The different types of reinsurance: definition
Even though the reinsurance market only represents approximately 5% of the insurance market, reinsurance coverage remains essential to limit an insurance company’s risk exposure.
Reinsurance is a transaction by which a reinsurer undertakes, in exchange for payment, to take on all or part of a risk covered under a policy issued by an insurance company. In exchange, the reinsurer compensates the insurer in the event of a claim.
The different methods of reinsurance
Reinsurance methods differ according to the reinsurer’s capacity to accept or refuse the risks ceded under the reinsurance agreement. Three reinsurance methods are usual: Treaty Reinsurance, Facultative Reinsurance and a hybrid mode with elements from the Treaty and the Facultative.
- Treaty Reinsurance
This is the most common cession method within the reinsurance market. The treaty corresponds to a reinsurance convention involving multiple risks: all the risks falling within the scope of the agreement will be covered by the Treaty Reinsurance, which greatly facilitates its management. Establishing the scope of the treaty allows the covered portfolio to be defined. It may be a specific sector, such as the automobile sector.
Should the totality of a portfolio be ceded to a reinsurer, this would imply the latter cannot refuse certain risks within the defined scope: there is no selection of risks.
- Facultative Reinsurance
Facultative reinsurance is fundamental in adapting reinsurance cover to a precise risk as this type of reinsurance contract focuses on a specific risk or policy. Unlike Treaty Reinsurance, Facultative Reinsurance involves higher management costs as the reinsurer is more deeply involved in the process.
Facultative is particularly relevant when the risk or the policy (which may cover several risks) have certain particularities:
- The amount insured for the risk exceeds the insurer’s underwriting capacity
- The insurer accepts the risk from its client on a commercial basis even though it is outside of its area of expertise
- It is a special risk requiring expert intervention
Cession by way of facultative reinsurance remains flexible: the parties can freely negotiate the specified risk with the insurer being free to cede this risk and the reinsurer free to accept it.
- Facultative Obligatory Reinsurance and ‘Fac-Fac’
These types of reinsurance are much more unusual, mixing elements of both Treaty and Facultative Reinsurance.
Facultative Obligatory is a type of cession where the insurer chooses the risks they wish to cede to the reinsurer, the latter not having a choice and obliged to cover. This method is therefore hazardous for the reinsurer if the insurer covers poor risks: the reinsurer would have to cover undesirable risks, which is why this reinsurance method is rare.
Cession by way of ‘fac-fac’ is similar with facultative obligatory reinsurance with one important difference: the importance of the role of the reinsurer in accepting or refusing ‘fac-fac’ reinsurance.
In case of co-reinsurance, the lead reinsurer will be the leader of all reinsurers and will be able to define the terms and conditions relating to the reinsurance contract. As such, the lead reinsurer remains free to accept or refuse the risks proposed by the insurer as part of the ‘fac-fac’ reinsurance. Its refusal or acceptance will oblige all the followers, which has consequences.
Proportional or non-proportional: what are the two types of reinsurance?
To fit the needs of an insurance company, reinsurers develop their cover offers based on two main types of reinsurance: proportional reinsurance and non-proportional reinsurance.
- Proportional Reinsurance
With proportional reinsurance, the reinsurer is involved with the entire reinsured portfolio: their participation in claims compensation is in principle equivalent to the proportion of premiums they are to receive.
- Quota Share
For quota share, the reinsurer undertakes to reinsure a percentage of the insurer’s total portfolio, in exchange for a percentage of the total premiums received by the insurer.
As such, if the reinsurer accepts a 40% share on a quota share, they will receive 40% of the premiums collected by the insurer and will need to contribute up to 40% in each claim’s settlement.
The main advantage with quota share is that management is simple, which allows the insurer to develop new lines of business thanks to the reinsurer’s financial support. However, the disadvantage with this type of cession is the high amount of premiums ceded.
- Surplus Share
In this type of reinsurance, a level of capital is freely negotiated and determined by the parties. This level of capital plays the role of a deductible as it remains at the expense of the Insurer : the reinsurer intervenes whenever the level of capital is reached. This serves as a limit to the reinsurer’s involvement in the program: the reinsurer can limit its intervention to X surplus share.
Contrary to Quota Share, the advantage of Surplus Share reinsurance is a much lower amount of premiums ceded to the reinsurer. In fact, for each risk the reinsurer receives a proportion of the premiums corresponding to the same surplus proportion accepted within the insured capital.
However, administrative management of this reinsurance method is relatively complex and cumbersome.
- Non-Proportional Reinsurance
With non-proportional reinsurance, the reinsurer only intervenes when the priority is reached, as defined in the contract. The emphasis is no longer on the reinsurer’s share in the reinsured portfolio but on the notion of loss, which becomes essential.
- Excess Loss
Excess of loss leads to reinsurer’s intervention when the amount fixed within the contract has been exceeded, known as ‘priority’, and within the ‘limit’ of the contract, which is the maximum amount payable by the reinsurer in case of loss. Sums up to the priority, not being covered by the reinsurer, remain supported by the insurer.
There are two types of excess of loss:
- Excess of Loss Per Risk: the reinsurer intervenes for a claim on one insured or one cover for a single loss
- Excess of Loss Per Event: this allows the aggregation of several individual claims within the same event (for example a catastrophe)
Excess of Loss is therefore particularly suitable to cover risk of intensity, since only claims with significant financial implications will likely exceed the priority leading to reinsurer’s intervention.
- Stop Loss
Stop Loss allows the insurer to protect themselves against the risk of a large loss, being either poor performance on a portfolio or catastrophes. Stop Loss covers the event aggregating the policies in the portfolio that have suffered a loss during a period defined in the contract. When the total loss sustained by the insurer exceeds the priority amount, as determined within the contract the reinsurer intervenes and will pay an amount up to the ‘limit.’
How is the loss ratio determined?
The loss ratio is the ratio of the amount of claims payable to the amount of premiums received by the cedent.
A single reinsurance contract can combine different types of reinsurance as described above.