Webster’s dictionary states reinsure by definition is to insure again. This is done by transferring to another insurance company all or part of a liability assumed. In other words, reinsurance is insurance for insurance companies.
Reinsurance is the next link in the risk-spreading chain. An insurance company may be reinsured by another insurance company or by a professional reinsurance company that deals only in matters of reinsurance. There can be numerous layers of reinsurance. Insurance companies may deal directly with reinsurance companies or they may deal through reinsurance brokers whose function is to facilitate and arrange reinsurance agreements.
The “C11 Principles and Practices of Insurance” exam book defines the key terms of the Reinsurance process:
When a company reinsures its liability with another company it cedes business (risk). This company is called cedent.
The transmission of all or some risks to the reinsurance company helps the cedent company maintain its solvency margin. The reinsurance process is enhancing the underwriting capacity by reducing the associated costs.
Solvency is ability to pay one’s debts. European Union has created a set of regulations for Reinsurance under the name Solvency II.
The amount ceded by the original insurance company is called the cession. The amount the original insurer keeps for its own account is called retention.
When an insurance company or reinsurance company accepts part of another company’s business it assumes business. It thus becomes a reinsurer.
When one reinsurer cedes part of its business to another reinsurer that type of reinsurance is called a retrocession. The second reinsurer is called a retrocessionaire.
There are two types of reinsurance treaties in terms of risk sharing mechanisms – proportional treaty and non-proportional treaty.
In proportional reinsurance a percentage of the risk is transferred to the reinsurer and the reinsurer receives that same percentage of the original premium and is responsible for that same percentage of each loss.
Both proportional treaties and non-proportional treaties can be concluded over a longer period of time or as one time deal.
In terms of duration of the treaty there are Reinsurance treaties and Facultative treaties.
Optimization of Reinsurance
The insurance companies plan their insurance at least one year ahead. The actuarial mathematicians have to build mathematical models for predicting the insurance companies future. They build models for predicting future number of claims and volume of claims.
They usually use statistical data such as number and type of policies sold, number of claims, volume of claims in the past. They also plan together with the marketing and sales department the future sales plan.
Based on this the mathematical model for the future is build. And the insurance company understands it’s needs in terms of reinsurance treaties.
Choosing the right combination of reinsurance treaty from a variety of treaties and multiple reinsurance companies can be a difficult. It involves building probabilistic models that compare the different outcome for all the combinations of all feasible treaties. The best treaty combination for the insurance company is the one which ensures highest profit at high probability of surviving. Based on the strategy of the insurance company the optimal reinsurance treaty can be one with the highest protection for a certain amount of ceded premium, or with lowest amount of premium ceded to a certain level of reinsurance protection.