net premium income of N1,400,000.

 

NITEL REINSURANCE PAYS THE NEXT 378,000

The balance of the claim = N1,500,000 -N980,000 – N378,000 = N142,000 will be paid by the insurer (LACO Insurance).

The total money payable by LACO Insurance N980,000 + N142,000 = N1,122,000.

While the reinsurer (NITEL reinsurance) pays only N378,000.

 

USES OF REINSURANCE

The following are the uses of reinsurance:

  1. Increased Underwriting Capacity.
  2. A Source of Capital/Financing.
  3. Protection of Company Equity (part of Enterprise Risk Management).
  4. Diversification of risk (cede some business, assume some business).
  5. Access expertise of the reinsurer for new lines of business.
  6. Income Smoothing.

 

REINSURANCE POOL

This is a situation whereby a number of insurers come together in a group to pool resources that are exceptionally heavy to be carried by an individual insurer. This is adopted mainly in catastrophe risk like aviation and atomic risk which involves very heavy claims and that no one insurer can handle successfully.

These groups of insurers come together to enjoy a wider spread of risk by sharing between themselves in an agreed proportion of any business handled under pool arrangement. The whole risk is usually ceded to the pool by all insurers involved with the class of business on which the pool is created. Loss and profit are shared as agreed.

In Nigeria for example, there is Nigeria Aviation pool comprising 17 insurance companies which went into operation since January 1984. Another example is WAIPO pool, which was set up in West Africa as that of Nigeria Aviation pool to reduce two much reliance on foreign reinsurance.

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