Rajesh 100 Marks 6th Semester

PRINCIPLES & TYPES OF REINSURANCE
Principles of Reinsurance
Table of Contents
Chapter One - Introduction to Reinsurance
Origins of Reinsurance
Reinsurance Types
Facultative Reinsurance
Treaty Reinsurance
Proportional Reinsurance
Quota Share
Surplus Share
Non-Proportional Reinsurance
Chapter Two - Types of Life and Property & Casualty Reinsurance
Proportional Reinsurance for Life Insurance Companies
Yearly Renewable Term
Coinsurance
Modified Coinsurance
Reinsurance for Property & Casualty Companies
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Quota Share
Surplus Share
Non-proportional Reinsurance
Individual
Occurrence
Aggregate
Layering
Non-proportional Reinsurance for Life Insurance Companies
Stop Loss Reinsurance
Catastrophe Reinsurance
Spread Loss Reinsurance
Chapter Three - Purposes of Reinsurance

Assumption Reinsurance
Indemnity Reinsurance
Entering New Lines of Business
Underwriting Impaired Risks
Chapter Four - Reinsurance Agreements

The Facultative Agreement
The Treaty Agreement
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The Cession Form
Chapter Five - Reinsurance in Operation

Claims
Change in Reinsurance Amounts
Agreement Duration
Experience Rating
Supplemental Coverage
Substandard Reinsurance
Decisional Factors in Setting Retention Limits
Chapter Six - The Reinsurance Environment
Product, Market and Classification Development
New Products
Classification of Life Insurance Risks
Emergence of New Reinsurance Markets
Company Restructuring
Increased Risk
Competition
Interest Rates and Financial Volatility
Chapter Seven - Reinsurance Regulation

Introduction
Disclosure
3
Assessment of Risk Transfer and Accounting

Security
Glossary
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Chapter One
Introduction to Reinsurance
Origins of Reinsurance
Think about a business in which you have invested all of your assets—your
savings, your house and everything else of value. In fact, you have invested
more than that because you have borrowed against your future profits in
order to raise the capital to start and run the business. Now, consider the
possibility that all of your assets could be lost because of a storm. If you can
mentally transport yourself back to the 17th century, you may begin to have
an understanding of the business environment in which English and other
ship owners operated in the year 1688, the year that the world’s most famous
reinsurer—Lloyd’s of London—had its first meeting.
For many ship owners in the 17th century, the example above was a very real
fact of business life. Since few ship owners could afford to bet everything
on a single roll of the dice—or on a single voyage—they would seek out
others that would, for a fee, agree to accept a part of the risk. Typically, a
ship owner would write information about the impending voyage on a piece
of paper and solicit investors willing to accept some or all of the risk by
posting the description on or near the wharf.
An investor wishing to accept a part of the risk of the voyage would place
his initials below the line on the notice and would indicate the percentage of
the risk that he would bear. The investors that accepted some or the entire
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risk incident to the voyage became known as “underwriters” since they were
writing their name under the description of the risk.
Since each of these underwriters would typically bear only a part of the total
risk rather than the entire risk, the ship owner needed to take the information
about the voyage to multiple underwriters until all of the risk—or at least the
portion of the risk that he wouldn’t agree to bear himself—was assumed. As
the number of voyages increased and potential investors grew in number as
they became more familiar and comfortable with the risks, the business of
insuring these voyages became chaotic. In 1688, a group of investors met
for the first time in a central place in order to facilitate these insurance
transactions. That first meeting took place at Lloyd’s Coffeehouse—a
location from which Lloyd’s of London took its name.
It wasn’t long before Lloyd’s Coffeehouse became the center of marine

insurance in England and, subsequently, worldwide. As the marine
insurance industry grew, fewer ship owners had contact with the
underwriters. Instead, ship owners and underwriters used middlemen to
bring the transaction together for a fee. These middlemen, individuals that
came to be known as “brokers,” negotiated the insurance, and when a claim
was incurred the brokers collected the claim from each underwriter and
made payment to the ship owner.
By the late 18th century, the underwriters that continued to use Lloyd’s
Coffeehouse moved the insurance operation to the Royal Exchange in the
city London and formed a committee to manage the day-to-day operation of
the organization. About a hundred years after its move to the Royal
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Exchange—late in the 19th century—Lloyd’s was incorporated and became

known as the Society of Lloyd’s.
The bulk of Lloyd’s of London’s business continues to come from the

transportation sector, where they insure or reinsure airline, shipping and
other risks related to transportation. About one-third of its income is derived
from a type of reinsurance that we will discuss, known as “treaty”
reinsurance and about 15 percent is the result of “facultative” reinsurance, a
reinsurance type that we will also consider.
While Lloyd’s of London still looks to Great Britain for the largest part of its
income, much of its income comes from other parts of the world and from
non-marine type coverages. Now that we have looked at the beginnings of
the world’s best-known reinsurer, let’s turn our attention to some of its basic
concepts.
Just the way that any individual may choose to insure a certain risk—or part
of a risk—and retain other risks, an insurance company may also elect to
insure some of the risk it has assumed. When an insurance company makes
that choice to insure some of its risk, it is known as “reinsurance,” and the
policy that it negotiates is called a “reinsurance treaty.”
Although there are certainly some similarities between the individual as

purchaser of insurance and an insurance company as purchaser of
reinsurance, there are many differences. One reinsurance situation may
differ from another in the:
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• Type of reinsurance
and
• Use of reinsurance
As we will see, the types and uses of reinsurance can be quite complex.
The concept of risk-sharing is as fundamental to reinsurance as it is to

insurance in general. It involves the spreading of a significant risk over a
number of individuals and, thereby, exchanging the possibility of a
potentially catastrophic financial loss for a certain, but manageable, loss
known as the premium. When insurance companies share their risk through
reinsurance, the amount of the risk that they don’t share is known as their
retention; the amount of risk shared is the amount “ceded” to the reinsurer.
The presence or absence of reinsurance is not generally something of which

the policyowner is aware. Typically, the policyowner’s interaction has only
been with the primary insurer rather with the reinsurer. And, if the
policyowner has a claim covered under the policy, the primary insurer is
obligated to honor it, irrespective of whether there is any reinsurance
involved. So, the parties to the reinsurance contract are the primary insurer
and the reinsurer; the policyowner is not a party to it.
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Reinsurance Types
There are two basic types of reinsurance, known as:
• Facultative reinsurance
and
• Treaty reinsurance
Facultative Reinsurance
The difference between the two types of reinsurance lies in the power of the
primary insurer and the reinsurer to decide whether or not to assume the risk.
In facultative reinsurance the reinsurer retains the power to assume or
decline any risk presented to it. In other words, it retains the “faculty” to
take on the risk or reject all or part of it. The agreement in facultative
reinsurance is negotiated for each risk. In the property & casualty insurance
industry, facultative reinsurance is employed when the value of the property
is higher or the risk is greater than those risks covered by the reinsurance
treaty. Similarly, the primary insurer can choose whether or not to purchase
reinsurance for a particular risk and from whom.
Treaty Reinsurance
If the facultative type of reinsurance enables both the primary insurer and
the reinsurer to determine whether or not to reinsure each particular risk,
treaty insurance is just the opposite. Once the agreement for treaty insurance
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is struck between the primary insurer and the reinsurer, each risk is subject
to the agreement. The two parties to the reinsurance contract have generally
contracted away their right to decide whether or not to reinsure.
Regardless of whether the reinsurance arrangement is facultative or treaty,

the reinsurance agreements are either:
• Proportional
or
• Non-proportional
The primary difference between proportional and non-proportional

reinsurance is how the losses covered by the insurance contract are
apportioned.
In the case of proportional reinsurance—also called a pro-rata agreement—

the primary insurer retains a predetermined share or amount of the liability
that is assumed under the original insurance contract. Accordingly, the
reinsurer also receives a predetermined share of the premium paid for the
policy.
Proportional reinsurance is further divided into two categories depending on

the method used to determine the amount of risk retained by the primary
insurer:
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• Quota share
and
• Surplus share
Quota Share
In quota share reinsurance a fixed percentage of coverage provided under

each policy is retained and the balance is ceded. The percentage of coverage
retained—which could be 10%, 25%, 50% or some other percentage—is
generally the same for every policy, regardless of the amount. The
corresponding premium is also paid to the reinsurer. In turn, the primary
insurer receives a commission for the business from the reinsurer.
In the event of a claim under the policy the reinsurer would pay that
percentage of the claim equal to its percentage share of the policy.
For example, suppose a property and casualty insurer entered into treaty
reinsurance with a reinsurer to share risks on a 25% - 75% quota share basis.
Following the establishing of the reinsurance agreement, the primary insurer
entered into the following risks:
Insurance Amount Amount Ceded
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Amount Retained
$50,000 $12,500 $37,500

$150,000 $37,500 $112,500
$500,000 $125,000 $375,000
$1,000,000 $250,000 $750,000
As we can see, in the case of a quota share treaty reinsurance agreement,

each and every insurance policy is split between the primary insurer and the
reinsurer according to the quota share percentage stated in the reinsurance
agreement.
Surplus Share
But, as we noted earlier, quota share is not the only type of proportional
reinsurance agreement; a surplus share agreement might be negotiated
instead.
In a surplus share agreement, the primary insurer retains a fixed amount of

the issued coverage. If the liability under the issued policy is less than the
dollar amount retained by the primary insurer, none of the coverage is ceded
to the reinsurer; conversely, if the liability under the issued policy is greater
than the dollar amount retained by the primary insurer, the excess is
reinsured. The premium for each policy reinsured is shared in the ratio of
the retained liability to ceded liability. If the premium paid by the applicant
was $1,200 and the reinsurer was ceded $40,000 of a $100,000 policy, the
reinsurer would also receive a 40 percent share of the premium, or $480.
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Looking back at the example of the amounts retained and the amounts ceded
under the quota share agreement, we can see the difference in a surplus share
agreement. Under a surplus share agreement that provides for the primary
insurer’s retention of the first $50,000 of coverage, the split would look like
the following:
Insurance Amount Retained Amount

Amount Ceded
$50,000 $50,000 $ 0
$150,000 $50,000 $100,000
$500,000 $50,000 $450,000
$1,000,000 $50,000 $950,000
As we can see, the basic difference between quota and surplus share is in
terms of the retention by the primary insurer. Under quota share, it is a fixed
percentage; under surplus share, it is a fixed amount.
So, we have seen that reinsurance may be proportional or non-proportional.

If it is proportional, it is either quota share or surplus share. But, what if it is
non-proportional?
Non-Proportional Reinsurance
Non-proportional reinsurance is also called “excess of loss” reinsurance. In

this type of reinsurance, the primary insurer, i.e. the ceding company, is
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indemnified for the portion of a loss that exceeds the ceding company’s net
retention. The primary difference between excess of loss reinsurance and
surplus share reinsurance, which it closely resembles, is the premium paid
by the primary company to the reinsurer. In the case of surplus share
reinsurance, the premium paid by the primary insurer to the reinsurer is
based on the proportionate share of the liability borne by each party. In
excess of loss reinsurance, the premium paid by the primary insurer to the
reinsurer bears no proportional relationship to the original premium paid by
the policyowner. Instead, it is a charge based on the potential for loss.
Excess of loss plans may cover policies on an individual basis, but they may
also apply to an occurrence—an earthquake, for example—that would allow
the ceding company to recover losses associated with a single catastrophic
event in excess of a particular amount. They may also be written to cover an
aggregate of losses that are incurred over a period of time. Although that
period is often a year, it may be a period of several years. These latter
reinsurance contracts are often referred to as stop-loss contracts.
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Chapter Two
Types of Life and Property & Casualty Reinsurance
Proportional Reinsurance for Life Insurance Companies
We have looked at reinsurance in a general fashion and considered the

differences between treaty and facultative, proportional and non-
proportional and between quota share and surplus share. We will turn our
attention now to the application of these types of reinsurance to different
insurance industries, beginning with proportional reinsurance the life
insurance industry.
Two basic approaches are taken to the providing of proportional reinsurance

in the life insurance industry:
• The yearly renewable term insurance plan

and
• The coinsurance plan
Yearly Renewable Term
In the case of proportional reinsurance provided under a yearly renewable

term insurance plan, the primary company purchases term life insurance
from the reinsurance company on a yearly renewable term insurance basis.
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The amount of yearly renewable term life insurance purchased is equal to

the net amount at risk in the policy that is in excess of the primary life
insurance company’s retention limit.
The net amount at risk in a life insurance policy is simply the amount
payable as a death benefit under the policy less the policy’s terminal reserve.
Although the reserve is technically defined as the difference between the
present value of future benefits (which increase with age) and the present
value of future net premiums (which decrease with age), resulting in a steady
increase in terminal reserve over the years, it approximates a life insurance
policy’s cash value—and that is sufficient for our purposes.
Net amount at risk
The net amount at risk is generally equal to the difference between the death
benefit of a life insurance policy and its cash value. To the extent that a life
insurance policy’s cash value increases over time while the death benefits
remain constant, the net amount at risk will decrease as the policy ages. The
net amount at risk is graphically illustrated below:
Death benefit
Net amount at risk
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Cash value
Death benefit
Net amount at risk
Cash value
To illustrate how the yearly renewable approach would work in the case in
which a primary life insurer has a retention limit of $500,000, let’s suppose
that the insurer’s agent sells a whole life insurance policy for $1 million to a
35 year-old applicant. At the end of the first year, the terminal reserve is
about $8,800. The net amount at risk under this policy, according to our
definition, is the difference between the death benefit of $1 million and the
terminal reserve of $8,800. The net amount at risk, therefore, is $991,200.
($1,000,000 - $8,800 = $991,200)
Since the primary insurer purchases one year renewable term life insurance
from the reinsurer in an amount equal to the difference between its retention
limit and the net amount at risk, if greater, it will purchase term insurance
for $491,200 in the first year. ($991,200 - $500,000 = $491,200) What the
primary life insurer has done by purchasing the term insurance is simple; it
has transferred the risk of the insured’s death, to the extent that the net
amount at risk exceeds its retention limit, to the reinsurer. Reinsurance often
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remains in effect for many years, so the one year term insurance purchased
by the primary insurer must be renewed from year to year. Let’s look at
what happens by year 8.
Since the policy is whole life insurance, it is characterized by a level death

benefit and a constantly increasing cash value that approximates the policy’s
terminal reserve. Because the policy’s terminal reserve has increased, the
net amount at risk has decreased commensurately. The policy’s terminal
reserve at the end of the 8th year would be $77,800, so the net amount at risk
has decreased to $922,200, and the amount of one year term life insurance
purchased from the reinsurer would be reduced to $422,200.
In the case of the yearly renewable term insurance plan of life reinsurance,
the primary insurer purchases liability-reducing coverage for a portion of the
death benefit only. As a result, the reinsurer’s obligations extend solely to
paying a part of the death benefit upon the insured’s death. There are no
reinsurer obligations in the case of the yearly renewable term insurance plan
for any dividends, cash surrender values or nonforfeiture provisions. As we
will shortly see, this is a major difference between the yearly renewable term
insurance plan or reinsurance and the coinsurance plan.
The benefits of the yearly renewable term insurance plan to the primary
insurer are its:
• Simplicity
• Favorable impact on asset growth
and
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• Ability to choose a reinsurer that is unlicensed in the primary

insurer’s domiciliary state
Because the yearly renewable term insurance plan is characterized by greater

simplicity, it is considerably easier to administer—and that translates into
administrative savings. The more important benefits of this life reinsurance
approach, however, are the remaining two: asset growth impact and
reinsurer choice.
By employing a yearly renewable term insurance plan as a method of

reinsuring, the primary insurer generally retains most of the policyowner’s
premiums, since it is purchasing the type of life insurance with the lowest
premium, i.e. yearly renewable term insurance. As a result, this reinsurance
arrangement has the smallest adverse impact on the primary insurer’s asset
growth. Although this characteristic may appeal to any primary insurer, it is
usually of greatest appeal to smaller primary life insurance companies.
A primary life insurance company may choose the yearly renewable term
insurance approach because of its desire to reinsure its risk with a reinsurer
that is not licensed in the primary insurer’s state of domicile. The reason for
the preference for yearly renewable term insurance rather than another
approach in this case is because the primary insurer cannot deduct the
reinsurer’s reserves held against the liability from its own reserves if the
reinsurer is not licensed in the primary insurer’s state. Since it cannot
deduct the reinsurer’s reserves from its own, it makes much more sense for
the primary insurer to opt for the yearly renewable term insurance approach
in which it holds all of the policy reserves anyway.
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Coinsurance
The yearly renewable term insurance plan of reinsurance is quite simple and
straightforward. The parties to the reinsurance agreement need not have a
particularly close working arrangement. The second type of life insurance
reinsurance that we will examine—the coinsurance plan—is quite different
with respect to virtually all the characteristics of the first type.
In the first place, the coinsurance plan is significantly more complex than the
yearly renewable term approach, and that greater complexity arises
principally from the nature of the relationship between the two parties to the
reinsurance agreement. We noted earlier that the relationship between the
two parties to the yearly renewable term plan was a fairly arm’s-length
arrangement. In the coinsurance plan, the relationship is much closer since
the two insurers—primary and reinsurer—agree to provide all of the benefits
purchased by the policy owner jointly.
We noted that, in the yearly renewable term insurance plan, the reinsurer
was obligated only to provide its portion of the death benefits if the insured
died during the period of reinsurance. Other than that, the reinsurer has
virtually no obligation to the primary insurer. In the coinsurance plan, to the
contrary, the reinsurer is liable for its proportionate share of the policy’s:
• Death benefits
• Cash surrender value
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• Dividends, in the event the insurance is participating

and
• Non forfeiture benefits
Clearly, the two insurance companies are bound much closer in the
coinsurance plan of reinsurance than they are in the yearly renewable term
insurance plan. That greater proximity comes at a price.
You will recall that one of the advantages to the primary insurer of the
yearly renewable term plan was its ability to retain the lion’s share of the
premium, and that translated into faster asset growth. In that case, the
reinsurer received a relatively small portion of the total policy premium.
The reinsurer’s portion of the premium in the coinsurance plan is much
greater.
Let’s return to our earlier example of the 35 year-old applicant that

purchased a $1 million whole life insurance policy from the primary insurer
whose retention limit was $500,000. Of the approximately $15,000 annual
premium for the policy, the reinsurer may have received $500 or so in the
first year of the agreement; the primary insurer kept the balance. If the
reinsurance agreement in effect called for coinsurance of 50 percent, the
reinsurer would have received one-half of the total premium, or $7,500.
From a death benefit perspective, the result between the two arrangements
would have been identical.
The remitting of one-half of the total premium to the reinsurer is, however,
not the whole financial story. In the case of the coinsurance plan, the
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reinsurer pays the primary insurer a commission, known as a “ceding

commission” that reimburses the primary insurer for the costs incurred by
the company in putting the business on its books. As we will discuss when
we examine the uses of reinsurance, this ceding commission is vital for
many small companies with substantial growth rates and relatively small
surplus positions who may want to use reinsurance to finance their growth.
The ceding commission that is paid by the reinsurer is designed to include:
• An allowance for the commissions paid by the primary insurer to its

agent
• The premium taxes paid by the primary insurer
and
• A part of the primary insurer’s overhead expenses
The ceding commission is negotiated between the primary insurer and the
reinsurance company and is often greater than the first year premium that is
ceded—along with the liability—to the reinsurer. This approach is
consistent with the primary insurer’s new business acquisition cash flow in
which the life insurance company’s first year costs to acquire new life
insurance business may exceed its first year premium by 50 percent or more.
In more concrete terms, a primary insurer may pay out in first year
commissions, overrides, expense allowances and other acquisition costs a
total of $1,500 to put a life insurance policy with a $1,000 annual premium
on its books. That additional $500 by which the expenses exceed the
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revenue must generally come from the primary insurer’s surplus. So, a life
insurance company with limited surplus may look forward to reinsuring
much of its new business as a way of replacing that lost surplus.
As we noted, in addition to this commission arrangement, the coinsurance

plan requires much more from the reinsurer. If the life insurance policy that
was reinsured is a participating policy, the reinsurer must be ready to pay
dividends as declared by the primary insurer. Since participating policy
dividends generally reflect the experience of the company paying the
dividends, and since the primary company and the reinsurance company may
have vastly different experience, this arrangement can cause significant
concerns for the reinsurer.
Assume, for example, that the reinsurer’s net investment earnings are less
than those of the primary insurer. In such a case, the reinsurer’s dividend
scale would be lower than the primary company’s scale, and yet the
reinsurer must pay dividends according to that higher scale.
Although participating policy dividends tend to be affected more

significantly by investment earnings than by mortality experience, mortality
is still a factor in any company’s dividend declaration. However, if the
reinsurer’s mortality experience is less favorable than that of the primary
company, the reinsurer’s normal dividend scale will be even further out of
step with the dividend scale of the primary insurer.
To make matters more complicated for the reinsurer, the mortality results
experienced on life insurance business that is reinsured are generally poorer
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than the mortality experience on business that is written directly and fully
retained. Conventional wisdom suggests that the underwriting standards of
smaller companies that rely most heavily on reinsurance may be somewhat
more liberal than the standards of companies with higher retention limits.
Despite these complications in the relationships between primary insurers

and their reinsurers, there is generally little reason for concern; the
reinsurers’ actuaries have considered all of the issues in their determining of
the amount of ceding commissions paid to the primary insurer, so that the
differences in dividend scales generally create little difficulty for the
reinsurer.
In addition to dividends, the reinsurer, in the case of coinsurance, is liable

for a part of the policy’s surrender value if it is surrendered for its cash
value. Alternatively, a terminated policy may be placed under one of the
non forfeiture provisions, such as reduced paid-up or extended term
insurance. If either of those conditions apply, the reinsurer continues to be
liable for its proportionate share of those benefits as well.
Modified Coinsurance
It is possible that for any particular primary insurer, neither the coinsurance
plan nor one year renewable term insurance plan fits particularly well. As a
result of this, reinsurers have developed a reinsurance arrangement known as
“modified coinsurance.”
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The benefit to the primary life insurer derived from yearly renewable term
reinsurance, when compared to coinsurance, is that the primary insurer is
able to retain much more of the policy premium. Since retaining a greater
amount of the premium helps the company grow its assets more quickly,
many companies prefer this particular feature. The disadvantage of yearly
renewable term insurance to the primary insurer is that it is responsible for
paying all of its acquisition costs. Because of its payment of these
acquisition costs that often exceed the first year premium, new business
drains the primary insurer’s surplus and limits its ability to write additional
new life insurance business. So, the yearly renewable term approach has
both important advantages and significant disadvantages.
The coinsurance plan approach to reinsurance resulted in the reinsurer’s

paying a large portion of the primary insurer’s acquisition costs through its
payment of a ceding commission. While this commission has a favorable
impact on the primary insurer’s surplus position, the coinsurance plan also
has certain disadvantages: the primary insurer must pay a portion of each
annual premium—possibly a substantial portion—to the reinsurer. As we
noted, this arrangement helps surplus but negatively affects asset growth.
Primary insurers—particularly those that are most sensitive to the surplus

and asset issues—view the reinsurer’s accumulation of substantial premium
funds as an unnecessary and undesirable feature of reinsurance. Because of
this concern, an approach to reinsurance was developed that enables the
primary insurer to retain the entire reserve of the reinsured policy. This third
approach is known as the modified coinsurance plan.
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Under the modified coinsurance plan, the primary insurer pays the
reinsurance company a pro rata portion of the premium for the reinsured
policy—similar to the coinsurance plan. The premium payment made to the
reinsurer is netted by the amount of the ceding commissions that would have
been paid to the primary insurer.
The big difference in the modified coinsurance plan is that at the end of each
policy year the reinsurer pays to the primary insurer an amount that is equal
to the net increase in the policy reserve that year. Although the actual
reserve increase payment calculation is somewhat more complicated than
suggested, this is what occurs.
Under this modified coinsurance arrangement, as a result of this annual

payment back to the primary insurer, the reinsurance company never holds
more of the premium than the amount equal to the gross premium on the
death benefit reinsured for a single year. In simpler terms, the reinsurer has
not been permitted to accumulate significant premium funds.
As we can see, this modified coinsurance plan answers the critics of both the
yearly renewable term plan and the coinsurance plan. By reducing the
amount of premium held by the reinsurer, it helps the primary insurer to
grow its assets more quickly. Furthermore, the recouping of much of the
primary insurer’s acquisition cost from the reinsurer helps the primary
insurer to maintain a more favorable surplus position. In many respects, the
modified coinsurance plan of reinsurance is the best of both worlds.
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Reinsurance for Property & Casualty Insurance Companies
The types of reinsurance we examined thus far—yearly renewable term,

coinsurance and modified coinsurance—are all proportional reinsurance
types used in the life insurance industry. The same proportional reinsurance,
however, is used in the property and casualty industry. Let’s turn our
attention now to how this proportional reinsurance functions in property and
casualty insurance.
The idea behind reinsurance is, of course, identical in the life insurance and
property & casualty industries: a spreading of the risk among two or more
insurance carriers. The language and operation of the reinsurance, however,
are different. Reinsurance in the property & casualty industry tends to be
somewhat less complicated than the reinsurance that we have already
examined.
We noted that there are two basic types of proportional reinsurance plans in
the life insurance industry: yearly renewable term and coinsurance. There
are also two types of proportional reinsurance plans in the property &
casualty insurance industry. These proportional reinsurance plans are called:
• Quota share
and
• Surplus share
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Quota Share
Under a quota share agreement, the primary insurer cedes a fixed percentage
of each policy it issues in a particular line or class of business.
In a quota share reinsurance arrangement, a primary insurer might agree to

reinsure 70 percent of every policy that it issues and retain the remaining 30
percent. Just as we noted in the coinsurance arrangement in the life
insurance industry, the reinsurer pays a ceding commission to the primary
insurer.
Once the percentage to be ceded has been agreed upon, the premium and
loss division that occurs after that is completely automatic. In the 70 percent
quota share arrangement, the primary insurer retains 30 percent of the
premium and liability, and 70 percent of the premium and liability is
assumed by the reinsurer. The arrangement is quite simple and
uncomplicated and applies to all policies issued by the primary insurer in the
class of policies reinsured, regardless of the policy size.
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Example -Quota share reinsurance arrangement
A quota share reinsurance arrangement would produce the following

revenue and claims liability for the primary insurer and the reinsurer,
assuming the limit of the policy in question is $100,000:
Insurance policy limit $100,000
Primary insurance company retention 30%
Primary insurer’s coverage share 30,000

Reinsurer’s coverage share 70,000
Total insurance coverage 100,000
Total annual policy premium $1,200
Primary insurer’s premium share 360

Reinsurer’s premium share 840
Total insurance premium 1,200
Hypothetical claim $75,000
Primary insurer’s claim share 22,500

Reinsurer’s claim share 52,500
Total claim 75,000
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Surplus Share
The other property & casualty proportional reinsurance arrangement is

known as “surplus share.” The surplus share approach to reinsurance has
some resemblance to the coinsurance method that is used in the life
insurance industry.
In a surplus share arrangement, the primary insurer retains a stated amount,

rather than a stated percentage as in the quota share method. Under this
agreement, the reinsurer does not become involved in any particular risk
until the policy limits exceed the primary insurer’s retention limit.
However, once the amount of reinsurance is determined—by the amount that
the policy provides in excess of the primary insurer’s retention—the
premium is shared in the same proportion. So, if the coverage is shared on a
50%-50% basis between the primary insurer and the reinsurer, each receives
one-half of the premiums. It is entirely possible that the reinsurance
outcome—in terms of liability and premiums—could be the same under a
quota share and surplus share reinsurance approach.
Example -Surplus share reinsurance arrangement
30
A surplus share reinsurance arrangement would produce the following

revenue and claims liability for the primary insurer and the reinsurer,
assuming the limit of the policy in question is $100,000:
Insurance policy limit $100,000
Primary insurance company retention $30,000
Primary insurer’s coverage share 30,000

Reinsurer’s coverage share 70,000
Total insurance coverage 100,000
Total annual policy premium $1,200
Primary insurer’s premium share 360

Reinsurer’s premium share 840
Total insurance premium 1,200
Hypothetical claim $75,000
Primary insurer’s claim share 22,500

Reinsurer’s claim share 52,500
Total claim 75,000
To summarize the proportional approach to reinsurance in the property &

casualty industry, the difference between the surplus share and quota share
arrangements is only in terms of how the primary insurer’s retention is
stated. In the case of quota share, it is stated as a percentage of every policy,
31
regardless of its size; in the case of surplus share, it is stated as a dollar

amount.
As a result of this difference in approach, the percentage of liability assumed

by the reinsurer under quota share is the same irrespective of the policy size.
However, under a surplus share arrangement, the reinsurer’s liability
percentage increases as any policy’s limits increase in excess of the primary
insurer’s retention limit.
Individual
We noted at the outset of our discussion of reinsurance that it may be either

proportional or non-proportional. Thus far, we have examined only the
proportional type. Let’s turn our attention, now, to this second type: non-
proportional reinsurance. We will begin with its application in the property
& casualty industry.
When we talk about non-proportional reinsurance in the property & casualty

industry, we really mean coverage better known as “excess of loss”
reinsurance. This reinsurance coverage is so-called because it protects the
primary insurer against losses in excess of a particular deductible. In this
case, the ceding company is indemnified for any losses that exceed a
specified amount that is the primary insurer’s retention.
Similar to yearly renewable term reinsurance in the life insurance industry,

the premium paid for excess of loss reinsurance by the primary insurer bears
no proportional relationship to the policyowner’s premium. Rather, the
32
reinsurance premium is based solely on the likelihood of loss. In a sense,

the primary insurer is purchasing coverage, like renewable term insurance,
from the reinsurance company.
There are three forms that excess of loss reinsurance takes in the property &
casualty industry:
1. Individual
2. Occurrence
and
3. Aggregate
Let’s examine each of these approaches.
Individual
In the case of individual excess of loss reinsurance coverage, the reinsurer

pays any claim on an individual policy to the extent it exceeds the retention
limit of the primary insurer. For example, if the primary insurer’s retention
limit is $25,000 and an individual claim is received for $30,000, the $5,000
excess amount would be paid by the reinsurer.
Occurrence
33
The occurrence approach to excess of loss reinsurance coverage is equally

straightforward. In that case, a loss resulting from a catastrophic event—an
earthquake, tornado or hurricane, for example—that exceeds an agreed-upon
total is paid by the reinsurer. The primary insurer may feel that its financial
status would not be severely affected until and unless it was required to pay
losses for a specific event exceeding $10 million. So, it would establish
occurrence reinsurance for any amount over the $10 million.
Aggregate
Aggregate reinsurance simply provides protection for a primary insurer

against any losses that exceed a specified amount over a period of time or
for a particular policy. This type of reinsurance is also called:
• Stop-loss coverage
and
• Excess of loss ratio reinsurance
The aggregate reinsurance coverage limits a primary insurer’s liability to a

specified amount under a particular policy or for a specified period. The
period is usually one year, but it may be several years, depending on the
needs of the primary insurer and the reinsurance agreement. It is not
unusual for this type of coverage to reinsure losses that exceed $100 million
in a calendar year.
34
We can represent the relationship of these coverages graphically as shown

below:
Excess of loss reinsurance
Excess of Loss
Non-proportional coverage for losses in excess of primary insurer’s retention
Individual Occurrence Aggregate
Coverage on an Coverage for an Coverage for

individual policy occurrence, such as losses in excess of
basis an earthquake a total amount, or
per policy, or per
year
Layering
The insurance industry is creative in its use of reinsurance to enable

companies to meet customer requirements. An example of that creativity
can be seen in the use of various reinsurance agreements to produce a
“layering” effect.
A customer that needs $20 million of coverage may apply for it from a
primary insurer that chooses to limit its own exposure to $50,000. Clearly,
35
in such a case there is a substantial need for large amounts of reinsurance.

Often, the reinsurance needed exceeds even the reinsurers’ limits, so
multiple reinsurers are enlisted to provide coverage. In the example shown
below, two automatic reinsurance arrangements apply in the case of
reinsurers 1 and 2.
Layering of reinsurance coverage
Primary Reinsurer Reinsurer Reinsurer

Insurer 1 2 3
$20,000, $15,000,000
000 Facultative
reinsurance
(excess of
loss)
$5,000,0 $4,500,000
00 Treaty
reinsurance
(excess of
loss)
$500,00
0 Treaty
reinsurance
(surplus
share)
$50,000
Primary
insurer
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retention
limit
Primary Reinsurer 1 Reinsurer 2 Reinsurer 3
insurer exposed to has $4.5 has $15
exposed to risk of million million
$50,000 $450,000 exposure exposure
limit under after first after first after first $5
retention $50,000 $500,000 of million of
schedule assumed by loss loss
primary
insurer
As we can see in the example above, the primary insurer has several
reinsurance arrangements. It has a surplus share agreement with Reinsurer 1
under which all business above its $50,000 retention limit is reinsured.
However, since Reinsurer 1’s limit is only $500,000, additional reinsurers
are needed. In this case, two additional reinsurers are pressed into service.
Reinsurer 2 has a limit of $5 million, so that a third reinsurer is needed to
cover the entire liability up to the $20 million that is needed by the
customer.
Layering like this is not uncommon in the property & casualty industry,
especially among insurers that provide very large coverage for their
customers. While the illustrated coverage is, of course, hypothetical, such
arrangements are not particularly rare.
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Non-Proportional Reinsurance for Life Insurance Companies
Unlike the property & casualty industry, in which much of the reinsurance is
non-proportional, reinsurance in the life insurance industry has traditionally
been accomplished on the proportional basis that we examined initially.
However, in the recent past, increasing interest has been shown in a
reinsurance approach in which the life insurance reinsurer’s liability is
related to the primary insurer’s mortality experience on all of its book of
business instead of on an individual policy.
This kind of non-proportional arrangement is used widely in the property &

casualty business. In the life insurance business, non-proportional
reinsurance may be:
• Stop loss reinsurance

• Catastrophic reinsurance
or
• Spread loss reinsurance
Stop Loss Reinsurance
Stop loss reinsurance is used in the life insurance industry principally as a

supplement to proportional reinsurance. It is designed to ensure that the
primary insurer is not placed in financial jeopardy due to abnormally-high
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mortality in a prescribed period. That period is usually one calendar year.

Typical stop loss reinsurance arrangements provide that the reinsurer must
reimburse the primary insurer to the extent that claims exceed 10 percent of
its normal mortality.
Reimbursement payments from the reinsurer may be equal to 100 percent of

the amount in excess of the primary insurer’s limit or may only be a portion
of the excess. In order to ensure that the primary insurer has a vested
financial interest in properly underwriting even reinsured business,
reinsurers are tending to reimburse only a portion of the excess mortality.
The result is that the primary insurers are likely to underwrite these risks
more carefully.
The stop loss reinsurance arrangement is a very flexible one. The reinsurer
may agree to cover:
• selected portions of the primary insurer’s book of business

• varying levels of mortality
or
• periods of varying duration
The appeal of stop loss reinsurance to primary insurers is its providing of

protection against unexpected swings in mortality. These swings might arise
out of an unexpectedly large number of small claims of an increase in the
individual claims’ average size. Regardless of the cause, these swings can
39
wreak havoc on a company’s financial results, especially in smaller

companies.
Another advantage of stop loss reinsurance is its relatively low cost.

Primary insurers may choose to reduce their total reinsurance outlay by
increasing their retention limits under proportional agreements and
reinsuring any retained amounts under stop loss agreements. Its final appeal
lies in the fact that, because it is so uncomplicated, it is easy and inexpensive
to administer.
Catastrophe Reinsurance
Catastrophe reinsurance is the second type of non-proportional reinsurance

employed in the life insurance industry. Catastrophe reinsurance generally
calls for the reinsurer to reimburse a fixed percentage of the primary
insurer’s:
• aggregate losses
• in excess of the primary insurer’s conventional
reinsurance
• which exceed a prescribed limit
and
• which result from a single catastrophic event
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The reinsurance agreement normally requires the reinsurer to reimburse 90

percent to 100 percent of these excess aggregate losses.
The limit of coverage may be expressed in an aggregate dollar amount or in

terms of the number of lives lost. It normally covers a one-year period and
limits the reinsurance company’s liability to that prescribed period.
Catastrophe reinsurance is a prime example of coverage that is designed to

protect the primary insurer from a risk that has very low probability of
occurring but, if it does occur, it has an enormous liability attached to it. For
example, although the likelihood of another San Francisco earthquake is
fairly small, an insurer’s resulting liability could be astronomical.
Spread Loss
Spread loss is the final type of non-proportional reinsurance used in the life
insurance industry that we will consider. Although reinsurance tends to be
somewhat complicated, especially when it is being put to creative use,
spread loss reinsurance is probably the least complicated. This reinsurance
coverage has a single function: to spread an abnormally large loss incurred
in a single year over several years.
Spread loss reinsurance typically works as follows. In any calendar year in

which the primary insurer’s aggregate death claims exceed a specified
amount, the reinsurer steps in and assumes the claim payment liability.
Having paid these excess claims, the reinsurer adjusts the reinsurance
41
premium so that the amount of claims paid in that year plus 20 percent is
collected from the primary insurer over the ensuing five years. The net
result has been to spread these abnormally high claims over several years.
We can summarize these three types of non-proportional reinsurance as

shown in the graphic representation below:
Non-proportional reinsurance
Non-proportional reinsurance used in the life insurance industry generally

assumes three forms: stop-loss, catastrophe and spread loss.
Life Insurance Non-Proportional Reinsurance
Stop Loss Catastrophe Spread Loss
• Supplemental • Stop loss for • Spreads

• Losses exceeding accidental death large one year
normal mortality • Extraordinary losses over a
losses from longer period
single cause, e.g.
a plane crash
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Chapter Three
Purposes of Reinsurance
Why Insurers Choose to Reinsure
To this point we have considered how the various types of reinsurance

arrangements operate to meet the objectives of primary insurers, both life
insurance and property & casualty insurance companies. What we haven’t
yet done is consider why an insurer would choose to reinsure, other than for
the obvious reason of risk reduction.
As we continue our examination of reinsurance, we will see that reinsurance

is generally used by a primary insurer for one of two reasons:
• To transfer to another company some or all of a

primary insurer’s liabilities; or
• To accomplish one or more broad managerial
objectives
When reinsurance is used for the first purpose, it is generally referred to as

portfolio or assumption reinsurance; when used for the second purpose, it is
called indemnity reinsurance.
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Assumption Reinsurance
Through assumption reinsurance, a primary insurer transfers some or all of

its liabilities to a reinsurer. This type of reinsurance is always tailored to the
particular requirements of the situation and its parties. For that reason,
assumption reinsurance does not lend itself to broad generalizations.
However, it is a fairly simple matter to identify several uses to which
assumption reinsurance has been put.
The traditional uses of assumption reinsurance include:
• Assisting insurance companies during a period of financial

distress
• Financing mergers between and acquisitions of insurance
companies
and
• Facilitating restructuring
A traditional method of bailing out troubled insurers has been through the
use of assumption reinsurance. A number of life insurance companies have
found themselves forced to liquidate because they encountered severe
financial problems, including such companies as:
• Executive Life
• Confederation Life
and
44
• Mutual Benefit Life
In each of these cases, it might have been possible for the insurer to avoid
liquidation by reinsuring, if a reinsurance company was willing to assume
the risks involved.
It is not unusual in cases like these for two companies to implement a plan
whereby a solvent insurer will agree to assume the liabilities of the
distressed company. Not unexpectedly, the “white knight” will also gain
something in the transaction. In return for assuming the distressed insurer’s
liabilities, the reinsurer will generally obtain the assets underlying the
liabilities as well as the right to receive future premiums under the policies.
Sometimes, of course, the assets are insufficient to offset the liabilities. In

fact, this is a fairly likely scenario in a financially failing insurer. In such a
case, the reinsurer will normally place a lien against the cash values of the
ceded policies until the deficiency can be liquidated through the company’s
earnings on the policies. When a lien is placed on the failing insurer’s
policies, policyowners are restricted in their access to cash in their policies
—a situation that Executive Life policyowners encountered.
Many other dynamics are occurring in the life insurance industry that call for
the likely use of assumption reinsurance. Some of those changes are:
• Demutualization
• Mutual holding company formation
45
and
• Mergers and acquisitions
Insurance companies face significant challenges. Among those challenges

are the enormous costs involved in maintaining cutting-edge technology and
sustaining new product development initiatives. As insurers address the
important issues of identifying and returning to core competencies and
establishing critical mass levels, many of them have identified their ability to
raise capital as essential to their survival.
At one time, most of the insurance giants were mutual companies, owned by
and operated for the benefit of their policyowners. They had no
stockholders and were largely unable to raise capital. Because of that
inability, many of those companies considered demutualizing, forming
mutual holding companies, entering into strategic alliances and merging
with or acquiring other companies. Each of these alternatives that are
designed to help insurers raise capital involves a change in organizational
structure.
When insurers restructure, they often employ reinsurance to enable them to

cede business that isn’t core to their business strategy. For example, an
acquiring company will often cede much of the business of an acquired
insurer in order to divest itself of less profitable policies. Additionally,
restructuring insurers will often attempt to carve out mortality risks during
the demutualization process or during the formation of a mutual holding
company.
46
Sometimes, when mergers and acquisitions are being contemplated,

reinsurers may be asked to assume a portion of the transaction in order to
provide a certain amount of financing. Depending on the cost to borrow
money, financing through reinsurers may be less expensive.
Assumption reinsurance may involve only a portion of a ceding company’s

book of business. A prime example of that can be found in the home service
side of the life insurance business. Some of the largest life insurers in the
United States were initially in the home service—also known as the debit—
business, a business involving the sale of relatively small policies by an
agent who operates within an assigned geographical area selling and
servicing policies. While these companies may owe their current stature to
this type of business, many companies are leaving the debit business in
pursuit of more upscale clientele capable of purchasing larger policies. In so
doing, they may choose to identify such business as marginally profitable
and cede all of it—through assumption reinsurance—to another company.
In other situations, assumption reinsurance may be employed to enable an

insurer to withdraw from a particular state or region. Rather than being
required to continue to service insurance contracts in areas from which it had
withdrawn, an insurer may choose to cede the business to another insurer
that has continued to operate in the area. In such a case, everybody’s
interest—the policyowner’s, the ceding insurer’s and the reinsurer’s—is
usually served through the reinsuring of this business.
47
As we can readily see, assumption reinsurance must be individually

designed for each situation in order that the primary reinsurer’s objective can
be met.
Indemnity Reinsurance
Indemnity reinsurance is generally used by a primary insurer to transfer its

liability with respect to individual policies to its reinsurer. The transfer of
liability may involve all of the primary insurer’s liability under the life
insurance policy, or it may be a transfer of only a portion of it.
The use of indemnity reinsurance is widespread, and a primary insurer may

choose to use it for many reasons. Among the primary reasons for the use of
indemnity reinsurance are:
• Limiting the amount of insurance held on a single life

• Stabilizing the primary insurer’s mortality experience
• Reducing the insurer’s drain on surplus
• Gaining access to the reinsurer’s product development and
underwriting expertise
and
• Transferring liability under substandard insurance contracts
Of all the important reasons given for the use of indemnity reinsurance, its
most prevalent use is to enable the primary insurer to avoid too heavy a
48
concentration of risk on the life of a single policyowner. Almost all

companies choose to limit the amount of life insurance that they will retain
on the life of a policyowner. The amount limit is generally referred to as the
insurer’s retention limit. Although the actual amount may differ from
insurer to insurer, life insurance companies generally limit their retention to
no more than 1 percent of capital and surplus. It should come as no surprise,
therefore, that insurers with larger assets will generally have greater net
retention limits.
In addition to the amount of surplus that impacts an insurer’s retention level,

it will also be affected by the amount of insurance that the company has in
force and management’s confidence level in the company’s underwriting
ability. As a result of these considerations, a company’s retention limit may
be as low as $10,000 for a small, relatively young company to $30 million or
more for one of the giants.
Insurance companies may also have retention limits that differ based on
several factors. Some of the factors that might affect a company’s retention
for a particular risk are:
• The life insurance product—whether term insurance or

permanent insurance is being applied for
• The proposed insured’s age
and
• The proposed insured’s underwriting classification
49
Normally, those products that entail a higher degree of mortality risk, such
as term life insurance or insurance that is issued on a rated or substandard
basis, will have lower retention limits that apply. Additionally, many
companies will retain lower amounts for very young and very old insureds.
There is little question but that it is generally in an insurer’s interest to retain

as much of its business as it can prudently manage. As a result of that
general principle, insurers usually increase their retention limits as their
book of in-force business increases and their surplus funds grow.
In addition to limiting an insurer’s exposure to significant liability on a

single life, indemnity reinsurance is often used to stabilize the insurer’s
mortality experience. Typically, insurers will use stop-loss, catastrophe and
spread-loss arrangements to reduce their exposure to unwanted risk
concentrations as a means of stabilizing experience. It is these first two uses
of reinsurance that are most obvious. However, there are other reasons for
reinsurance that may be equally as important but far less obvious: surplus
management and reinsurer expertise.
Surplus in a life insurance company can be equated to retained earnings in

any other corporation. And, it is through its retained earnings that most
companies fuel their growth. Surplus serves the same purpose in a life
insurance company.
Surplus and the management of surplus are important issues in all life
insurance companies. In the small and medium size life insurance company,
it is critical. The reasons for that importance are:
50
• Surplus is generally in short supply

and
• Surplus is an absolute requirement in order to finance the
insurer’s ability to write new business
Surplus is used by an insurance company to meet its long-term commitments

and to finance its acquisition of new life insurance business. In a property &
casualty insurance company, state requirements typically prohibit an insurer
from writing insurance greater than 10 percent of its surplus on any single
loss exposure. As a result of that restriction, many companies would be
unable to write very much new business if it were not for the ability to
transfer liability by way of reinsurance. In fact, many property & casualty
companies would be severely restricted in their ability to write new business
were it not for reinsurance outlets.
An insurance company’s principal surplus source is its gain from operations.

Surplus is created to the extent that the insurer’s actual experience is more
favorable than its assumed experience on its book of business. This
favorable experience may result in:
• Mortality savings
• Excess earnings
and
• Expense savings
51
Although gain from operations is the principal source of surplus for

insurance companies, a second source of surplus comes from traditional
capital markets. In other words, insurance companies that are organized as
stock companies can issue stock.
Since generating surplus through the issuing of stock is an alternative

available only to insurance companies that are organized as stock
companies, mutual companies are at a significant disadvantage. Over the
last decade, this mutual company disadvantage has led many of the largest
mutual life insurance companies to elect to change their organizational
structure from a mutual company to a stock company; in other words, to
demutualize.
It is easy to see the beneficial results of demutualization in terms of surplus

creation by looking at the first financially healthy mutual insurance company
to demutualize in the United States. In 1986, a company then known as
Union Mutual changed its organizational structure to a stock company and
raised $580 million in its initial public offering of stock. It also doubled its
surplus.
We have looked at gain from operations and demutualization as ways in

which surplus can be created for an insurer, and we have left a major source
of surplus to the last: reinsurance. Reinsurance can serve as a major capital
source in the insurance industry. In a certain sense, a primary insurer that
purchases reinsurance can be seen as borrowing the reinsurer’s capital.
52
When the use of proportional reinsurance was examined in the life insurance
industry, we considered two major forms: coinsurance and modified
coinsurance. In both cases, a reinsurer paid the primary insurer a ceding
commission based on the amount of reinsured life insurance. That ceding
commission included an allowance for:
• Commissions paid by the primary insurer to its agent

• Premium taxes and
• A portion of the primary insurer’s overhead expenses
The reinsurer, by paying the primary insurer a ceding commission that may
be greater than an annual premium is, in fact, financing the primary insurer’s
ability to put additional business on its books. Through its commission
payment, the reinsurer is reducing the primary insurer’s surplus drain that
was caused by the writing of new insurance business.
Although the financial aspect of reinsurance is critical to many primary

insurers, it isn’t only the financial aspect of reinsurance that plays an
important role. Another important reinsurance use concerns the primary
insurer’s borrowing of the reinsurer’s expertise. This reinsurer expertise is
often used by primary insurers in two areas:
• Entering new lines of business

and
• Underwriting substandard risks
53
Let’s briefly consider each of these uses.
Entering New Lines of Business
It shouldn’t be surprising that when a primary insurer—normally a

particularly conservative organization—decides to add to its product line
there is a felt need to tap into available experience. That experience often
comes from reinsurers.
Consider, for example, the movement of a number of smaller life insurance

companies in the late 1970s and early 1980s to enter or expand their
marketing efforts in the disability income insurance line of business. While
offering what appeared to be a substantial source of profit, disability
coverage—at least in terms of its new forms and cutting edge features—was
new ground and needed to be developed and marketed cautiously.
A concern shared by many of these companies was that a noncancellable,

guaranteed renewable disability income policy with an “own occupation”
definition of disability could result in many millions of dollars in claims
over its life. For that reason, they turned to reinsurers that had a wealth of
54
accumulated disability income knowledge and experience in underwriting

disability income insurance.
Through the efforts of these reinsurers, many smaller life insurance

companies successfully entered the disability income business at a level that
would enable them to compete with other primary insurers having far greater
disability underwriting experience. Although many of these primary
insurers have since returned to marketing only their core life insurance
products and have sold their book of disability business to other companies,
they were able to enter the disability business only because of these
reinsurance companies.
Underwriting Impaired Risks
Another area in which primary insurers use the expertise of reinsurance

companies to significant advantage is in the area of impaired risks. Many of
these impairments are seen by underwriters on such an infrequent basis that
even the largest primary insurers have little experience in underwriting them.
Not unexpectedly, an underwriter faced with an impairment that may be
encountered once or twice in an entire career is justifiably concerned about
his or her ability to properly underwrite the risk.
In such a case, underwriters for primary insurers are likely to look for a
reinsurer that possesses the needed expertise. This type of knowledge—how
best to select impaired risks—is a special service that reinsurers offer to their
primary insurer customers.
55
Even though a particular impairment may be fairly common, primary insurer

underwriters will typically submit the risk to one or more reinsurers with
whom they have agreements. While they may want to solicit the best offer
from the reinsurer, primary insurers also have another objective in sending
the case to several reinsurance companies: it demonstrates to the soliciting
agent that everything has been done to ensure that his or her client has
received the most favorable underwriting decision.
Sometimes a primary insurer will want to transfer all of its substandard

policies to a reinsurer. This type of transfer occurs most frequently in those
situations in which a primary insurer writes no substandard business on any
basis. However, in order to provide a more complete range of products and
services to its agents, the primary insurer may arrange to channel all of its
substandard risk applications to a reinsurer with both the interest in writing
the business and an expertise in doing so.
As an alternative to the complete transfer of all substandard risks to a

reinsurer, a primary insurer may elect to transfer only those substandard
risks that represent a particular multiple of standard mortality or morbidity.
For example, a primary insurer might want to reinsure any application for
life insurance in which the proposed insured falls into a mortality class that
is 150 percent or more than standard mortality.
At this point, it should be clear that the uses of reinsurance are far broader
than the simple risk spreading would seem to suggest. As we have seen, it is
often used to attain management objectives that have little to do with
underwriting any particular risk.
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Chapter Four
Reinsurance Agreements
Reinsurance Agreements
Since primary insurers may reinsurer their business to achieve a wide range
of objectives, it ought not to be surprising that there are various types of
agreements. We noted at the outset of this course that there are two basic
types of reinsurance agreements and that these agreements are known as:
• Facultative agreements
and
• Treaty agreements
Thus far, the basic types of reinsurance have been examined along with their
uses. It is time to consider the agreements under which primary insurers and
reinsurers are bound.
The Facultative Agreement
In a facultative agreement, the reinsurer has the faculty—another word for

the power—to accept or reject any risk that is brought to it by the primary
insurer. As a result of this reinsurer ability to select risks on a case-by-case
basis, the agreement must establish a procedure that the primary insurer uses
to offer risks to the reinsurer.
57
The fundamental characteristic of a facultative reinsurance agreement is that

neither the reinsurer nor the primary insurer is required to offer or accept any
particular risk. Both insurers have complete freedom of action to consider
the risks on their own merits.
In a reinsurance arrangement using a facultative agreement, a primary

insurer will submit a copy of the application for the risk that it is interested
in reinsuring. In addition, it will normally include all of the supporting
documents that it has received from its agent, such as:
• Attending physicians’ statements

• A heart chart
• Avocation forms
and
• Financial statements
and any other material that bears on the appropriate underwriting of the
particular risk.
Additionally, the primary insurer will also submit a form to the reinsurer on
which it specifies the basis on which it is requesting reinsurance and the
amount of the risk that it proposes to retain. It is this form that is the offer
for reinsurance. As the offer, the form and its attachments supply all of the
information concerning the risk in the possession of the primary insurer and
typically requests that the reinsurer telephone, e-mail, fax or telegram
notification of its acceptance or rejection of the risk.
58
Whether the risk is a property & casualty risk or a life insurance risk,
facultative reinsurance is normally used in those cases where:
• The value to be insured is unusually high

or
• The risk is deemed to be substantially greater than normal
The Treaty Agreement
While the facultative reinsurance agreement provides the maximum freedom

to both the primary insurer and reinsurer to undertake any particular risk, the
treaty agreement severely limits that freedom. Unlike the arrangement in a
facultative reinsurance agreement, the treaty agreement—remember, it is
also known as “automatic” reinsurance—requires that the primary insurer
offer to reinsure every risk that falls within the provisions of the reinsurance
agreement. Furthermore, the reinsurance company must accept every risk
that is envisioned in the agreement.
The treaty agreement contains a schedule of retention limits that apply to the
primary insurer. Whenever the primary insurer issues a policy exceeding the
limits, the excess amounts must be automatically reinsured. Since the
reinsurance applies automatically, the procedure used in the facultative
agreement wouldn’t make much sense. Because of its automatic application,
the primary insurer typically sends no copies of the application or supporting
documents to the reinsurer under a treaty agreement.
59
The amount of reinsurance to which the reinsurer agrees to be bound—a

subject covered in the treaty agreement—generally depends upon the
reinsurer’s assessment of the primary insurer’s underwriting ability. Based
on the reinsurer’s level of confidence in the expertise of the primary
insurer’s underwriting staff and the primary insurer’s retention limits, it is
not uncommon for the reinsurer to agree to its automatic risk acceptance of
up to four or five times the primary insurer’s retention limits. For a primary
insurer with retention limits of $250,000, a reinsurer may agree to
automatically accept an additional $1.25 million in risk.
Of course, if the primary insurer’s retention limits are unusually high, a

reinsurer may reduce its automatic acceptance of risks so that it will only
accept risks no greater than an amount equal to the primary insurer’s
retention. For example, a primary insurer with a retention limit of $10
million may find it difficult to find a reinsurer that will agree to treaty
reinsurance at a level of greater than an additional $10 million.
The reinsurer under an automatic or treaty agreement must be able to rely

completely on the underwriting of the primary insurer. To be able to
confidently rely on that underwriting expertise, a reinsurer may require that
the primary insurer retain an amount of risk equal to its retention limit. If
the primary insurer seeks to remove itself from the risk by reinsuring its
portion of the liability under the risk through facultative reinsurance, the
automatic reinsurer is relieved of its obligation to accept the risk on an
automatic basis. In such a case, the entire risk is typically handled on a
facultative reinsurance basis.
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Even under treaty agreements, there are certain cases in which the reinsurer
is not required to automatically assume liability. This special handling
normally applies to jumbo cases, defined as cases in which the total
insurance amount on the proposed insured’s life in all companies, including
the amount applied for, is greater than the amount recited in the reinsurance
agreement. When situations like that occur, the automatic agreement no
longer applies, and the case is handled completely on a facultative basis.
The Cession Form
The contract between the primary insurer and the reinsurer is known as the
cession form. Irrespective of whether the agreement under which a primary
insurer and reinsurer are operating is of the facultative or treaty variety, it
provides that the primary insurer must prepare a formal cession of
reinsurance. This occurs only after the primary insurer’s agent has delivered
the policy to the policyowner and collected the first policy premium.
The cession form, in addition to incorporating the reinsurance agreement by

reference, contains several important elements, including:
• The details of the risk

• A schedule of reinsurance premiums
and
• A schedule of ceding commissions, if any
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A copy of the cession form is sent to the reinsurer, and a duplicate copy is
retained by the primary insurer. It will describe the reinsurance arrangement
and whether it is of the yearly renewable term insurance, coinsurance or
modified coinsurance type. It also makes provision for premium payments
from the primary insurer to the reinsurer and for ceding commissions to be
paid by the reinsurer if a coinsurance or modified coinsurance arrangement
is in force.
Reinsurance premiums paid by the primary insurer are normally on an

annual basis. Usually, the reinsurer will bill the primary insurer on a
monthly basis for the annual premium for all reinsured policies with
anniversaries on that month.
As each of the forms of reinsurance has been discussed, reference was made
to the portion of the risk for which the primary insurer is responsible and the
portion for which the reinsurer is responsible. Although that language is
sufficiently descriptive to apportion liability between the parties to the
agreement, it may be somewhat misleading.
It is important to remember that the primary insurer is responsible to the

policyowner for meeting all of the policy’s terms and providing all of its
benefits, irrespective of any reinsurance agreement. The reinsurance
agreement does not make the reinsurer responsible to the policyowner.
Instead, the parties to the reinsurance agreement are only the primary insurer
and the reinsurer, so that the reinsurance agreement makes the reinsurer
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liable to the primary insurer only. The policyowner is not a party to the
agreement.
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Chapter Five
Reinsurance in Operation
Claims
Insurance is generally purchased because of the policyowner’s need to be

assured that a payment will be made if and when a claim is presented. So,
this is a reasonable place to begin a discussion of how reinsurance works in
the primary insurer’s day-to-day operations.
We observed, earlier, that a policyowner is not a party to a reinsurance

agreement. Often, the policyowner isn’t even aware that reinsurance is in
effect on his or her policy. Instead, the policyowner looks to the insurer that
issued the policy, i.e. the primary insurer, to pay any benefits due under it.
Because the policyowner expects claims payment from the primary insurer,
the reinsurance agreement provides that any settlement of the claim made by
the primary insurer is binding on the reinsurance company. That provision
applies irrespective of the type of reinsurance agreement in force. Even
though a primary insurer can bind its reinsurer to its claim decisions,
primary insurers often consult with reinsurers in situations involving
doubtful claims.
In settling policy claims, the reinsurer can be seen as an extension of the

primary insurer. To the extent that a claim is settled for less, the reinsurer
participates in the savings. Or, if legal costs are incurred in order to contest
a claim, the reinsurer must bear its part.
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Normally, when a policy has been reinsured, the reinsurer is legally

obligated for the life of the policy. However, there are two exceptions to the
general rule:
• When the amount of coverage in force has declined

and
• When the primary insurer increases its retention limits
Change in Reinsurance Amounts
The total amount of coverage in force may decline because certain coverage
has expired according to the policy’s terms. For example, a non-renewable,
non-convertible term insurance policy might expire because the insured
lived to the end of the specified term. Or, the policyowner may have lapsed
a policy by not paying its premiums when due.
Regardless of the cause of the decline in coverage, the amount reinsured

changes. There are generally two approaches for making the reduction in
the amount reinsured:
• An “off the top” reduction in reinsurance

or
• A pro rata reduction
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In the case of a reinsurance agreement that calls for an off the top reduction
in reinsurance, the total amount of the reduction in coverage comes solely
out of the sum reinsured, up to the total sum reinsured. For example,
suppose that the primary insurer retained $1 million of coverage in a total $5
million insurance portfolio. In an off the top arrangement, a reduction in
coverage of $500,000 would leave the retained amount unaffected but would
reduce the reinsured amount from $4 million to $3.5 million.
In a reinsurance agreement that provides for a pro rata reduction, the amount
retained and the amount reinsured would be reduced as a result of the
coverage reduction. In the example above of a $5 million insurance
portfolio that was reduced by $500,000, a reinsurance agreement calling for
a pro rata reduction would reduce the $1 million retained by $100,000 and
the $4 million reinsured by $400,000. The result would be a retention of
$900,000 and a reinsured amount of $3.6 million.
The other exception to the general rule of the reinsurer being at risk for the
duration of the coverage applies when the primary insurer increases its
retention limits. This increase in retention limits normally occurs as a
reinsurer’s small client insurers grow their assets and increase their
insurance in force. Often, in such a case, they will choose to increase their
retention and hold onto more of their risk exposure and their premiums.
In such a case, reinsurance agreements normally permit a “recapturing” of

the primary insurer’s reinsured business. Under the recapture provision of
many reinsurance agreements, a primary insurer that increases its retention
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limits is permitted to reduce the amount of risk previous transferred to the

reinsurer and, thereby, retain more of its premiums.
For example, a primary insurer that initially had a retention limit of $2

million would, of course, reinsure everything in excess of $2 million. If it
insured an individual for $5 million, it would reinsure $3 million. However,
if the primary insurer subsequently increased its retention to $3 million, it
would generally be permitted to recapture the $1 million of coverage that it
had previously reinsured.
Although primary insurers are typically able to recapture risk amounts

formerly reinsured, there are restrictions normally placed on when a primary
insurer may recapture. The principal restriction imposed on recapture is in
the form of time limits.
The time limit restrictions placed on a primary insurer’s ability to recapture

amounts previously reinsured are designed to permit the reinsurer to recover
its costs to acquire the business. While any particular reinsurance agreement
may differ, reinsurance customs generally permit recapture according to the
following:
• Recapture of business reinsured under a yearly renewable

term arrangement only after being in force for at least 5 years
and
• Recapture of business reinsured under a coinsurance
arrangement only after being in force for at least 10 years
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The reason for the longer required duration before recapture under a
coinsurance arrangement is due to the generally higher business acquisition
costs under the coinsurance form of reinsurance.
Agreement Duration
Although the reinsurance remains in force for as long as the insurance

policies continue, subject to these exceptions, the reinsurance agreement
may be terminated. When a reinsurance agreement is terminated, either by
the primary insurer or by the reinsurer, it affects only those insurance
policies issued after the effective date of the termination.
Reinsurance agreements generally provide for a required 90-day notice

before either the primary insurer or reinsurer may terminate the agreement.
The principal reason for the 90-day notice requirement is to give the primary
insurer sufficient time to make other arrangements to reinsure its new
business.
Experience Rating
Individual policyowners that purchase participating policies are able to

receive dividends if the insurer’s experience is better than anticipated. A
somewhat similar arrangement is available in the reinsurance arena. Known
as experience rating, primary insurers are able to participate in a reinsurer’s
mortality gains and losses. Although experience rating was a common
reinsurance practice early in the 20th century, it ceased following the
disastrous experience of life insurance reinsurers during the Great
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Depression. Experience rating in the reinsurance market is making a

comeback.
By virtue of this sharing agreement, a primary insurer could receive a

mortality refund from the reinsurance company based on its combined
experience under all of the business that it reinsures. The potential
disadvantage of this arrangement, however, is that a primary insurer would
also be required to participate in mortality losses that exceeded a certain
limit. In such a case, the primary insurer would be assessed a surcharge.
There are several different arrangements under which a gain or loss sharing
can take place between a primary insurer and its reinsurance company.
Supplementary Coverage
Reinsurance agreements used in the life insurance industry may or may not
apply to supplementary coverages, such as accidental death benefits.
Usually, supplementary benefits are reinsured at the same time that basic
benefits are reinsured when the reinsurance agreement is facultative.
However, when the agreement calls for the automatic reinsuring of business,
there is usually a separate agreement that deals with the reinsuring of
supplementary benefits.
Special arrangements that apply to supplementary benefits are sometimes

required when a primary insurer establishes different retention limits for
basic benefits than for supplementary benefits. For example, a primary
insurer’s establishing higher basic benefit retention limits than it does for
supplementary benefits is not uncommon. In such a case, it may frequently
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be necessary to reinsure a supplementary benefit even though basic benefits

are completely retained. For example, if an insurer had a $500,000 basic
benefit retention limit but only a $250,000 supplementary benefit limit, a
$500,000 policy with an equal amount of accidental death benefit would
only have $250,000 of accidental death benefit reinsured.
Substandard Reinsurance
We noted earlier that some primary insurers reinsure all of their substandard
business while other insurance companies reinsure it only in accordance
with their normal retention schedule. As with standard risks, substandard
business may be reinsured under a coinsurance or yearly renewable term
basis.
If the substandard risks are reinsured using a coinsurance arrangement, the

primary insurer pays the reinsurer the appropriate portion of the gross
premium which includes its portion of the additional substandard charge.
Similarly, if the substandard risk is reinsured under a yearly renewable term
arrangement, the reinsurance premium is normally determined using the
same multiple of the standard insurance rate. In simpler terms, the reinsurer
always receives its portion of the additional premium charged to substandard
risks that are reinsured.
Decisional Factors in Setting Retention Limits
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We have talked about retention limits that are established by primary

insurers without examining the factors that need to be considered before the
limits are set. Let’s turn our attention to those factors now.
The decisional factors that typically play a part in a primary insurer’s

establishing retention limits include:
• The amount of surplus that the primary insurer has

• The distribution of the insurer’s business, with respect to
amounts, number and types of policies, ages and
geographical dispersion
• The expected distribution of new business, including the
average face amount per policy
• The effectiveness of the primary insurer’s agents and
home office underwriters to acquire policies whose actual
mortality rates approximate the mortality rates assumed in
the premium calculations
Once a primary insurer has assessed its in-force business and likely new
business, it then needs to consider several related issues that bear on its
retention limits. For example, should the company set its retention limit at
the same level for all ages? For many insurers, the answer to that question is
no.
Many insurers establish their highest retention limits for policies to insured
with issue ages between 21 and 60. Policies issued to insured below 21 or
above 60 are subject to reduced retention limits. Sometimes an insurer will
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have retention limits that become increasingly reduced, as the issue age is
further away from age 60.
Another consideration in establishing retention limits relates to whether

separate retention limits should be established for standard risks that are
different than the limits that apply to substandard risks. In practice, many
primary insurers set lower retention limits to substandard issues. In
addition, the retention limits are often further reduced for additional
substandard levels.
A primary insurer must also decide if it should establish separate retention

limits based on the different plans of insurance. Since term insurance
involves a generally greater net amount at risk, should it be more heavily
reinsured than whole life insurance? While it continues to be fairly standard
practice for an insurance company to reinsure a disproportionate amount of
term insurance, there is some indication that the disparity in retention limits
between different insurance types is moderating.
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Chapter Six
The Reinsurance Environment
Product, Market and Classification Development
Industries generally tend to become more competitive over time; this

observation is true of the insurance industry as well. As the insurance
industry grows and continues to mature, it has implications with respect to
its products, markets and insurance classification.
New Products
And, as the industry becomes increasingly competitive, it is creating and

bringing new products to the marketplace at an ever-faster rate. These new
products are causing primary insurers to broaden and expand their
relationships with reinsurers who provide new product-design expertise
along with their customary risk-transfer function.
Some of these new products involve a blend of investment and mortality

risks. For example, guaranteed minimum death benefits under variable
annuities and variable universal life insurance generally require a substantial
level of competent and knowledgeable assistance in order to ensure that
primary insurers won’t experience a critical drain on reserves. Reinsurers
are the obvious choice to provide this expertise by assisting primary insurers
in developing attractive and reasonably priced products.
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Classification of Life Insurance Risks
Reinsurers also play a continuing role in the classification of life insurance

risks and help bring about a certain level of stability in what has become an
evolution in preferred risk underwriting. To appreciate the proliferation in
risk classification, it is only necessary to see the growth in underwriting
classes from the early standard smoker and non-smoker classes to the eleven
risk classes available at certain life insurance companies today.
Emergence of New Reinsurance Markets
In addition, new reinsurance markets are emerging that are likely to change
the face of the industry. The Bermuda reinsurance market has grown
substantially and is the third largest insurance market in the world, following
only London and New York. The Bermuda reinsurance market continues to
see activity in life and annuity reinsurance, financial guaranty reinsurance
and in the securitization of risk.
Company Restructuring
We noted earlier that reinsurance is often at the forefront of the industry’s

restructuring efforts, whether it involves demutualization, merger or
acquisition.
Insurers in the process of demutualization may attempt to carve out their

mortality risks so that they can determine on a block-by-block basis which
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business is likely to result in long-term value to the firm. Typically, those

blocks of business that are deemed to offer less value are ceded to reinsurers
just the way that blocks of business outside their core business are
transferred. Insurers that are demutualizing often use reinsurance to run off
their books of business, and once they have demutualized, they are likely to
have a significant reinsurance need.
In addition to providing assistance in demutualization, reinsurers can expect

to be asked to provide financing for mergers and acquisitions. Depending on
the prevailing interest rates, primary insurers may find reinsurance financing
to be cheaper than borrowing or issuing stock.
Increased Risk
Despite the many favorable changes in the reinsurance marketplace, not all
of the changes are good ones. Reinsurers are experiencing considerable
increases in potential losses and exposures to risk. This is a long-term trend
that doesn’t appear to be moderating.
The increased risk that is affecting the reinsurance marketplace comes from:
• Increased levels of civil litigation

• An increase in the size of average jury awards
• Significant increases in insurance claim payments
and
• High catastrophic losses
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Additionally, the increasing world unrest has greatly increased the threat of
global and local terrorism.
Product liability has become an increasingly expensive issue for reinsurers.

The prevailing legal doctrine with respect to product and seller liability has
changed over the years from caveat emptor—let the buyer beware—to
caveat vendor, which means “let the seller beware.”
The standard in product liability had long been the traditional tort standard.
Specifically, the plaintiff was required to prove the manufacturer had been
negligent in some way before the plaintiff could recover damages. That
standard has been eroded by both legislation and court decisions so that it
has now been replaced, in large measure, by a standard of strict liability.
Negligence appears no longer to be a central ingredient in the successful
maintenance of a civil suit for product liability. All that may now be
necessary is a showing that a product defect caused an injury. For reinsurers
this change has had significant adverse financial effects.
Competition
New entrants continue to come into the reinsurance market. A significant

number of the new reinsurers have been Bermuda companies. With their
significant levels of expertise and generally narrower focus, these reinsurers
have accounted for almost one-third of the overseas reinsurance market.
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While competition is generally a good influence, there is some suggestion

that it has resulted in pushing rates down below the level of risks being
assumed. In light of the increasing risks that are affecting reinsurers, rates
are likely to rebound.
Interest Rates & Financial Volatility
The reinsurance industry is sensitive to interest rate and capital market

volatility. These stresses have generally reduced the tolerance for any error
in the reinsurance business.
In the reinsurance market—particularly among property & casualty insurers

—high interest rates often result in cash flow underwriting. In cash flow
underwriting, greater emphasis is placed on generating cash flow for
investment at the expense of traditional underwriting prudence. As a result,
insurance rates are driven downward and the usually conservative
underwriting posture is largely abandoned.
While this strategy may result in high levels of cash flow for investment, the
decline in interest rates inevitably results in lower earnings at the same time
that liberal underwriting has produced high claims levels. The result, of
course, is loss for primary insurers and their reinsurers.
Another related problem that affects reinsurance companies is inflation.

While inflation levels have generally been well controlled in recent years,
the danger continues to exist.
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For reinsurers, the inflation problem is caused by the generally higher

product liability and tort judgments that reflect inflation. As judgments
increase, there is an increase in unanticipated reinsurer liability that was
unexpected at the time that the business was ceded. While reinsurers have
tried to avoid this inflation-caused concern by inflation-indexing the
retention of primary insurers so that it, too, would keep pace with changes in
the CPI, this attempt has been met with considerable opposition from
primary insurers.
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Chapter Seven
Reinsurance Regulation
Introduction
As recently as fifteen years ago, reinsurers’ accounting requirements were

minimal and were addressed in the space of two or three pages in the NAIC
Accounting Practices and Procedures Manual. Since that time, reinsurance
regulatory oversight has increased significantly. The areas in which these
increases have been found include:
• Disclosure
• Risk transfer assessment and accounting and
• Security
This increased regulation has resulted from the regulators’ realization that
the solvency of primary insurers often depends on their ability to collect
under their reinsurance agreements. Since primary insurers cede more than
$50 billion in premiums in any given year to reinsurers, the ability to collect
under reinsurance agreements is a very serious issue.
Another significant factor in the pressure that state regulators feel towards
their regulation of the reinsurance industry is the federal government’s
interest in this area. The failure of several large property & casualty insurers
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resulting from their inability to collect under their reinsurance agreements

has spurred this federal interest.
Several natural catastrophes occurred during the decade of the 1990s that
caused many to fear the imminent collapse of the reinsurance industry. Even
Lloyd’s of London would have difficulty meeting its obligations. Due to
these natural disasters and the growing concern about reinsurers’ financial
stability, the Financial Accounting Standards Board has tightened generally
accepted accounting principles (GAAP) for reinsurance transactions.
Following FASB’s lead, the National Association of Insurance
Commissioners developed new accounting guidance for reinsurance that was
based on the Standards Board’s action.
Disclosure
The first area to feel the increase in regulatory oversight is disclosure. The
required additional disclosure permits regulators to perform a more
extensive analysis of a primary insurer’s reinsurance programs and a more
thoroughgoing evaluation of its exposure to additional risk in the event any
of its reinsurers fail to fulfill their contractual obligations.
Schedule F in the NAIC Annual Statement provides a detailed disclosure of

information regarding the insurer’s reinsurance. All of the information on
the ceded business can be found there. This schedule was greatly expanded
in 1992 to include eight separate parts. While an analysis of each part of the
schedule would probably provide little in the way of important information,
it is instructive to appreciate the magnitude of the change between the old
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part 1 of Schedule F and the new part 1. While the old part 1 only required
financial information concerning reinsurance payable on paid and unpaid
losses to each reinsured, the new part 1 requires substantial increases in
disclosure.
In fact, the new part 1 requires, for each reinsured, that the following
disclosures be made:
• The paid losses and loss adjustment expenses

• The known case losses
• The incurred but not reported losses
• The contingent commission payable
• The assumed premium receivable
• The funds held or on deposit
• The letters of credit posted
and
• The amount of assets pledged or compensating balances
The net effect is a significant increase in the disclosure requirements of

reinsurance operations.
Assessment of Risk Transfer & Accounting
In additional to substantially increased disclosure requirements, the NAIC’s

Accounting Practices and Procedures Task Force has modified the NAIC’s
accounting guidance.
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The Accounting Practices and Procedures Manual identify the essential

ingredient of a reinsurance contract as the transfer of insurance risk. This
element of insurance risk transfer is essential because it enables a
reinsurance contract to qualify for loss reserve credit, and this credit is an
important financial consideration. The Manual goes on to state that
investment risk is not an element of insurance risk.
The result of this requirement that there be an insurance risk is to curb a

practice that the insurance regulators consider a misuse of reinsurance
contracts. However, the regulators have used changes in accounting
requirements rather than regulatory restraint to bring about the change. A
failure of a reinsurance contract to contain insurance risk will result in the
reinsurance balances being accounted for as deposits rather than qualifying
for loss reserve credit.
Security
Heightened regulatory oversight is primarily the result of concern about the

financial soundness of reinsurers. This heightened oversight is intended to
assure that reinsurance assures security.
Under the law, if security is not deemed to exist, then a credit for
reinsurance against loss reserves is not allowed the ceding company. The
effect on the ceding company in the event that security is not seen to exist is
a charge against its surplus. Since surplus is the vital ingredient in an
insurer’s ability to write business, this is a significant issue.
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Security is not deemed to exist if:
• The reinsurer is not authorized or accredited and

• The reinsurance from the unauthorized insurer is not
secured by funds withheld, trust funds or letters of credit
The result of this increased regulatory oversight is a much increased

security for primary insurer and, ultimately, for their policyowners.
For reinsurers, the decade of this heightened regulatory oversight has
been a period of significant turmoil and change.
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Glossary
Aggregate excess Aggregate excess of loss reinsurance is a non-

of loss reinsurance proportional type of reinsurance used in the property &
casualty industry that is also called “stop-loss” and
“excess-of-loss ratio” reinsurance. It is reinsurance
designed to cover a total of losses over a period of time
or for a particular policy.
Assumption Assumption reinsurance is reinsurance used to transfer

reinsurance some or all of a primary insurer’s liabilities to a
reinsurer. It is always tailored to the specific facts and
requirements of the situation and is frequently employed
to assist insurance companies that are in financial
difficulty. It is employed in both the life insurance and
property & casualty insurance industries.
Cash flow Cash-flow underwriting is a generally discredited

underwriting business-acquisition strategy sometimes employed in the
property & casualty industry that puts greater emphasis
on writing business that generates cash flow for
investment at the expense of traditional underwriting
prudence. It has been used in periods of high interest
rates.
Ceding Ceding is the act of transferring liability from a primary

insurer to a reinsurer through reinsurance.
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Ceding A ceding commission is used in coinsurance and

commission modified coinsurance forms of reinsurance. A ceding
commission is paid by the reinsurer to the primary
insurer for placing business with the reinsurer. This
ceding commission reimburses the primary company for
the expenses incurred in its acquiring the business and
normally includes: a) an allowance for commissions paid
to the primary company’s agent, b) premium taxes, and
c) a portion of the primary insurer’s overhead expenses.
Cession form A cession form is the insurance contract between the

primary insurer and the reinsurer. It recites the details of
the particular risk, a schedule of reinsurance premiums
and ceding commissions and includes, by reference, the
entire reinsurance agreement between the primary
insurer and the reinsurer.
Coinsurance Coinsurance, when used in terms of reinsurance, is a

proportional type of reinsurance used in the life
insurance industry. Generally more complex than yearly
renewable term reinsurance, the reinsurer is liable for its
pro rata share of death benefits, dividends, cash
surrender value and other nonforfeiture benefits. The
reinsurer maintains the reserves on the ceded insurance
under this arrangement and generally provides a ceding
commission to the primary insurer.
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Excess of loss Excess of loss reinsurance is reinsurance that provides

coverage for losses in excess of the primary insurer’s
deductible. It is much greater developed in the property
& casualty industry than in the life insurance industry.
Experience rating Experience rating is an arrangement whereby the

primary insurer participates in the reinsurer’s mortality
gains and losses. Depending on the reinsurer’s
combined experience under all of the business that it
reinsures, a primary insurer may receive a mortality
refund or be required to pay a mortality surcharge. This
arrangement normally reduces the importance to the
primary insurer of recapturing its reinsured business.
Facultative Facultative reinsurance is a broad, general category of

reinsurance reinsurance under which reinsurance is arranged for each
separate risk at the time that it is incurred. The reinsurer
retains the faculty or power to accept or reject any risk
presented to it.
Indemnity Indemnity reinsurance is a reinsurance arrangement

reinsurance designed to transfer a primary insurer’s liability with
respect to some or all of the coverage under individual
policies to a reinsurer. Normally employed to a) limit
the liability on a single life, b) stabilize mortality
experience, c) reduce surplus drain, d) use the
reinsurer’s expertise, or e) transfer substandard
insurance, its use is widespread.
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Individual excess- Individual excess-of-loss reinsurance is a form of non-

of-loss reinsurance proportional reinsurance used in the property & casualty
industry under which the reinsurer is liable for any claim
that exceeds the primary insurer’s net retention.
Jumbo case A jumbo case is usually defined as a life insurance case

in which the total amount of insurance in force and
applied for on the life of the proposed insured in all
companies exceeds an amount specified in the automatic
reinsurance agreement. Jumbo cases are always handled
on a facultative basis.
Life insurance- Catastrophic reinsurance is a form of non-proportional

catastrophic reinsurance used in the life insurance industry that calls
for the reinsurer to pay a fixed percentage of a primary
insurer’s aggregate losses in excess of its conventional
reinsurance in connection with a single catastrophic
event. It is sometimes referred to as stop-loss for
accidental death.
Life insurance- Spread loss reinsurance is a form of non-proportional

spread loss reinsurance used in the life insurance industry under
which a primary insurer is able to spread a large loss,
incurred in a single year, over a number of years.
Typically, the reinsurer pays the loss and recovers it
over the following five years.
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Life insurance-stop Stop loss reinsurance is a form of non-proportional

loss reinsurance used in the life insurance industry primarily
as a supplement to proportional reinsurance. Designed
to keep the primary insurer from suffering financial
reverses due to abnormally high mortality incurred
during a specific period, a typical agreement calls for a
reinsurer to assume any losses that exceed 10 percent of
the primary insurer’s normal mortality in a calendar
year.
Modified Modified coinsurance is a form of proportional

coinsurance reinsurance used in the life insurance industry. It is
similar to coinsurance except that the reinsurer does not
maintain the entire reserve for the reinsured business.
Each year, the reinsurer pays to the primary insurer the
net increase in the policy reserve that occurred on the
reinsured business that year.
Net amount at risk Net amount at risk is the amount of a death benefit that
exceeds the policy’s reserve held by the insurer.
Non-proportional Non-proportional reinsurance is also called “excess of

reinsurance loss” reinsurance and is a form of reinsurance under
which a reinsurer pays any and all claims in excess of
the primary insurer’s net retention.
Occurrence excess Occurrence excess of loss reinsurance is a form of non-

of loss reinsurance proportional reinsurance used in the property & casualty
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insurance industry under which a reinsurer pays any loss

on an individual catastrophic event exceeding a specified
total for the primary insurer.
Primary insurer The primary insurer is the insurance company whose

agents or brokers sell the insurance coverage. The
primary insurer cedes coverage to the reinsurer.
Proportional Proportional reinsurance is also called pro rata

reinsurance reinsurance. It is a form of reinsurance under which the
primary insurer retains a predetermined share or amount
of the liability and keeps a predetermined share of the
premium. Liability for loss is apportioned between the
primary insurer and the reinsurer based on their
proportion of premium retained.
Quota-share Quota-share reinsurance is a form of proportional

reinsurance reinsurance employed in the property & casualty
industry under which the primary insurer cedes a fixed
percentage of each policy that it writes in a certain line
or class of business. The premiums and losses on the
policy are shared between the primary insurer and
reinsurer based on that percentage.
Recapture Recapture is an arrangement, detailed in the reinsurance

agreement, under which a primary insurer may re-
assume amounts of insurance previously reinsured.
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Reinsurance Reinsurance is a device by which one insurance

company transfers all or a portion of its risk under an
insurance policy or group of policies to another
insurance company called the reinsurer.
Retention Retention is the amount of any risk that is not reinsured

but, instead, is kept by the primary insurer.
Substandard Substandard insurance is insurance written on risks that

insurance are expected to produce higher than normal claims.
Substandard insurance is sometimes ceded to a reinsurer
in its entirety by primary insurers that do not wish to
write substandard insurance but want to provide a full
range of services to their agency forces.
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Surplus Surplus is an insurance company’s capital. It is used

by a company to meet its long-term obligations and to
finance its acquisition of new insurance business.
Surplus drain Surplus drain refers to a negative impact on an

insurer’s surplus. It is often caused by an insurer’s
acquisition of new insurance.
Surplus share Surplus share is a form of proportional reinsurance

used in the property & casualty industry under which
the primary insurer’s retention is stated as a dollar
amount. Under such an agreement, the reinsurer does
not participate in the risk unless the policy’s limits
exceed the primary insurer’s net retention. Once the
amount of reinsurance is determined under this
arrangement, the premium is retained by each party in
the same proportion as the assumed liability.
Terminal reserve The terminal reserve is the difference, in dollars,

between the present value of future benefits and the
present value of future net premiums at the end of any
given policy year. It approximates the policy’s cash
value.
Treaty reinsurance Treaty reinsurance is also called “automatic”

reinsurance. It is reinsurance that is automatic for all
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policies that fall within the terms of the reinsurance

agreement and is not negotiated separately for each
risk.
Yearly renewable The yearly renewable term plan is a form of

term plan proportional reinsurance employed in the life
insurance industry. Under this form of reinsurance the
primary insurer buys term insurance from the reinsurer
on a yearly renewable basis for the amount of risk on a
particular policy that is in excess of the primary
insurer’s retention limit.
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PRINCIPLES & TYPES OF REINSURANCE

Chapter One - Introduction to Reinsurance

Chapter Two - Types of Life and Property & Casualty Reinsurance

Proportional Reinsurance for Life Insurance Companies

Yearly Renewable Term

Non-proportional Reinsurance for Life Insurance Companies

Stop Loss Reinsurance

Spread Loss Reinsurance

Chapter Three - Purposes of Reinsurance

Underwriting Impaired Risks

Chapter Four - Reinsurance Agreements

The Cession Form

Chapter Five - Reinsurance in Operation

Chapter Six - The Reinsurance Environment

Product, Market and Classification Development

Emergence of New Reinsurance Markets

Chapter Seven - Reinsurance Regulation

Assessment of Risk Transfer and Accounting

It wasn’t long before Lloyd’s Coffeehouse became the center of marine

Exchange—late in the 19th century—Lloyd’s was incorporated and became

The bulk of Lloyd’s of London’s business continues to come from the

Although there are certainly some similarities between the individual as

The concept of risk-sharing is as fundamental to reinsurance as it is to

The presence or absence of reinsurance is not generally something of which

There are two basic types of reinsurance, known as:

Regardless of whether the reinsurance arrangement is facultative or treaty,

The primary difference between proportional and non-proportional

In the case of proportional reinsurance—also called a pro-rata agreement—

Proportional reinsurance is further divided into two categories depending on

In quota share reinsurance a fixed percentage of coverage provided under

Insurance Amount Amount Ceded

$50,000 $12,500 $37,500

As we can see, in the case of a quota share treaty reinsurance agreement,

In a surplus share agreement, the primary insurer retains a fixed amount of

Insurance Amount Retained Amount

So, we have seen that reinsurance may be proportional or non-proportional.

Non-proportional reinsurance is also called “excess of loss” reinsurance. In

Proportional Reinsurance for Life Insurance Companies

We have looked at reinsurance in a general fashion and considered the

Two basic approaches are taken to the providing of proportional reinsurance

• The yearly renewable term insurance plan

Yearly Renewable Term

In the case of proportional reinsurance provided under a yearly renewable

The amount of yearly renewable term life insurance purchased is equal to

Net amount at risk

Net amount at risk

Net amount at risk

Since the policy is whole life insurance, it is characterized by a level death

• Ability to choose a reinsurer that is unlicensed in the primary

Because the yearly renewable term insurance plan is characterized by greater

By employing a yearly renewable term insurance plan as a method of

• Dividends, in the event the insurance is participating

Let’s return to our earlier example of the 35 year-old applicant that

reinsurer pays the primary insurer a commission, known as a “ceding

The ceding commission that is paid by the reinsurer is designed to include:

• An allowance for the commissions paid by the primary insurer to its

As we noted, in addition to this commission arrangement, the coinsurance

Although participating policy dividends tend to be affected more

Despite these complications in the relationships between primary insurers

In addition to dividends, the reinsurer, in the case of coinsurance, is liable

The coinsurance plan approach to reinsurance resulted in the reinsurer’s

Primary insurers—particularly those that are most sensitive to the surplus

Under this modified coinsurance arrangement, as a result of this annual