Reinsurance companies play an important role in the overall insurance ecosystem. Their purpose is to allow differentiation from the public facing insurance companies who need to manage a relationship with their many policy holders to prepare attractive policies, conduct effective marketing campaigns and deal with the day to day administration of all aspects of premium payments and payouts as well as managing their sales and marketing infrastructure. The reinsurance companies are specialists at working in investment markets and aiming to maximize the returns to the retail insurance companies who take them on in order to essentially cover their risk in offering more attractive payouts.
The logic of using reinsurance companies is quite straightforward, if an insurance company could be forced to payout 100% of the value of its policies due to certain circumstances occurring – this would be rare but potentially disastrous – the risk total payout of this doomsday scenario could be reduced if the policies were either sold on or underwritten by reinsurance companies who aggregate and consolidate policies from around the world and spread their investment portfolios into various investment markets. As an example, it would be assumed and hoped that environmental disasters would not occur on a worldwide basis all at the same time. So when an Australian insurance company is being hammered to pay out for extensive floods in a particular region and an insurer in the US is facing huge claims for damage done by forest fires, having used a reinsurance company, they have been underwritten and the premiums rolling in from quieter markets will guarantee that the local insurance company can honor its commitments.
How does it work and what are the options?
There are 2 core types of reinsurance; facultative reinsurance and treaty reinsurance. The key differences are that facultative reinsurance treats each individual policy on its own merits; all the title to benefits and potential loss are passed to the reinsurance company. This facility is used when the policy sold to the individual that includes the chance to claim for the insurance policy benefits that are not usually catered for by the primary insurer and the costs to manage the claim would be unacceptable to the primary insurer. The premium to pay for these types of reinsurance is high but overall, they offer good benefits. Treaty reinsurance is defined by a joint commitment between the insurer and the reinsurer where they divide the responsibility of who pays for what based on their capabilities. There are 2 methods that are practised; they are quota share treaty reassurance policies and excess of loss treaty reinsurance policies. In recent years, there has been a shift from quota share to excess of loss particularly in the areas of property and casualty claim fields.
How extensive are reinsurance programs?
The answer is, extremely extensive. Nearly all insurance companies have access to a reinsurance program. Reinsurance companies offer the ability to spread the risk from a regional or even national insurance crisis situation onto a global market of investment funds. Secondly, as the wider the risk is spread, insurance policies that do not result in claims are just added as full profit 100% to the bottom line.
The US government policy is extremely tight on reinsurance companies after the financial meltdown of 2008 and 2009. The spotlight of attention has been turned on them and accountability and transparency are at the top of the agenda. In the United States, the National Association of Insurance Commission is the watchdog that governs the activity of reinsurance companies and is operational in all the 50 US states, with wide ranging powers, it has the right of access to reinsurance companies to ensure that the asset risk ratio is maintained correctly and also to take corrective or punitive action if the rules are not being adhered to. The principal aim is to restore confidence to a damaged market image caused after the many spectacular financial collapses witnessed in 2008 and 2009.
There are a number of common reasons for the use of reinsurance companies which include risk transfer, income smoothing, surplus relief, arbitrage, re-issuers expertise, creating a manageable and profitable portfolio of insured risks as well as managing cost of capital for an insurance company. Reinsurance companies have been reviewing the market opportunities for good investment returns and in 2011, they are particularly interested in the fast growing Asian markets that have weathered the economic recession extremely well, so one can expect that most of their investments will go there in the next 12 months.