Principles of Insurance (Part 2)
Page 7 of 8
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Reinsurance

Basically, reinsurance is an agreement between the insurance company that issues the policy (called variously the "ceding company", the "primary insurer", the "direct insurer", the "first insurer") and another insurance organization (or organizations) called the reinsurer (or reinsurers).

There are a number of definitions of reinsurance in textbooks and case law, making it difficult to pin down the meaning of the term.

The purpose of reinsurance is to spread the risk of loss and to protect an insurance company against one or more very large individual losses or against the accumulation of a number of losses from one event.

To spread a fairly substantial risk among a number of insurance companies, the reinsurer may then reinsure some of the risk it has assumed. Technically, this type of agreement is known as "retrocession". Retrocession is a transaction in which the reinsurer transfers all or part of the risks it has assumed to another reinsurer (with the fancy title of "retrocessionaire") in return for payment of premium.

Most insurance companies place some limit on the size of any risk they accept. For example, a company may choose to retain the obligation of paying from its own coffers only the first $100,000 of any general liability contract. Any remaining amount would be paid by other insurance companies through the reinsurance agreement.

Many risk managers turn to reinsurance companies for Excess or Stop Loss coverage above some type of self-insurance programs. Typically, the insured absorbs or retains an initial loss up to some pre-determined amount, e.g., $150,000 per occurrence. The Stop Loss coverage protects against catastrophe losses in excess of that amount.

A Stop Loss is basically a guarantee from one company (the reinsurer) to another (the reinsured) that losses over and above an agreed upon amount will be paid by the reinsuring company.

Another function of reinsurance is to increase the flexibility of an underwriter in the size and types of risk and volume of business they can accept. It would otherwise be prohibitively risky to insure certain very risky exposures.

There are three basic methods for arranging or placing reinsurance:
  • Facultative
  • Treaty
  • Pool

    Facultative reinsurance
    The facultative approach is the oldest method of placing reinsurance. Traditionally it involves the reinsurance of one specific policy of insurance. It is negotiated individually and is completely optional ("facultative") in the sense that the primary or ceding company has no obligation to offer the business nor is the reinsurer obligated to accept it.

    Facultative reinsurance is generally more costly and takes more time then treaty reinsurance, which is largely automatic. Therefore, it is generally used only when a risk is too large or too hazardous to be handled under treaty.

    Treaty reinsurance
    Treaties are contracts or agreements between the ceding company and one or more reinsurers under which the ceding company agrees to cede and the reinsurer agrees to accept a certain portion of any business specified in the treaty.

    For example, a property insurer may execute a treaty with a reinsurer by which it cedes some percentage of all mercantile properties in a specified territory up to a certain limit.

    Typically the treaty will contain some type of prohibited list - risks that the reinsurer is unwilling to accept.

    Reinsurance pools
    In a pool arrangement, a number of primary insurers agree to place all business of a certain type into a pool. Each member of the pool gets a prearranged percentage of the total premiums and pays an agreed percentage of all losses.

    A reinsurance pool is basically an extension of the reinsurance treaty idea. Many reinsurance pools have been created to handle specific classes of business - marine, aviation, nuclear, etc.


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    Not only are policy forms, clauses, rules and court decisions constantly changing, but forms vary from company to company and state to state. This material is intended as a general guideline and might not apply to a specific situation. The authors, LunchTimeCE, Inc., CEfreedom, and Insurance Skills Center, and any organization for whom this course is administered will have neither liability nor responsibility to any person or entity with respect to any loss or damage alleged to be caused directly or indirectly as a result of information contained in this course.