Risk Management and insurance

Part-II
Chapter-seven
REINSURANCE
Chapter learning objectives:
Dear learners! After studying this chapter you should be
able to:
 Define reinsurance
 Explain reason for reinsurance
 Explain reinsurance management and,
 Explain different types of reinsurance arrangements

7.1. Definition and reason for reinsurance

Definition:
Reinsurance: is the shifting of part or all of the insurance
originally written by one insurer to another insurer. The
insurer that initially writes the business is called the
ceding company/primary/direct insurer. The insurer that
accepts part or all of the insurance from the ceding company
is called the reinsurer. The amount of insurance retained by
the ceding company for its own account is called the net
retention or retention limit. The amount of the insurance
ceded to the reinsurer is known as the cession. Finally, the
reinsurer in turn may obtain reinsurance from another
insurer .The process by which a reinsurer passes on risks to
another reinsurer is known as retrocession.
Reason for reinsurance:
There are many risks in all classes of business, which are
too great for one insurer to bear solely on its own account.
Reinsurance, therefore, is a method created to divide the
task of handling risk among several insurers. Naturally, the
insuring public wishes to effect cover with one insurer and

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it is the insurer who in these circumstances accepts a risk

greater than it considers prudent to bear, hence reinsures
all or part of the risk with other direct insurers or with
companies which transact reinsurance business only.
It is not good business to refuse to write insurance in
excess of the retention amount. Imagine the displeasure of
the applicant and particularly of the producer when the
application is rejected or accepted in part. For these and
other reasons insurers commonly insure that portion of their
liability under their contracts in excess of their retention
with one or more insurers.

In general, reinsurance had a very simple beginning. When a

risk that was too large for the company to handle safely was
presented to an insurer, it began to shop around for another
insurance company that was willing to take a portion of the
risk in return for a portion of the premium. A few current
reinsurance operations are still conducted in this manner,
but the ever-present danger that a devastating loss might
occur before the reinsurance becomes effective led to the
development of modern reinsurance treaties.

7.2. Reinsurance Management

Reinsurance management refers to the selection, monitoring,
review and control of reinsurance arrangements. For this
purpose, reinsurance arrangements also include financial
reinsurance and alternative risk transfer products.

Insurers should have a clear strategy to mitigate and

diversify risks, such as defining limits on the amount of
risk retained, taking out appropriate reinsurance cover or
using other risk transfer arrangements consistent with its

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nature, business and capital position. This strategy is an

integral part of the insurer’s overall underwriting policy
and must be approved and regularly monitored and reviewed by
the board of directors.

The reinsurance program should be appropriate for the size,

business mix and complexity of operations of the insurer and
provide coverage appropriate to the level of capital of the
insurer and the profile of the risks it underwrites.

The reinsurance program should, among other matters, address

how the reinsurance is to be purchased, how reinsurers will
be selected, including how to assess their security, and
what collateral, if any, is required at any given time.
If requested, an insurer’s reinsurance arrangements should
be available for review by the Authority.

7.3. Methods/Types of REINSURANCE Agreements

One of the complexities of reinsurance is the arrangement on
sharing the premiums and insurance between the ceding
company and the reinsurer. There are two principal forms of
reinsurance (1) Facultative reinsurance and (2) Automatic
treaty.

7.3.1. Facultative reinsurance

The term facultative means optional; the power to act
according to a free choice. Thus one of the main features of
this method of reinsurance is that the reinsurance
underwriter is free to accept or decline each proportion,
and the insurer is not compelled to cede as he is with a
treaty.
Facultative reinsurance is reinsurance on an optional basis,
case-by-case method that is used when the ceding company

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receives an application for insurance that exceeds its

retention limit. There is no advance agreement between the
ceding company and the re-insurer regarding the sharing of
risks and premiums. Before the policy is issued, the primary
insurer shops around for reinsurance and contacts several
reinsurers on it, attempting to negotiate coverage
specifically on this particular contract. Each risk, which
is offered, is described as they see fit. A life insurer,
for example, may receive an application for birr 1 million
of life insurance on a single life. Not wishing to reject
this business, but still unwilling to accept the entire
risk, the primary insurer communicates full details on this
application to another insurer with whom it has done
business in the past. The other insurer may agree to assume
40% of any loss for a corresponding percentage of the
premium. The primary insurer then puts the contract in
force.
The reinsurance agreement does not affect the insured in any
way. The insured is generally not aware of the reinsurance
process and the primary insurer remains fully liable to the
insured in event of loss.
As stated earlier the insurer retains the right to decide
whether and how much of his risk to submit for
reinsurance .The re-insurer also retains the right to accept
or reject any business offered by the insurer.
Facultative reinsurance is frequently used when a large
amount of insurance is desired. Before the application is
accepted, the primary insurer determines if reinsurance can
be obtained. If available, the policy can then be written.

Facultative reinsurance has the advantage of flexibility,

since a reinsurance contract can be arranged to fit any kind

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of case. It can increase the insurer’s capacity to write

large amounts of insurance. The reinsurance tends to
stabilize the insurer’s operations by shifting large losses
to the reinsurer.

The major disadvantage of facultative reinsurance is that it

is uncertain. The ceding insurer does not known in advance
if a reinsurer will accept any part of the insurance. There
is also a further disadvantage of delay, since the policy
will not be issued until reinsurance is obtained.

7.3.2. Treaty Reinsurance

Treaty reinsurance, also called automatic treaty means the
primary insurer has agreed to cede insurance to the
reinsurer, and the reinsurer has agreed to accept the
business. All the business that falls within the scope of
the agreement is automatically reinsured according to the
terms of the treaty. Under automatic treaty reinsurance the
ceding insurer agrees to pass on to the reinsurer all
business included within the scope of the treaty, the
reinsure agrees to accept this business, and the terms-
example, the premium rates and the method of sharing for
reinsurance and the losses -of the agreement.

Treaty reinsurance has several advantages to the primary

insurer. It is automatic, and no uncertainty or delay is
involved. It is also economical, since it is not necessary
to shop around for reinsurance before the policy is written.

Treaty reinsurance could be unprofitable to the reinsurer.

The reinsurer generally has no knowledge about the
individual applicant and must rely on the underwriting
judgment of the primary insurer. The primary insurer may

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write bad business and then reinsure it. Also the premium
received by the reinsurer may be inadequate. Thus, if the
primary insurer has a poor selection of risks or charges
inadequate rates, the reinsurer could incur a loss.
There are several types of reinsurance treaties and
arrangements, including the following:
 Quota-share treaty
 Surplus-share treaty
 Excess-of-loss treaty

1. Quota-share treaty
Under a quota-share treaty, the ceding insurer and reinsurer
agree to share premiums and losses based on some proportion.
The ceding insurer’s retention limit is stated as a
percentage rather than as a Birr amount. The insurance and
the loss are shared according to some pre-agreed
percentage .For example, if a Birr 100,000 policy is written
and the agreed split is 50-50, the reinsurer assumes one-
half of the liability, the insurer and the reinsurer each
pay one-half on any loss.

2. Surplus-share treaty
Under a surplus-share treaty, the reinsurer agrees to accept
insurance in excess of the ceding insurer’s retention limit,
up to some maximum amount. The retention limit is referred
to as a line is stated as a Birr amount. Under surplus share
treaty the ceding company decides what its net retention
will be for each class of business. The reinsurer does not
participate unless the policy amount exceeds this net
retention. If the amount of insurance on a given policy
exceeds the retention limit, the excess insurance is ceded
to the reinsurer up to some maximum limit. The primary

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insurer and reinsurer then premium and losses based on the

fraction of total insurance retained by each party.
Under a surplus-share treaty, premiums are also shared based
on the fraction of total insurance retained by each party.
However, the reinsurer pays a ceding commission to the
primary insurer to help compensate for the acquisition
expenses.

The principal advantage of a surplus-share treaty is that

the primary insurer’s underwriting capacity is increased.
The major disadvantage is the increase in administrative
expenses. The surplus-share treat is more complex and
requires greater record keeping.

Example:
Assume that Apex Fire has a retention limit of Birr 200,000(called a line) for a single
policy, and that four lines, or Birr 800,000 are ceded to General Reinsurance .Apex Fire
now has a total underwriting capacity of Birr 1 million on any single exposure. Assume
that a Birr 500,000 property insurance policy is issued. Apex Fire takes the first Birr
200,000 of insurance, or two-fifths, and General Reinsurance takes the remaining Birr
300,000, or three-fifths. These fractions then determine the amount of loss paid by each
party. If a Birr 5,000 loss occurs. Apex Fire pays Birr 2,000(two-fifths), and General
Reinsurance pays the remaining Birr 3,000(three-fifths).This can be summarized as
follows:
Apex Fire Birr 200,000 (one line)

General Reinsurance 800,000(four lines)

Total underwriting capacity Birr 1,000,000

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Birr 500,000 policy

Apex Fire
Birr 200,000(2/5)
General Reinsurance
300,000(3/5)

Birr 5,000 loss

Apex Fire Birr 2,000(2/5)

General Reinsurance 3,000(3/5)

3. Excess-of-loss treaty
An excess-of-loss treaty is designed largely for
catastrophic protection. Losses in excess of the retention
limit are paid by the reinsurer up to some maximum limit.
The excess-of-loss treaty can be written to cover (1) a
single exposure, (2) a single occurrence, such as a
catastrophic loss from a windstorm, or (3) excess losses
when the primary insurer’s cumulative losses exceed a
certain amount during some stated time period, such as a
year. The reinsurer agrees to be liable for all losses
exceeding a certain amount on a given class of business
during a specific period.

In contrast to quota-share reinsurance, in which the

reinsurer shares part of every loss, excess-of-loss
reinsurance coverage commits the reinsurer to pay part of a
claim only after the primary insurer’s coverage has been

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exhausted. The reinsurer pays only the excess of loss beyond

what the primary insurer has retained.
The following example illustrates how the excess-of-loss treaty works. Assume that the
reinsurer agrees to pay for all losses in excess of Birr 50,000 up to a further Birr 200,000:
the way in which various losses are divided is shown below:
Loss Direct Insurer Excess Treaty
Birr 10,000 Birr 10,000 Nil
50,000 50,000 Nil
70,000 50,000 Birr 20,000
100,000 50,000 50,000
250,000 50,000 200,000
300,000 100,000* 200,000
*
i.e., its original retention of Birr 50,000 plus a further
Birr 50,000 in excess of the treaty’s (reinsurer’s)
liability
Such a contact is simple to administer, because the
reinsurers are liable only after ceding company has actually
suffered the agreed amount of loss. Because the probability
of large losses is small, premium for this reinsurance are
likewise small.
Activity: 7-1
1. Define reinsurance. Why is reinsurance used?
_______________________________________________________
_____________________________________________________
2. Distinguish between facultative reinsurance and treaty
reinsurance
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3. Describe the following types of reinsurance treaties:
a. Quota-share treaty

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-------------------------------------------------------
-----------------------------------------------------b.
Surplus-share treaty
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-----------------------------------------------------c.
Excess-of-loss treaty
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Chapter summery
Insurance companies are not totally freed from larger than
expected loss even if they may increase their forecasting
ability using the principle of law of large numbers. Thus,
they need insurance protection by themselves. Reinsurance
is, then, insurance for insurance companies. Reinsurance has
got a number of benefits which includes security and
reliability of profits, increase underwriting capacity,
protection against catastrophic loss, and etc. to attain
these ends reinsurance activities should be properly

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managed. Reinsurance management refers to the selection,

monitoring, review and control of reinsurance arrangements.

Reinsurance had a very simple beginning. When a risk that

was too large for the company to handle safely was presented
to an insurer, it began to shop around for another insurance
company that was willing to take a portion of the risk in
return for a portion of the premium. A few current
reinsurance operations are still conducted in this manner,
but the ever-present danger that a devastating loss might
occur before the reinsurance becomes effective led to the
development of modern reinsurance forms. This includes:
Facultative reinsurance and Treaty reinsurance. The treaties
with which dividing the task of handling risk among several
insurers can be carried out includes: Quota share treaty,
Surplus share treaty, Excess -of -Loss treaty.

Self assessment test

Solve the following question before referring to the answer key provided.
1. Awash insurance wishes to enter in to one of the following reinsurance agreements.
i. A quota share arrangement with the ceding insurer retaining 2/3of any loss
ii. A surplus share arrangement, under which ceding insurer will retain at most
Br.150, 000 policy amount.
iii. An excess loss arrangement, under which the reinsurer will retain all loss in
excess of Br.150, 000 up to further Br.200, 000.
How much will the ceding company and the reinsurer pay under each of these
arrangements if the loss is:
A. Br.60, 000 under a Br. 150,000 policy
B. Br.60, 000 under a Br.200, 000 policy
C. Br.300, 000 under a Br.300, 000 policy

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Answer key
Case-A: 60,000Br. Loss under 150,000Br. Policy
Treaty Ceding Reinsurer
Quota share 40,000Br. 20,000Br.
Surplus share 60,000Br Nill
Excess of loss 60,0000Br Nill

Case-B: Br.60, 000 losses under Br.200, 000 policy

Treaty Ceding Reinsurer
Quota share 40,000Br. 20,000Br.
Surplus share 45,000Br. 15,000Br.
Excess of loss 60,000Br Nill

Case-C: Br.300, 000 losses under a Br.300, 000 policy

Treaty Ceding Reinsurer
Quota share 200,000Br. 100,000Br.
Surplus share 150,000Br. 150,000Br.
Excess of loss 150,000Br 150,000

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