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REINSURANCE MANAGEMENT

Written by

Mr. George Steven Okotha (B.Sc (Stat & Econ)

ACII, FIIU

Chartered Insurance Practitioner

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REINSURANCE MANAGEMENT

GENERAL INTRODUCTION

This course is designed for candidates preparing for the Diploma examination of the Insurance

Institute of Uganda.

The course is written with examples and readers will find the contents useful in better

understanding as well as gaining knowledge of the subject. The course is useful not only to those

appearing for the Diploma examination, but also to the general reader interested in the subject.

Although the course gives detailed knowledge of the subject, it is recommended that the candidates

should read additional literature on the subject.

Course description

This course will explore the basic characteristics, practices and procedures for the reinsurance

transactions in a ceding/reinsurance company. The course will develop basic analytical skills that

are vital in determining the interrelationship of reinsurance accounts for a better understanding and

reporting of reinsurance results. Covers the need for and purpose of reinsurance, how to comply

with requirements, the process of placement, how to process facultative and treaty claims and how

to calculate the costs of recovery - including reinstatements of reinsurance claims

Course objectives

i) To explain the importance and needs for reinsurance protection

ii) To understand the principles underlying the reinsurance business

iii) To appreciate the role of reinsurance in the insurance industry

iv) To understand the different approaches to reinsurance

v) To understand the intent and implications of a company and reinsurer perspectives when

ceding coverage

vi) To understand the underwriting activities, process, management and the regulation of

underwriting of reinsurance business

Learning Outcomes

Upon completion of the program, the reader should be able:

(i) To explain the need for and purpose of reinsurance

(ii) To identify and describe the different methods of reinsurance

(iii) To comply with the reinsurance requirements of an insurer

(iv) To explain the process of reinsurance placement

(v) To outline how to process facultative and treaty reinsurance claims

(vi) To demonstrate how to calculate the recovery, including reinstatements, of reinsurance

claims.

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Detailed course outline

CHAPTER TOPIC LESSON DETAILS

Chapter 1 Introduction to

Reinsurance

1.0 Key reinsurance terms

1.1 Legal principles of reinsurance

1.2 Privity of contract

1.3 Benefits of reinsurance

1.4 Nature of reinsurance

1.5 Need for reinsurance

1.6 Functions of reinsurance

1.7 Example of need for reinsurance

1.8 Advantages of reinsurance to ceding company

1.9 Factors which influence the results of

reinsurance

1.10 Graphical illustration

Chapter 2 Types of Reinsurance 2.0 Types of reinsurance arrangements

2.1 Facultative reinsurance

2.2 Treaty reinsurance

2.3 Proportional treaty

2.4 Non-proportional treaty

2.5 Risk attaching, losses occurring and claims

made

2.6 Reinstatements

2.7 Pools

Chapter 3 Proportional

Reinsurance

3.0 Basics of proportional reinsurance

3.1 Quota share

3.2 Surplus treaty

3.3 Facultative obligatory treaty

3.4 Reinsurance commission

Chapter 4 Non-Proportional

Reinsurance

4.0 Non proportion reinsurance

4.1 Status of ceding insurer

4.2 Different types of excess of loss reinsurances

4.3 Non proportional treaty

4.4 Important features of non proportional

reinsurance

Chapter 5 Processing Information

for Reinsurance

Decisions

5.0 Importance of statistics in reinsurance

5.1 Underwriting issues in reinsurance treaties

5.2 Provision for outstanding losses

5.3 Control of accumulation

5.4 Assessment of cumulative commitments

5.5 Systems and procedure

5.6 Guidelines for developing a system

5.7 Use of information technology

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5.8 Organization of the reinsurance department

Chapter 6 Retention 6.0 Setting retentions

6.1 Factors influencing retention

6.2 Types of retentions

6.3 Retentions for property and

engineering reinsurance

6.4 Retention for different lines of

reinsurance

Chapter 7 Reinsurance

Underwriting

7.0 Reviewing the reinsurance program

7.1 Negotiating a reinsurance contract

7.2 Property proportional reinsurance

7.3 Property non – proportional reinsurance

7.4 Accident proportional reinsurance

7.5 Accident non – proportional reinsurance

7.6 Life reassurance

7.7 Treaty Reaasurance

Chapter 8 Basics Of Reinsurance

Accounting

8.0 Reinsurance accounting

8.1 Types of premium income

8.2 Unearned premium reserves and portfolios

8.3 Outstanding losses and IBNR

8.4 Loss reserves and outstanding loss portfolios

8.5 Formats and methods of reinsurance

accounting

Chapter 9 Reinsurance Treaty

Wording

9.0 Treaty wordings

9.1 Proportional wordings

9.2 Non – proportional wordings

9.3 Common clauses

Chapter 10 Reinsurance Market 10.0 Nature of the reinsurance market

10.1 Buyers of reinsurance

10.2 Sellers of reinsurance

10.3 Reinsurance brokers

10.4 London market

10.5 Uganda reinsurance market

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CHAPTER 1

Learning outcomes:

After completing this Chapter, readers should be able to understand:

The terms used in discussing reinsurance.

The legal principles involved.

The main benefits of reinsurance.

1.0 KEY REINSURANCE TERMS

Let us look at some of the terms you will come across, and need to understand when studying the

subject of reinsurance.

Please note that although these are from the short term insurance perspective, these definitions are

very similar, in application to those used in life assurance.

Accumulation

Concentration of a large number of individual risks which are correlated such that a single event

will affect many of all of these risks.

Broker

Professional intermediary for insurance or reinsurance business. Places business on behalf of

policyholder or reinsured.

Burning Cost

Total estimated loss payment expressed as a percentage of the sum insured.

Bordereau (plural Bordereaux)

A form providing premium or loss data with respect to identified specific risks which are furnished

to the reinsurer by the reinsured.

Capacity

The percentage of surplus or the shilling amount of exposure that all insurer or reinsurer is willing

to place at risk. Capacity may apply to 'a single risk, a program, a line of business, or an entire

book of business

Catastrophe Reinsurance

A form of reinsurance that indemnifies the insurer for the accumulation of losses in excess of a

stipulated sum, arising from a catastrophic event such as earthquake or Windstorm.

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Cash loss

This is one of the usual provisions of a Treaty and enables the reinsured to collect immediately, on

production of the necessary documents a large claim without waiting to include it in the usual

periodic adjustment.

Catastrophe loss generally refers to the total loss to the insurer arising out of a single catastrophic

event.

Cedant

The reinsurer’s client (i.e. the primary insurer) who passes on (cedes) risk to the reinsurer against

payment of a premium. Also referred to as the reinsured.

Ceding or Reinsurance Commission

The insurer’s acquisition costs and overhead expenses, taxes, licenses and fees, plus a fee

representing a share of expected profits - sometimes expressed as a percentage of the gross

reinsurance premium.

Ceding Company

The original or primary insurer: the insurance company which purchases reinsurance, the cedant,

the reinsured, underwriter, underwriting organization, the insurer, direct writing company

NB Throughout this chapter reference will only be made to insurer(s).

Cession

The actual amount of business passed by the insurer to the reinsurer

Claim

Demand by an insured for indemnity under an insurance contract or demand by the reinsured for

indemnity from the reinsurance company.

Coinsurance

Arrangement by which a number of insurers and/or reinsurers share a risk.

Commission

Remuneration paid by the primary insurer to his agents, brokers or intermediaries or by the

reinsurer to the primary insurer, for costs in connection with the acquisition and administration of

insurance business.

Cover

Insurance and reinsurance protection based on contractual agreement.

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Common Account Reinsurance

Reinsurance which is purchased by the insurer to protect both itself and its reinsurer, usually quota

share reinsurer, and which applies to net and treaty losses combined. This may also be referred to

as Joint Account Excess of Loss Reinsurance.

Deductible or Excess

The first amount borne by the insured for his own account of each loss.

Used as an underwriting tool in order to:

Minimize the number of small administratively expensive claims,

Reduce loss ratios and

Impose a duty of care on the insured.

Facultative

Facultative reinsurance means reinsurance of individual risks by offer and acceptance:' wherein

the reinsurer retains the option to accept or reject each risk offered.

Gross Premium

Insurance premium before deduction of the ceded premium (cession); reinsurance premium before

deduction of the retroceded premium (retrocession). Term also used for premium amount before

deduction of commission, taxes, etc.

Gross Net premium income

Used to describe the base for rating of Xs of loss reinsurance. It is measured net of refunds,

cancellations and premiums paid for reinsurance cover being rated. Gross because expenses are

not deducted.

IBNR

Incurred but not reported claims.

Layer

Section of cover in a non-proportional reinsurance programme in which total coverage is divided

into a number of consecutive layers. Individual layers may be placed with different reinsurers.

Limit

The maximum amount which an insurer is prepared to lose on a particular risk

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Long-tail business

A type of business in which claims take a long period of time to occur or be settled. Claims may

be made long after the policy has expired

Loss borderaux

Listing of cedant’s claims (often issued quarterly) directed to the reinsurer informing him of those

claims affecting his treaty participation.

Net Line

The amount of risk which an insurer keeps for its own account which is the maximum net loss that

can be sustained on that risk by the insurer before the application of any non-proportional

reinsurance

Non-proportional (NP) reinsurance (also XL reinsurance)

Reinsurance in which the reinsurer assumes the part of the primary insurer’s (reinsured’s) losses

that exceed a certain amount (deductible), against payment of a specially calculated premium.

Per Risk Excess Reinsurance

Retention and amount of reinsurance apply per risk rather than on a per-accident or event or

aggregate basis.

Pool

An entity established by insurers or reinsures for underwriting and spreading particularly exposed,

undesirable or unbalanced risks on a wider basis. Typically employed in aviation and nuclear

energy.

Portfolio

The totality of risks assumed by an insurer or reinsurer, also, the totality of a company’s

investments.

Proportional (prop) reinsurance

Form of reinsurance in which the premiums and losses of the primary insurer (cedant) are shared

proportionally by the cedant and reinsurer.

Professional Reinsurer

A term used to designate a company whose business is confined solely to reinsurance and the

peripheral services offered by a reinsurer to its customers as opposed to an insurer who exchanges

reinsurance or operates a reinsurance department as adjuncts to their basic business of primary

insurance. The majority of professional reinsurers provide complete reinsurance and service at one

source directly to the insurer.

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Quota Share

The basic form of participating treaty whereby the reinsurer accepts a stated percentage of each

and every risk within a defined category of business on a pro rata basis. Participation in each risk

is fixed and certain.

Reinsurer

An insurer or reinsurer assuming the risk of another under contract

Profit Commission

A provision found in some reinsurance agreements which provides for profit sharing. Parties agree

to a formula for calculating profit, an allowance for the reinsurer's expenses, and the cedent's share

of such profit after expenses.

Reinsurance

The practice whereby one party called the Reinsurer in consideration of a premium paid to him

agrees to indemnify another party, called the Reinsured, for part or all of the liability assumed by

the latter party under a policy or policies of insurance which it has issued. The reinsured may be

referred to as the Original or Primary Insurer, or Direct Writing Company, or the Ceding Company.

Reserves

Amount required to be carried as liability in financial statements of a primary insurer or reinsurer

to provide for future commitments.

Short-tail business

Type of business in which claims are reported and settled during the policy term or shortly

afterwards.

Retention

The net amount of risk which the insurer or the reinsurer keeps for its own account or that of

specified others i.e. its net line.

Retrocession

The reinsuring of reinsurance, for example, Reinsurer B has accepted reinsurance from insurer A.

and then obtains for itself, on such business assumed, reinsurance from reinsurer C. This secondary

reinsurance is called a Retrocession. The transaction whereby a reinsurer cedes to another reinsurer

all or part of the reinsurance it has previously assumed.

Sliding Scale Commission

A ceding commission which varies inversely with the loss ratio under the reinsurance agreement.

The scales are not always one to one: for example, as the loss ratio decreases b) 1 %, the ceding

commission might increase only 5%.

Stop Loss

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A form of reinsurance under which the reinsurer pays some or all of a insurer's aggregate retained

losses in excess of a predetermined dollar amount or in excess of a percentage of premiums.

Surplus Share

A form of proportional reinsurance where the reinsurer assumes pro rata responsibility for only

that portion of any risk which exceeds the original insurer's established retentions.

Treaty Reinsurance

A general reinsurance agreement which is obligatory between the insurer and the reinsurer

The agreement contains the contractual terms which apply to the reinsurance of some class or

classes of business, in contrast to a reinsurance agreement covering an individual risk.

Unearned premium (also premium reserve)

Premiums received for future financial years and carried over to the next year’s financial

statements (also refer to Earned premium).

Underwriting result

Premiums earned, less the sum of losses paid, change in the provision for unpaid claims and claim

adjustment expenses and other expenses (acquisition costs and other operating costs and expenses).

Working Layer

The first layer above the insurer's retention wherein moderate to heavy loss activity is expected by

the insurer and reinsurer. Working layer reinsurance agreements often include adjustable features

to reflect actual underwriting results.

Xs – Excess of Loss

N.B: Students should note that these terms are not exhaustive and where possible they should

familiarize themselves with further terminology that can be found on the internet. Suggested sites:

www.captive.com; www.guvcarp.com and www.reinsurance.org

1.1 LEGAL PRINCIPLES OF REINSURANCE

Reinsurance is a contract under which one party, the reinsurer, undertakes to support the other

party, the cedant, in respect of the latter's involvement in original risks. The standard definition of

reinsurance in English law was made by Lord Mansfield in Delver v. Barnes (1807) us:

“A new insurance, affected by a new policy, on the same risk which was before insured in order

to indemnity the underwriters from their previous subscriptions; and both policies are in existence

at the same time”.

From this, and other cases, a number of important legal considerations arise:

reinsurance arrangements are types of insurance contracts:

for reinsurance ,there needs to be an original policy of insurance:

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reinsurance may cover all or part of a cedant's liability under an original policy:

reinsurance is a separate contract between the cedant and reinsurer to which the original

insured is not a party.

Reinsurance arrangements are types of insurance contracts, so that reinsurance is subject to the

general law of contract and the special features of contract law which apply to insurance. They

are:

Insurable interest

Good faith: and

Indemnity

1.1.1 Insurable Interest

Insurable interest has been defined as the legal right to insure arising out of a financial relationship,

recognized at law between the insured and the subject matter of insurance.

Any insurance taken out without insurable interest will be deemed to be a wagering contract and.

Therefore, unenforceable at law.

The validity of a reinsurance contract, because it is a form of insurance for the purposes of contract

law, also depends on insurable interest. The cedant must have an insurable interest in the subject

matter of the insurance. In the case of Uzielli vs Boston Marine Insurance Company (1884) the

judge described a cedent's insurable interest in a marine insurance contract as follows:

“They were not the owners of the ship, and therefore they had no insurable interest as owners. But

they have an insurable interest of some kind, and that insurable interest is the loss which the) might.

or would suffer under the policy, upon which they themselves were liable”.

The main concern is when insurable interest must exist. In insurance policies the position varies

dependent upon the type of business involved:

in life insurance. insurable interest must exist at Inception:

in marine insurance, insurable interest must exist at the time of loss;

in other insurances, insurable interest is required both at inception and at the time of loss, which is effectively, throughout the currency of the policy.

In reinsurance, to claim from a reinsurer, a cedant would either have paid or have an

outstanding valid claim under the original policy or policies, which are the subject of the

reinsurance. The cedant's insurable interest must exist at that time.

1.1.2 Good Faith

Both parties to an insurance contract are under a duty not just to refrain from making

misrepresentations, but to fully disclose all the material facts about the proposed arrangement.

As reinsurance is a type of insurance for the purposes of contract law, the same duty of disclosure

falls upon both the cedant and reinsurer. For direct business, although the duty applies to both

parties, in practice however the onus tends to rest primarily upon the proposer and in reinsurance

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it falls upon the cedant. One major difference in reinsurance, however, is that both parties to the

contract can be assumed to be experts, equally knowledgeable about the underlying business.

A cedant will be considered to have knowledge of those facts which in the ordinary course of

business it ought to know. Also, a reinsurer may presume that the underlying original insurance

policies are subject to the sort of terms and conditions which would normally apply to that type of

business. A positive duty rests upon the cedant to disclose any unusual circumstances surrounding

a risk.

In direct insurance. the duty of disclosure applies in all matters leading up to the formation of the

contract and at renewal. Usually, a policy condition also makes this a continuing duty during the

currency of the insurance. In reinsurance, the position would be exactly the same for individual

facultative covers.

In the case of treaties however, it would be different. At common law, the duty of disclosure would

apply to each individual risk to be ceded to the treaty. Normally, however, treaty conditions would

override the common law position in order to allow a cedant considerable latitude in operating

under the treaty.

Example

An insurer, reinsured by a quota share, which decides to increase the portfolio of its motor

business, despite knowing the tariff to be insufficient, is not abiding by the principal of “Utmost

Good Faith”.

1.1.3 Indemnity

There is a difference between original insurance and reinsurance.

In original insurance, not all covers are contracts of indemnity. Life insurance and personal

accident contracts are known as contracts of compensation because it is impossible to provide an

exact financial indemnity in respect of the loss of life, health or limb.

All reinsurance including life and personal accident business are contracts of indemnity. This is

because in reinsurance the reinsurer’s liability is limited to some part of the original loss that the

cedant has suffered under the underlying contract.

1.2 PRIVITY OF CONTRACT

A contract exists only between the parties who have entered into the contractual relationship.

Contract creates personal rights that one party has against the other(s).

A reinsurance contract is one entered into between the cedant and the reinsurer. The original

insured is not a party to this, and has no right of claim against the reinsurer.

An original policyholder, whose claim had been accepted but nut paid by the insurer finds that the

insurer has gone into liquidation and is unable to meet its liabilities, May discover that the insurer

had a 90% reinsurance in place. The policyholder might feel that as 90% of the original risk was

being carried by the reinsurer, then a legal action on his part against the reinsurer will recover 90%

of the claim.

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Following the legal position outlined above, the policyholder has no rights against the reinsurer

and any legal action would fail.

A payment by the reinsurer to the original policy holder, would not discharge its obligation to the

insurer, so that it might end up paying the claim twice,

1.3 BENEFITS OF REINSURANCE

As explained, reinsurance is a form of insurance for insurance companies: a way of spreading risk

more widely. The benefits of reinsurance are similar to those of original insurance in which some

degree of financial uncertainty is removed from the insured party.

Just as original insurance enables policyholders to protect themselves against economic loss and

manage their finances more effectively, reinsurance enables insurers to plan more effectively, for

future events which are possible but cannot be predicted with certainty. In limiting the liability

they assume by issuing policies, reinsurance allows original insurers to provide greater amounts

of insurance cover to policyholders

Therefore the main benefits of reinsurance are:

Risk spreading:

Capacity boosting

Financial advantage

Financial stability

Protection against catastrophe

1.4 NATURE OF REINSURANCE

Large risks are encountered in all sections of insurance business. In every class of insurance, there

are risks, which because of their size or their nature, an insurance company cannot afford to keep

for its own account. When these risks are insured on sharing basis by the insurance companies

each company taking such as share of the risk as it can absorb itself the practice is called "Co-

insurance"

On the other hand an insurance company may insure the entire risk itself and lays off some of the

amount it has accepted to other insurance or reinsurance companies, keeping only what it can retain

on absorb for its own account. Thus, when a risk or group risks forms an exposure to one hazard

is such that it is beyond the limit of an insurance company to carry, effecting of reinsurance

becomes necessary.

1.5 NEED FOR REINSURANCE

Some of the important reasons why an insurer purchases reinsurance are:

i. To reduce an insurer's line on any particular risk to an amount which he could retain on his

account. This will be his "net retained line"

ii. To reduce his acceptance of a doubtful undesirable risk:

iii. To increase market capacity by spreading the risk over the international market

iv. To level out fluctuations, that is, iron out the peaks and through in the profit margin of the

original underwriter;

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v. To obtain reciprocity, that is, exchange of business for comparable business from another

underwriter: this enables insurers to participate in risks which are not otherwise available

to them, leading also to further spread of risks.

vi. To secure protection against "catastrophe" loses when a major share of these offloaded to

a reinsurer.

1.6 FUNCTION OF REINSURANCE

Well planned and carefully considered reinsurance arrangements go a long way:

i. To protect the direct insurer from underwriting losses which may weaken his solvency.

ii. To stabilize underwriting results on an overall basis.

iii. To increase the financial capacity of an insurer in respect of the size and type of risk he can

underwrite: and

iv. To spread the risk of loss

Reinsurance may also assist in financing of insurance operations, and major reinsurers and brokers

can offer a range of valuable technical services in the field of underwriting and claims handling.

So, reinsurance covers direct insurer (ceding company) against financial losses which he could

suffer as a result of having to pay, out on the policies issued by him. In the main reinsurance is the

offloading of liability contractually assumed by an insurer on an individual risk or the whole risk

with another insurer so as to minimize his possible maximum loss.

1.7 AN EXAMPLE OF NEED FOR REINSURANCE

As per the definition above, and by the nature of insurance, reinsurance is necessary for any

insurance company if it is exist. An example below can demonstrate why reinsurance is necessary

for insurance company. Suppose the share capital of company X is Shs. 4.000.000.000/= and the

insurance company is called upon to offer cover as follows:

Marine - Shs. 50,000,000,000 anyone shipment.

Fire - shs. 18.000.000.000 anyone risk

Motor - Shs. 350.000.000/=

To provide such over would appear impossible for insurance company X, but with substantial

reinsurance cover, it is possible because it will have enabled it to reduce its net liabilities to the

level proportionate to its share capital.

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It can use reinsurance facilities and reduce its net liabilities by setting its retention to something

like:-

Marine 200,000,000/=

Fire 200.000.000/=

Motor 10.000.000/=

From the above, we can correctly say that reinsurance is very vital for the effective establishment

of insurance companies, for it puts them in positions of accepting big liabilities and at the same

time allowing them to keeping retained amounts to levels which are proportional to their capital

and reserve.

Even for the already well-established insurance companies, reinsurance arrangements are still very

essential. -

Example

(i) A company Y has issued a policy to its insured covering several perils. Y then considers

that in case of loss by reason of two or more of the perils, the amount it would have to pay

would render it insolvent. Y then takes advantages of reinsurance cover. It seeks indemnity

against its own contractual obligations. It reinsures its risks of loss with companies A, B

and C.

(ii) Company Y may feel secure as long as it has only minor losses.

However, it realizes that in case of a catastrophe or a major disaster, the amount of money

it would have to pay would force it to wind up. It therefore decides to reinsure against such

catastrophe losses.

(iii) A ceding company may also derive substantial profits by employing reinsurance. It may

use reinsurance cover to assist in paying its losses and in fact obtain good results from such

transaction because the premium paid out for the reinsurance may be very much less than

the benefits it has derived. Reinsurance therefore tends to stabilize the profits of reinsured.

1.8 ADVANTAGES OF REINSURANCE TO A CEDING COMPANY

i. Due to insufficient capital it would be impossible for insurers to meet huge claims on their

own, hence need for reinsurance.

ii. It helps to protect insurers' cash flow as quick payment of claims may affect both the capital

and reserve.

iii. In the absence of reinsurance arrangement, insurers would for all practical purposes accept

risk within their capacity to pay in case of a loss. Bigger risks would have to be declined.

iv. Reinsurance smoothens out what would be harmful fluctuations in an insurer's trade profit

record.

v. Reinsurance spreads risks so that they are not accumulated in anyone country.

vi. Professional reinsurance accumulates a lot of experience and knowledge which are

invariably passed over to their ceding companies through training management assistance.

vii. Commissions paid by reinsurers to the reinsured form a source of income for the insurance

company and contribute to profits as well

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1.8.1 Factors which influence the results of reinsurance

Professor Prolss of Swiss Re gave excellent analysis of the factors which influence the results of

reinsurance. Here is a summary of his analysis:

a) Risks emanating from the insured (original risk)

This mainly concerns the technical risk, in other words the risk run by granting cover through an

insurance policy. There is also a contractual risk, as for example an unjustified, exaggerated or

fraudulent claim. These two risks are covered by the reinsurance contract in the "Follow the

fortunes clause.

b) Risks emanating from the insurer or the reinsurer

Improper business administration (negligence, incapacity) on the part of the insurer can

considerably increase the risk run by the reinsurer. Following factors have a direct effect on the

results of reinsurance:

(i) Deficient underwriting methods

(ii) Excessive generosity in the settlement of claims

(iii)Hastily development of business and inefficient technical attention

Finally, moral hazard inherent in all human undertaking can occur to the detriment of both the

insurer and the reinsurer.

c) Risks beyond the control of the contractual parties

Reinsurer assume no responsibility for rate of exchange risk, despite the fact that it directly affects

the result. Depending on the fluctuation in the value of the currencies he is working in, the reinsurer

may have to pay larger or smaller sums than those he had foreseen, without the insurer bearing

any of the consequences.

Therefore, one of the most important, and most delicate, tasks of the reinsurer is to set up an

investment budget which takes into account exchange rate fluctuations and the task is certainly

made no easier by the numerous legal provisions on this subject.

Inflation also deserves mention in this paragraph as it reduces the value of the investments on the

one hand and distorts technical statistics on the other, by artificially inflating premiums, loses and

costs, thus rendering the statistics either useless or dangerously optimistic on short-term basis.

Payment of foreign exchange is also subject to risks, mostly due to the monetary situation which

can affect both the insurer and the reinsurer. Several countries restrict foreign currency payments,

which considerably delays the payment of balances and cash calls

Very often reinsurance operations are subject to special and most unrealistic exchange controls. In

extreme cases, payments to reinsurers are "frozen" for months and this naturally results in loss of

interest to the reinsurance markets, a diminution of the cover and eventually, an increase in rates.

The deposit of technical reserve as security implies monetary investment and administrative risks,

particularly if the reinsurer is not absolutely free to use the reserves.

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In the countries with deficit budgets, reinsurers are particularly exposed to fiscal risks. As is with

insurance, reinsurance operations are easily, controlled by the supervisory authority and tax can

be levied on:

i. Ceded premiums.

ii. Commission on

iii. Profit commissions.

iv. Interest and even on the settlement of losses.

In some countries, the reinsurance's profit; which for simplicity's sake is calculated by using a

fictitious and very unrealistic-margin is subject to tax.

d) Risks inherent to Reinsurance

As the reinsurer must work on as wide a basis as possible and consequently grant cover to as many

companies as possible, they run the risk of accumulation of exposure from any single event or risk.

Though, on an important policy, direct participation is easily controlled, it is practically impossible

to control indirect commitments from reinsurances as accepted.

The internal and external organization of a reinsurance insurer is of prime importance. The

acquisition and underwriting results are directly dependent on its quality. Indeed, several

reinsurance companies have suffered considerable setbacks through deficient organization as a

result of bad planning. incomplete control or lack of specialist.

1.10 GRAPHICAL ILLUSTRATION

Insurance

It is a contract of Risk Transfer between insured ‘A” and insurer ‘B” whereby ‘B’ indemnifies ‘A’

up to a prescribed maximum limit of indemnity in the event of a loss arising out of prescribed

insured Perils as per terms and conditions of the policy or a group of polices issued and A Agrees

to pay premium as a price of insurance protection to’ B’ as per prescribed negotiated rate on

indemnity limits

Co-insurance

It is an insurance contract of risk sharing by many insurers for a large risk where leading insurer

decides terms commonly accepted by other co- insurers.

A B

Contract of Risk Transfer

Layman Insurance expert

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Layman Insurance experts

If a co-insurer goes into liquidation, the other co-insurers are not liable for his share of indemnity

limit unless they agree as a special case.

Reinsurance

It is a separate contract of Risk Transfer between insurer and Reinsurer where original insured is

not a party to the contract. Insurer retains a part of the Risk and transfers the balance to his

Reinsurers by various methods of reinsurance. In event of the liquidation of the insurer, the

Reinsurers are not liable to pay losses to the original insured unless there is a provision of Cut

Through Clause.

There cannot be 100% Reinsurance of a Risk as Insurers must retain a Risk before Reinsurance.

Retrocession

Reinsurances for the reinsurers.

Revision Questions

1. What are the principles of reinsurance?

2. What is an accumulation?

3. Give two benefits of reinsurance.

4. State two advantages that an Insurance Company derives from arranging reinsurance.

A

B

C

D

20

%

50%

30%

Risk Transfer

A B

E

F

G

H

I

J

K

L

Risk Transfer

insurer

Reinsurer Retrocessioners

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5. What is a Ceding Company?

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SUMMARY

Legal principles of reinsurance Reinsurance is subject to the general law of contract and the special features of contract law

which apply to insurance and these are:

Insurable interest

Good faith: and

Indemnity

Privity of contract A reinsurance contract is one entered into between the cedant and the reinsurer. The original

insured is not a party to this, and has no right of claim against the reinsurer.

Benefits of reinsurance The main benefits of reinsurance are:

Risk spreading:

Capacity boosting

Financial advantage

Financial stability

Protection against catastrophe

Need for reinsurance The important reasons why an insurer purchases reinsurance are:

To reduce an insurer's line on any particular risk to an amount which he could retain on his

account. This will be his "net retained line"

To reduce his acceptance of a doubtful undesirable risk:

To increase market capacity by spreading the risk over the international market

To level out fluctuations, that is, iron out the peaks and through in the profit margin of the

original underwriter;

To obtain reciprocity, that is, exchange of business for comparable business from another underwriter: this enables insurers to participate in risks which are not otherwise available

to them, leading also to further spread of risks.

To secure protection against "catastrophe" loses when a major share of these offloaded to a reinsurer.

Functions of reinsurance

To protect the direct insurer from underwriting losses this may weaken his solvency.

To stabilize underwriting results on an overall basis.

To increase the financial capacity of an insurer in respect of the size and type of risk he can underwrite: and

To spread the risk of loss

Advantages of reinsurance to ceding company

Due to insufficient capital it would be impossible for insurers to meet huge claims on their

own, hence need for reinsurance.

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It helps to protect insurers' cash flow as quick payment of claims may affect both the capital and reserve.

In the absence of reinsurance arrangement, insurers would for all practical purposes accept

risk within their capacity to pay in case of a loss. Bigger risks would have to be declined.

Reinsurance smoothens out what would be harmful fluctuations in an insurer's trade profit record.

Reinsurance spreads risks so that they are not accumulated in anyone country.

Professional reinsurance accumulates a lot of experience and knowledge which are invariably passed over to their ceding companies through training management assistance.

Commissions paid by reinsurers to the reinsured form a source of income for the insurance

company and contribute to profits as well

Factors which influence the results of reinsurance

Risks emanating from the insured (original risk)

Risks emanating from the insurer or the reinsurer

Risks beyond the control of the contractual parties

Risks inherent to Reinsurance

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CHAPTER 2

TYPES OF REINSURANCE

Learning outcomes:

After completing this chapter participants should be able to know:

The nature of Facultative Reinsurance

The difference between proportional and Non-proportional treaty reinsurance

Quota share and surplus treaties

Excess of loss per risk and occurrence

Pools

2.0 TYPES OF REINSURANCE ARRANGEMENTS

There are two types of reinsurance namely: Facultative Reinsurance and treaty reinsurance

Table one below shows, the types of reinsurance and the methods

Reinsurance

Treaty Facultative

Proportional Non - Proportional Proportional

Quota share Surplus Per occurrence Excess of loss

Excess of loss per risk

Stop loss excess of loss

Excess of loss

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2.1. FACULTATIVE REINSURANCE

“The facultative reinsurance” implies optional action. The ceding company under the facultative

reinsurance has a free power in its choice of business to be offered and the reinsurer to be. The

direct underwriter is therefore under no duty to make an offer and the reinsurer is also under no

duty to accept the risk ceded. The reinsurer can accept or decline and the cedant can offer or retain

as each may consider favourable under the circumstances.

In this method of reinsurance, each risk to be reinsured is dealt with individually and the same

underwriting considerations are used by the reinsurer in his assessment of the risk as had been used

by the direct insurer. The offer normally takes the form of a slip containing full details of the risk

offered for reinsurance. The reinsurer to whom the risk is offered signs the reinsurance slip

indicating his acceptance.

Facultative reinsurance is the oldest form of reinsurance .Having accepted a risk, an insurer may

decide to pass some of it to another risk carrier. To do this, the insurer will approach reinsurers

either directly or via a reinsurance broker. All the relevant information concerning the risk will

need to be presented to the proposed reinsurance.

Such information will include.

Class of business

Name of cedant

Name of the original insured

Sum insured

EML(estimated maximum loss) or PML(probable, possible maximum loss) figures, if known:

Location of risk

Construction details

Protection details

Loss record (usually to five years)

Period of insurance;

Rate of premium;

Commission;

Insurer’s retention;

Percentage already reinsured (if applicable)

Percentage to be reinsured; and

Survey report and plan (if applicable).

The reinsurance underwriter will consider a facultative proposal in exactly the same way that

the insurer considered the original risk and will request additional information where

appropriate.

Whilst a primary underwriter can accept or reject the risk, so can the facultative reinsurance

underwriter. The latter may also apply financial terms to the risk by manipulating the amount

of reinsurance commission that they are prepared to allow.

One reason why insurers arrange facultative reinsurance is the need for technical assistance. If

the insurer knows little about risk type he can arrange for a facultative reinsurer to do the

underwriting .The facultative reinsurer will set the rates for the business, arrange terms and

conditions of cover and impose any restrictions which they might consider appropriate.

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2.1.1. Advantages of facultative reinsurance

i. To reinsure hazardous risks excluded from the treaty

ii. Individual examination of the risk with the option to accept or decline, and as a result

the chance of selecting a portfolio which corresponds exactly to the insurers

underwriting guideline/manual.

iii. The possibility of exercising a certain amount of influence on the cedant’s underwriting

by asking him to improve the risk offered or advising him of covers which have shown

loss elsewhere.

iv. The possibility of obtaining adequate premium rate, either by requesting an increase in

the rate offered, by reducing reinsurance commission or by indicating a risk premium

(premium net of costs).

v. To reduce the liability to treaty reinsurance on certain risks by protecting the treaty

from adverse underwriting results

vi. A more advantageous way of determining the commitment per risk and on

accumulations.

vii. To provide extra knowledge of the cedants’ underwriting and selection methods

2.1.2 .Disadvantages of Facultative reinsurance

There are a number of disadvantages of facultative reinsurance namely:

i. It is rather slow, cumbersome and also costly due to the decision making process whether

to accept a risk or not

ii. There can be no guarantee that reinsurance cover needed will be obtained.

iii. Reinsurance liability does not commence until the reinsurer has seen and accepted the risk

by signing the slip

iv. The delay in issuing a policy can create problems with both agents and clients.

v. Administration costs are higher.

2.1.3 .Facultative obligatory reinsurance

Obligatory reinsurance is reinsurance for whole portfolios (groups of risk) and in this method,

the cedant has a free choice as whether to cede any part of the business originally accepted by

him or not.

On the other hand the reinsurer has no right to refuse any cession. These treaties are terminable

on an annual basis.

2.2 TREATY REINSURANCE

Treaty reinsurance encompasses a portfolio of business of the insurer where they negotiate in

advance for an automatic reinsurance facility.

When the reinsured (i.e. the original insurer) can guarantee or expects to produce a certain volume

of business of a particular kind, he negotiates in advance, with the reinsurers for an automatic

reinsurance, facility which is called a Treaty. Once the facility is finalized, the original insurer is

automatically reinsured in respect of all risks or polices which fall within the terms and conditions

of the agreement.

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Treaty reinsurance is an agreement between the original insurer and reinsurer whereby both parties

are automatically bound well in advance as regards all the risks that fall within the terms of the

agreement.

There are two main methods in use under Treaty Reinsurance namely:

Proportional; and

Non proportional

2.2.1 Advantages of treaty reinsurance

A major advantage from an insurer’s point of view is that treaty provides certainty as a reinsurer

is bound to accept any cession which falls within the terms of the treaty. The insurer can accept

original business without any doubts about whether reinsurance will be available.

There are other advantages namely

i. Administration- a treaty is an enabling arrangement whereby a large number of cessions

can be made. With minimal processing work compared to facultative reinsurance .The

administration costs for both insurer and reinsurer is low

ii. Underwriting- once a reinsurer is committed to a treaty, it no longer needs to consider

each of the risks which attach to it. This saves work for the reinsurer and means no time

delays for the insurer in acquiring cover.

iii. Continuity-Normally, treaties are continuous and will be automatically renewed each year

unless one of the parties takes specific steps to end the arrangement. This continuity allows

for long term relationships to be developed to the advantage of both parties.

iv. Spread of risk- underwriting a treaty means that a reinsurer will receive a larger volume

of business than by writing individual facultative risks. This guaranteed volume of business

means that a reinsurer is receiving a greater spread of risks and the greater the spread the

better are the insurance and/ or reinsurance underwriting results.

v. Commission-normally reinsurers pay commission to insurers for business which is passed

to them. This helps an insurer to defray its costs of acquisition of the original business.

From a reinsurer’s point of view, it acquires business at a lower cost than would be the case

if it underwrote at a primary level.

2.3. PROPORTIONAL TREATY

In proportional reinsurance, the insurer and the reinsurer apportion the sums insured, premiums

and losses in a contractually agreed ratio.

“The company hereby agrees to cede to the reinsurer and the reinsurer agrees to accept by way of

reinsurance a share of all insurance underwritten direct by the company, or accepted in coinsurance

or by way of facultative reinsurance from local companies, in the lines of business covered at the

terms and conditions and within the territorial scope set out in the special condition”.

The type and limits of this treaty are set out in the special conditions.

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2.3.1 Types of proportional treaties:

There are two types of proportional treaties namely Quota share and surplus.

(i) Quota share treaty

Quota share treaty is an arrangement whereby the reinsured agrees obligatorily to cede and the

reinsurer agrees obligatorily to accept a fixed percentage of each and every risk accepted by the

reinsured.

Consequently the reinsurer receives a fixed proportion of the losses incurred. The reinsurer may

be advised of the cession using bordereaux prepared by the cedants.The premium payable under

Quota treaty is as per original rate. The reinsurers usually pay the cedent reinsurance commission.

Quota share treaties are mostly used by small or new companies which can obtain adequate

reinsurance covers only by offering attractive business.

Example of quota share treaty arrangement

Suppose in a quota share treaty, there is a provision to cede 70% of all business classified as Fire,

the cedant then retains 30%. The reinsurers will accept the 70% up to a limit fixed in the treaty. In

case of policy limit of say Ugx. 50, 000,000/=, the cedant receives 30% of 50,000,000/=

15,000,000/= and the reinsurers receives 35,000,000/= (70% of 50,000,000/=). Premium is sent in

same proportion and claims settled in the same proportion as illustrated below:

Direct insurer's retention

30%

Reinsurer's quota share

70%

Sum insured

Ugx. 50,000,000/=

Share of the risk

Direct insurer's share 30%

Ugx.15,000,000/=

Reinsurer's quota share 70%

Ugx. 35,000,000/=

Loss

Direct insurer's share

30% of loss amount

Reinsurer's share

70% of the loss amount

(ii) Surplus treaty

As the name implies, surplus treaty is a contract whereby the reinsurer participates only after the

gross retention of the ceding company is exceeded.

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The reinsurer therefore undertakes obligatorily to accept any amounts up to an agreed limit being

the surplus of the cedant’s retention. The retention of the cedant is known as one line and the treaty

limit may be say 20 lines.

The premium for the risk will have to be ceded in the proportion as the sum insured,. Similarly a

claim under the policy will have to be a portioned in the same proportion.

The main advantages with surplus reinsurance is that it allows the ceding company to retain a

larger volume of premium that it could possibly under the quota share arrangement. It has a fixed

amount on every risk and limits its liability accordingly.

Example of surplus treaty arrangement

Insurance company X’s fire surplus treaty in 2016 is a follows

Retention Shs.100, 000,000/= per risk

Reinsurance cover 20lines i.e Shs.2, 000,000,000/=

Company Z insurers against fire for S.I Shs.500, 000,000/= and pays premium of 100,000/=

Premium

Insurance X’s Ret – Shs.100, 000,000/= - 20%-20,000/=

Reinsurers 4lines- Shs.400, 000,000/= - 80%-80,000/=

Loss occurs of Shs. 50,000/=

Insurance X’s share of loss 20% - 10,000/=

Reinsurer share of loss 80% - 40,000/=

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Insurer's Retention Reinsurer's Surplus

Sum

Insured

Shs. 500,000,000/= Shs. 100,000,000/=

translates to :

100,000,000 x 100% = 20%

500,000,000

Risk above the retention =

Shs. 400,000,000/=

translates to:

4 lines i.e.

(4x100,000,000 = 400,000,000/=)

Amount of risk due to the reinsurer:

400,000,000 x 100% = 80%

500,000,000

Premium Shs. 100,000/= 20% x 100,000 = 20,000/= 80% x 100,000 = 80,000/=

Loss

occurs

Shs. 50,000/= 20% x 50,000 = 10,000/= 80% x 50,000 = 40,000/=

N.B. In practice the premium sent to reinsurers is much less than the above as commission, losses

and reserves retained have to be deducted as stipulated under the treaty wording.

2.4 NON-PROPORTIONAL TREATY

2.4.1 Working excess of loss

This term is usually applied to that layer of excess of loss reinsurance where a number of losses

are expected each year. A working excess of loss arrangement is usually placed with the reinsurer

by means of a treaty for a portfolio of business. However, it can also be a facultative arrangement.

2.4.2. Maximum amount

The insurer will decide on the maximum amount that they wish to pay in the event of a single loss.

This is called the retention. Any losses that are less than the retention are paid by the insurer and

the reinsurer will not become involved. The reinsurer will only participate for those amounts in

excess of the retention. The retention is sometimes referred to as the deductible or priority.

Example

The insurer has a motor account and has arranged a working excess of loss treaty.

They decide that they only want to retain Ushs. 1 million on anyone loss for their own account. This is the retention.

The maximum value of vehicle in the motor account is Ushs. 50 million.

The working excess of loss treaty could be structured as follows:

Maximum value Shs. 50,000,000

Retention Shs. 1,000,000

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Layer1 9 million excess 1 million

Layer 2 10 million excess 10million

Layer 3 30 million excess 20 million

Layer Sum Insured (Shillings) Premium (Shillings)

3rd layer 30, 000, 000 750 ,000

2nd layer 10, 000, 000 5,000, 000

1st layer 9,000,000 30, 000, 000

Retention 1,000, 000 80, 000, 000

(see the very important note

below)

The premium for each layer varies, as the reinsurers in the 3rd layer, for example, will only become

involved if the loss exceeds Shs 20,000,000. Note that the maximum value is placed with reinsurers

in layers.

An example may explain this.

A vehicle valued at Shs 45,000,000 is badly damaged in an accident. It is decided not to write it

off, but to effect repairs. The damage is assessed at Shs. 17,500,000.

The loss would be allocated as follows:

Layer Allocation(Shs) Comment

3rd layer Nil Loss did not exceed Shs. 20 million

2nd layer 7,500,000 Paid by reinsurers

1st layer 9,000, 000 Paid by reinsurers

Retention 1,000, 000 Paid by the insurer

From this example, it should become clear that the reason for the higher premium for the first layer

relative to the cover provided is because there is a greater likelihood of more losses affecting this

layer than the higher layers.

Very important

It may seem strange that the retention is only Shs1, 000, 000 whilst the premium is Shs80, 000

,000. This is because the likelihood of many losses falling solely within the retention is far greater

than in the higher layers and these will have to be met out of the retained premium of Shs80 000

000.

The same applies to the 1st layer. It is only in the higher layers where the reinsurer is further

removed from the high frequency of losses that the premium charged by reinsurers can reduce

significantly.

2.4.3. Catastrophe Excess of Loss

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This type of reinsurance is arranged to protect the insurer against a major loss arising either by

way of an accumulation of losses from one event or from one single large loss.

Today most catastrophe treaties will apply a two risk warranty in that two or more risks must be

involved in the same loss before it will respond to the claim.

2.4.4 Maximum Amount

Unlike the working Excess of loss' that operates at a low retention level, the catastrophe excess of

loss commences at a reasonably substantial figure.

The insurer will have to use his Judgment using past experience and historical data in deciding

the retention and the level of reinsurance to purchase. They will also take into consideration such

phenomena as global warming and concentrations of values particularly around coastal areas

where there is the potential for tornadoes, tsunamis e.t.c

2.4.5 Layers

Like working excess of loss, catastrophe cover is also arranged in layers.

(a) The amount retained by the insurer can be referred to as the retention deductible or priority.

(b) The amounts reinsured are sometimes called the security.

Example 1

The insurer has issued a policy covering a very large building valued at Shs 1 billion. The insurer

has the financial strength to be able to retain for his own account Shs.100 million. He could

therefore arrange catastrophe reinsurance as follows.

Layer Amount Premium

3rd layer 400 million Reinsurers

2nd layer 300 million Reinsurers

1st layer 200 million Reinsurers

Retention 100 million Insurer

Example 2

Using the example of the working excess of loss in 2.4.2 above, the insurer retained Shs 1,000 000

for his own account. The insurer may decide that he cannot afford to pay more than 50 times that

amount for one event and will therefore purchase catastrophe excess of loss cover above this

amount.

That is, the retention will be Shs.1,000,000 x 50 = Shs. 50,000,000.

The insurer will, as in example 1 above, build up reinsurance cover in layers to a level that they

are satisfied will cover most eventualities.

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In practice, "This is not always possible and the insured may not be able to afford to purchase full

cover or he may decide to apply a PML to the event. This often is the case with the earthquake

peril.

Using our previous example, the insurer may have many buildings damaged from this one event.

Assume that the insured has arranged catastrophe cover up to Shs. 1 billion as follows:

Layer Amount Premium

3rd layer 400 million Reinsurers

2nd layer 300 million Reinsurers

1st layer 250 million Reinsurers

Retention 50 million 1,000,000 x 50

As a result of the flood, they have suffered 150 damaged buildings. On each one, they have retained

Shs. 1,000 000 for their own net account. The total net loss is therefore - 150 x 1,000, 000/ = 150

million. In this case, the insurer will be liable for the retention of Shs 50 million and the loss will

only affect the 1st layer to the extent of Shs. 100 million. The reinsurers in the 2nd and 3rd layers

will not be affected, and will not be called upon to contribute towards the loss.

2.4.6 Stop Loss Reinsurance

This type of reinsurance is sometimes referred to as aggregate excess of loss and excess of loss

ratio.

It is designed to protect a class of business from severe fluctuation in result. The reinsurer will not

be liable until the loss ratio for the year reaches an agreed percentage of the premiums, Thereafter

the reinsurer is responsible for all losses up to the limit of the treaty,

This form of reinsurance is commonly used for such classes as crop insurance retrenchment and

redundancy covers where results can vary greatly from year to year,

Example

The insurer has a stop loss treaty protecting his crop account.

The stop loss treaty cover will pay 90% of all claims which exceed 100% of the premiums up to a

maximum of 150% of the premiums,

The annual premium income for 2015 is Shs 300,000,000. The losses are Shs 360, 000, 000 as a

result of severe weather experienced during the growing season, The loss ratio is therefore 120%,

Loss ratio = Losses x 100%

Premium

= 360,000,000 x 100% = 120%

300,000,000

The claims have exceeded the premiums by 20%, Therefore the stop loss treaty will pay:

Total loss - premiums = 360,000,000 - 300,000,000 = Shs. 60,000,000/=

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Treaty pays 90% x 60,000,000 = Shs 54,000 000

Important note

Note that the stop loss treaty only provided 90% cover once the loss ratio reached 100%. This is

to ensure that the insurer retains a vested interest, thus encouraging them to underwrite properly

and prevent them taking on poor quality business.

Because stop loss cover is premium based, the insurer will have to give the reinsurer a fairly

accurate estimate of the premiums it will write in the forthcoming year.

2.5 RISKS ATTACHING, LOSSES OCCURRING AND CLAIMS MADE

Excess of loss contracts are arranged to protect a whole account for a period of time. One important

consideration is the definition of precisely when and how the reinsurer is going to be liable in

respect of losses. It is very much in the insured's interests to ensure that its reinsurance coverage

provides adequate protection relative to the underlying book of business. Problems would be

caused if there were any gaps or overlaps in reinsurance protection.

2.5.1 Risks attaching

On this basis of cover, which may also be called policies issued basis, excess of loss reinsurers

assume liability for original policies issued or renewed during the period of reinsurance, generally

one year. Provided the inception or renewal date of an underlying policy falls within the

reinsurance year then reinsurers' liability attaches to all claims arising from those policies.

In Figure 2.1 two original policies are shown: namely XX and YY. The inception / renewal date

of both is within the reinsurance year then the risks attach to the reinsurers for that year even

though part of the risks run outside the year. This means that when a loss occurs on risk YY some

months after the end of the reinsurance year, that loss is nevertheless protected by the reinsurers

for that year.

Figure 2.1: Risks Attaching Basis

Loss

X

Y Y

Reinsurance Year

X

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Reinsurance year

Example:

What sort of original policies would reinsurers be most worried about under this basis of cover?

Answer:

Reinsurers would be most worried about policies which run for long periods.

For example, a contractors' all risks insurance might run for three or four years embracing the

period of the construction of a large building. On a risks attaching basis, reinsurers could be liable

for claims arising years after the end of the reinsurance period.

To address the problem reinsurers may incorporate a warranty into the policy limiting the duration

of any underlying risk to a maximum of twelve months

An insurer underwrites a new class or category of risk on an experimental basis. In these

circumstances arranging excess of loss cover on a risks attaching basis would be very attractive.

If, at the end of the underwriting year, it was decided not to continue the account, reinsurance

protection would still be in place for the run-off of risks which still had exposure.

The risks which had been accepted towards the end of the underwriting year, like risk YY in the

model above, would still have the benefit of reinsurance protection subject to any time restrictions

like the twelve months policy maximum mentioned above.

2.5.2 Losses occurring

On this basis of cover excess of loss, reinsurers assume liability for claims arising where the date

of loss falls within the reinsurance period. This is irrespective of the inception date of any

underlying policies giving rise to a claim.

In Figure 2.2 the loss dates must be within the reinsurance year. This means that losses 1 and 2

will both fall to reinsurers even though loss 1 arises under a risk which attached before the

reinsurance period started.

Loss 3 however will not be covered by reinsurers as it occurred outside the reinsurance period

even though the policy incepted within it.

Figure 2.2: Losses Occurring Basis

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A refers to a calendar year, say 01/01/2008 to 31/12/2008

B refers to 01/01/2009 to 31/12/2009

The reinsurance year spans both calendar years.

The great merit of this method of excess coverage is its simplicity. The start and of the period for

which reinsurers are liable is clearly defined and there can be no doubt about whether cover applies

or not.

One possibility with this arrangement is that a loss could actually be happening at the very end of

the reinsurance year. Normally the reinsurance agreement will allow that such events are covered

provided the loss starts within the reinsurance year. Cover is extends until the loss is settled.

In the risk attaching system, the run-off problem of a closing underwriting account was naturally

taken care of by the nature of the reinsurance cover. With losses occurring basis an insurer in

similar circumstances would find itself with unprotected liabilities.

The reinsurance agreement may provide for cover to be extended to embrace the run- off. This will

normally be at terms agreed during the treaty negotiations.

2.6 REINSTATEMENTS

A major difference between risk excess of loss and catastrophe covers is that the former is expected

to pay for a number of losses in a year whilst the latter is expected to be rarely involved in losses.

The main limitation to cover on a risk excess basis is the event limit. This mechanism is designed

to prevent risk excesses from operating as both working and catastrophe covers.

Many catastrophe protection parallel original insurance in that they are exhausted by the amount

of a claim. For example, if a household policy with a sum insured of Shs 1,000 000 has a claim for

Shs 300, 000 then for the rest of that period of insurance, the cover stands reduced at Shs 700 000

unless the insured reestablishes or reinstates the sum insured and pays an extra premium.

The same principle applies to catastrophe excess of loss.

A A

Loss 1

1.1.08 31.12.08

Loss 2 Loss 3

31.12.09 1.1.09 B

Reinsurance year

35

Reinstatement practice varies according to different types of underlying business and to market

conditions. Treaties covering liability or motor business normally allow unlimited reinstatement

often without additional premium. In the case of property insurance, however, reinstatement will

normally be limited to perhaps just one reinstatement only during anyone period of reinsurance.

Moreover, reinsurers will usually charge an additional premium for reinstatement

If a claim exhausts the catastrophe reinsurance cover, this will need to be reinstated in full. Many

losses however only use a part of the reinsured amount. In this case, reinstatement may be

arranged pro rata as to amount and for the reinstatement premium to be similarly pro rata as to

time left till the end of the policy.

For example, if excess of loss reinsurers provided cover of Shs 10m (security) excess Shs

5,000,000 and there was a loss of Shs 7,500, 000, reinsurers would be liable for Shs 2,500 000.

As the claim is one quarter of the security, the reinstatement premium will be one quarter of the

amount required for a full reinstatement of the sum reinsured.

Sometimes, reinstatement premium is also calculated pro rata as to time. Premiums are normally

paid for a year's protection. If reinstatement is needed for only the remaining six months of a

contract, then a cedant may be allowed to pay half a full year's amount to reflect this. Reinstatement

premiums are normally pro rata as to amount but pro rata as to time is rarer.

Example

A cover is for Ugx. 2m/= excess Ugx 1m/= per event. It runs for 12 months from 1 January at a

premium of Ugx. 200,000/=.

An event on 31 March causes an aggregate loss of Ugx. 1,500,000/=. Calculate the premium

required for reinstatement if:

a) The reinstatement provision is pro rata as to amount only;

b) The reinstatement provision is pro rata as to both amount and time

Pro rata as to amount reinstatement:

Insurer’s liability (retention) = Ugx. 1m/=

Reinsurer’s liability = Ugx. 500,000/=

Reinstatement premiums = losses to reinsurers x annual premium

Security

= 500,000 x 200,000 = 50,000/= payable

2,000,000

Pro rata as to amount and time

The loss occurred on 31st March leaving nine months of the reinsurance cover to run after

reinstatement;

= Losses to reinsurers x annual premium x 9 months

Security 12 months

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= 500,000 x 200,000 x 9 = 37,500/= payable

2,000,000 12

Note: If the available reinstatements are limited, there is a very real danger that a series of large

losses could exhaust the excess of loss cover and its reinstatements.

2.7 Pools

Insurance deals with risks, but sometimes these are so large or so hazardous that no single insurer

is prepared to accept a meaningful proportion of the risk, a traditional response of the insurance

community to this difficulty is the formation of a pool. A number of different insurers form a

single collective entity, referred to as a pool, to underwrite certain types of risk. Each insurer is

liable for its own share of the pool which might deal with, for example, such hazardous covers as

atomic risks.

The principle of an insurance or reinsurance pool is that all the members put their premium for a

particular ri.sk into a common fund. They then share the aggregate claims arising either in the

same proportions as their premiums or in some other prearranged manner. Any profits, losses or

expenses are shared in the same way

The attraction of this form of operation is that the members of the pool can take a very cautious

way of experiencing new, difficult or dangerous risks.

As their pool involvement only exposes them to a very small proportion of risk compared with

normal lines of business they can acquire experience of the hazardous account with far less risk of

ruin if difficulties arise.

There a number of different pool structures, the main ones being:

Market pools

Government reinsurance pools; and

Underwriting pools.

2.7.1 Market Pools

A market pool involves the participation of the majority of insurers in a country. It is a useful

system for underwriting large or hazardous risks such as nuclear installations. Normally, any

member insurer can introduce business to the pool. The rates are agreed by a committee of pool

members and the risks are divided according to members’ participation in the pool.

A danger of a market pool operation is that if that if the members arranged their own reinsurance

of their pool exposure, there could be accumulation of risk. This would happen if one reinsurer

found itself unwittingly covering a number of different pool participants.

As the idea of a pool is to spread risk, such accumulations would be the very opposite of the

objective. Accordingly, reinsurance is often arranged for the whole pool exposure on a collective

37

basis. Often the individual pool members are prohibited from reinsuring their own net exposure.

They have to write an “absolute net line” to avoid accumulation dangers.

2.7.2 Government Reinsurance Pools

Pools have been created in certain countries or regions to reinsure the underlying business of that

country or region.

The intention is that by keeping the reinsurance in that territory, premium income will be held

therein and not exported to the international reinsurance market.

In many areas it is compulsory for all insurers in the territory to reinsure a portion of their account

with the government pool. In some cases the insurers are also shareholders receiving a share of the

pool in return.

A greater spread of risk is achieved by regional pools. Here the object is to increase the total

underwriting capacity of the whole region rather than just one territory. One example would be the

African Reinsurance Corporation which receives a 5% compulsory cession of all the reinsurances

of all the insurers in 42 countries in Africa. Other examples are the Arabian pools and the Asian

Reinsurance Corporation.

2.7.3 Underwriting Pools

Smaller, developing insurers, which wish to enter a new market, class or type of business may

have neither the expertise nor the necessary capacity to establish a sound foothold. They may,

therefore, form a pool represented by an experienced underwriter in the chosen field of

development, with sufficient collective capacity to accept competitive lines of business. There are

a number of such pools in existence around the world to underwrite international reinsurance

business.

Questions

1. What is the meaning of facultative reinsurance?

2. What are the two main types of proportional treaty?

3. What is referred to as deductible or priority?

4. What are the two main types of excess of loss treaties?

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SUMMARY

Types of reinsurance arrangements

1. Treaty reinsurance

Proportional

Non - proportional

2. Facultative reinsurance

Proportional

Excess of loss

Facultative reinsurance

The ceding company under the facultative reinsurance has a free power in its choice of business

to be offered and the reinsurer

Treaty reinsurance

Treaty reinsurance encompasses a portfolio of business of the insurer where they negotiate in

advance for an automatic reinsurance facility.

Proportional treaty

The insurer and the reinsurer apportion the sums insured, premiums and losses in a contractually

agreed ratio.

Non-proportional treaty

The reinsurer assumes the part of the primary insurer’s (reinsured’s) losses that exceed a certain

amount (deductible).

Risk attaching and losses occurring

Risk attaching also be called policies issued basis, excess of loss reinsurers assume liability for

original policies issued or renewed during the period of reinsurance.

Losses occurring, reinsurers assume liability for claims arising where the date of loss falls within

the reinsurance period irrespective of the inception date.

Pools

A number of different insurers form a single collective entity, referred to as a pool, to underwrite

certain types of risk with each insurer being liable for its own share of the pool.

39

CHAPTER 3

PROPORTIONAL REINSURANCE

Learning outcomes:

Upon completion of this chapter, readers should be able to:

Know the different forms of proportional treaty.

Calculate cessions to proportional treaties and subsequent loss apportionments.

Know the significance of reinsurance commission and the main techniques whereby commission is paid.

3.0 BASICS OF PROPORTIONAL REINSURANCE

A very important distinction in reinsurance is that between proportional and non-proportional

arrangements.

• In proportional cover, the whole of a risk is split in some ratio between an insurer and the

reinsurer.

• In non-proportional cover, one part of the risk is carried by the insurer and another, normally

the upper part of the risk, is carried by the reinsurer.

This can be demonstrated by the following models:

Figure 3.1

7 70% reinsurer’s share

30% insurer’s retention

The whole of the risk is being shared in some way. No matter how small a loss, both insurer and

reinsurer will be called upon to pay.

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Figure 3.2

Excess risk carried by the insurer

Working excess of loss cover

Insurer’s retention

Here, the reinsurer is carrying a specific part of the risk; the middle portion in Figure 3.2. The

insurer pays all losses up to the retention limit. It is only if losses exceed the retention that

reinsurers are called upon to pay. Any risk exceeding the reinsurer’s share is borne by the insurer

if no other layers have been obtained.

In proportional reinsurance, the reinsurer will allow a ceding commission to the insurer to offset

some of the insurer's expenses in acquiring and handling the underlying business, known as

acquisition commission.

Levels of commission are negotiable and will tend to reflect the past experience of the treaty. The

insurer will try and negotiate a commission which is higher than the acquisition commission so

that they can improve their margins.

Example

Julia pays a premium of Shs 200,000 for her household insurance to the Kitchen Insurance

Company. The sum insured is Shs.20,000,000

The Kitchen Insurance Company retains Shs 2,000 000 of the risk and reinsures the balance. If it

is a proportional reinsurance arrangement, how much premium will the Kitchen Insurance

Company pay to the reinsurer?

Answer

Shs 180,000 will be paid to the reinsurer, calculated as follows:

the retention is Shs. 2,000,000 out of a total sum insured of Shs. 20,000,000/= or 10%

Shs. 18,000,000 is reinsured out of a total sum insured of 20,000,000/= or 90%;

reinsurers get 90% of the original premium (90% of Shs.200,000 = Shs.180,000).

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Insurer's Retention

Reinsurer's Share

Sum

insured

Shs. 20,000,000 Shs. 2,000,000

Translates to:

2,000,000 x 100% = 10%

20,000,000

Shs. 18,000,000

Translates to:

18,000,000 x 100% = 90%

20,000,000

Premium Shs. 200,000 200,000 x 10% = Shs. 20,000 200,000 x 90% = Shs. 180,000

3.1 QUOTA SHARE TREATY

A quota share treaty is an agreement whereby the insurer is bound to cede and the reinsurer is

bound to accept a fixed proportion of every risk underwritten by the insurer of the account to which

the treaty relates. The reinsurer receives a fixed proportion of all the original premiums and pays

the same fixed proportion of all the claims.

Quota share treaties are normally expressed as percentage arrangements, for example, 50% quota

share or 80% quota share. The figure quoted is the amount passed to reinsurers with the difference

between that figure and 100% being the net retention of the insurer. In the two examples above,

the net retentions would be 50% and 20% respectively.

There is an important element of terminology arising at this point. , Retention is defined as a term

synonymous with net line, being the amount of a risk which an insurer keeps for its own account

which is the maximum net loss that can be sustained on that risk by the insurer.

The term gross retention and net retention can both be experienced in quota share arrangements:

• Gross retention is the amount of risk carried by the insurer and quota share reinsurers added

together;

• Net retention is that part of the risk carried by the insurer only.

Examples

An insurer has an 80% quota share treaty applying to a risk of Shs 500 000 000. What is the

monetary value of its net retention?

Answer

Shs.100 000 000 or 20% of the gross retention of Shs 500 000 000

Normally, a quota share arrangement will specify a definite monetary limit above which the

reinsurer will not accept commitment on anyone risk. This might be expressed as:

A quota share treaty to accept 75% of every risk insured, not to exceed Shs 1,000 000 000 for

anyone risk.

This would have the effect of limiting quota share reinsurers to Shs 750 000 000 exposure on any

one risk.

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Another probable restriction is that the percentage kept by the insurer, the net retention, must not

be further reinsured by proportional reinsurance, but kept for its own account. The idea is that an

insurer could accept low quality business, make a cession to its quota share reinsurers and arrange

a facultative reinsurance of the balance. This would leave the insurer with little or no exposure

while quota share reinsurers would be carrying their normal line.

Insisting that the net retention is not reduced ensures that the common interests of insurer and

quota share reinsurers are maintained.

In practice the insurer may buy excess of loss cover to protect its net retention, either on a per risk

or, an accumulation basis. For example, a risk excess of loss or a catastrophe excess of loss cover.

Probably the most important feature of a quota share treaty is that the insurer must reinsure the

agreed percentage of every risk falling within the scope of the treaty. It cannot retain an entire

risk or an increased proportion if, for example, the risk was very small or of a very high quality.

The insurer has no freedom of choice and the reinsurers receive their fixed proportion of all

risks, irrespective of whether they are good or bad, small or large, subject to the monetary limit

mentioned above.

Example 1

An insurer has a 40% quota share treaty. It accepts a risk and receives a premium of Shs 6 000

000. How much premium do the reinsurers receive?

Answer

Shs. 2,400,000 which is 40% of Shs. 6,000,000/=

Whenever a figure is shown for a quota share then that is the proportion reinsured.

Example 2

When a claim occurs on the risk described above, the insurer has to pay Shs. 10,000,000. How

much will it recover from its quota share reinsurers?

Answer

4 000 000: the quota share in this case receives 40% of all premiums and will pay 40% of all

claims, subject to the single risk limit.

3.1.1 The application of quota share

Quota share treaties are used when an:

Insurer has capital constraints;

Insurer is new to a particular type of business or to the insurance market. It will need a significant amount of reinsurance protection, but will have little experience and

reputation in the market. For reasons outlined below, it may find that the only protection

it can obtain is quota share reinsurance;

an insurer has had bad experience in its underwriting account and lost money for itself

and its reinsurers under other arrangements. Those reinsurers may only be prepared to

43

continue the relationship with the insurer by means of a quota share treaty.

insurer wants to accept reinsurance business inwards, but can only acquire that business exchanging of its own business by way of reciprocity quota share treaties are an efficient

means of transfer;

insurer may be a subsidiary of a larger insurance group. Inter-group quota shares may be

used to exchange business within the organisation.

3.1.2 Advantages of quota share

The main advantages of a quota share treaty are as follows.

i. The simplicity of operation. A fixed proportion of all relevant business is reinsured.

The same proportion of premium and claims recoveries follows.

ii. It receives a higher reinsurance commission. As reinsurers are guaranteed a fixed

proportion of the business, they are prepared to reward insurers by allowing them

a higher return than for other types of reinsurance arrangement which are more

selective against the reinsurer.

iii. It receives a share of each and every risk. There is no selection against the reinsurer

with the insurer unable to retain good risks for its own account. Consequently, the

reinsurer receives a much better spread and balance of business.

iv. It obtains a larger share of the profits from the insurer than it would be likely to

obtain through other forms of reinsurance.

3.1.3 Disadvantages of quota share

Insurer

i. The element of compulsion. It is not allowed to vary its retention for individual

risks and so it pays away reinsurance premiums on small risks or good risks

which it might have retained for its own account.

ii. It is possible that not all business in an account will fall within the scope of its

treaty.

Reinsurer

It generally has to pay higher reinsurance commission to the cedant than it would for other types

of treaty. This problem should be offset by the higher profits available from a quota share.

The advantages are reasonably well balanced between insurer and reinsurer. The quota share

treaty does not really have any significant disadvantages for a reinsurer.

3.2 SURPLUS TREATY

The primary function of a surplus treaty is to provide additional capacity. A surplus treaty is an

arrangement whereby reinsurers will accept an amount of a risk surplus to an insurer's net

retention. The Insurer will advise potential reinsurers of its pattern of retentions. Any insurer will

44

be prepared to keep more of what they perceive to be good risks and will want to expose themselves

to lesser amounts for poor risks.

A simplified example of a fire insurer's pattern of acceptance limits or net retentions follows:

Type of risk Line or net Retention

Office Block 10,000,000

Super Market 8,000,000

Ware house 6,000,000

Tannery 5,000,000

Plastic factory 3,000,000

Wood Factory 2,000,000

Office blocks are normally regarded as good quality fire risks whilst woodworkers and plastics

risks pose obvious hazards.

If it were possible to underwrite business and pass the surplus of the insurer's net line in an

uncontrolled manner to reinsurers, there would be a large potential problem.

Can you imagine what this difficulty would be?

To solve this problem, surplus treaties are expressed as a number of lines for example a five line

treaty. What this means is that reinsurers are prepared to carry five times the insurer's net retained

amount. If an insurer has a Shs 10m m net retention, five line surplus treaty reinsurers will accept

five times that figure, or Shs 50 million. If, however, the net retention is Shs 7million, surplus

treaty reinsurers will only accept Shs 35 million on that particular risk.

The objective is to establish a relationship between what an insurer keeps on a risk and the amount

which reinsurers can be allocated on that same risk. In addition, certain types of risk may be

completely excluded from the treaty. For example, petrochemical risks might be unacceptable to

reinsurers.

A surplus treaty is an extremely good way for an insurer to increase its capacity.

Example 1

What is capacity?

Answer

Capacity is the ability of an insurer to accept insurance business.

If a surplus treaty does not increase an insurer's capacity enough to cope with the profile of risks

that it underwrites they sometimes arrange a second surplus treaty. Another group of reinsurers

will write a certain number of lines in addition to those written under the first surplus treaty.

Normally, the second surplus treaty will not become involved in a risk until the insurer has used

all the available lines under the first treaty to their full capacity.

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Example 2

Using the fire insurance acceptance limits shown above, the following table shows the amount of

business, gross capacity, which an insurer can accept in total for each class of business if it has a

SIX line surplus treaty:

Line/net retention Six line surplus Total gross capacity

Office block 10million 60milion 70million

Super Market 8m 48m 56m

Warehouse 6m 36m 42m

Tannery 5m 30m 35m

Plastic factory 3m 18m 21m

Wood factory 2m 12m 14m

It is important to remember that the amount reinsured in addition to the amount retained makes up

the total or gross underwriting capacity of the insurer.

Example 1

As an insurer, you have a six line surplus treaty with a maximum retention of Shs.2,000 000. You

are asked to insure a risk with which you are not very happy. You therefore decide to limit your

retention to Shs.1,000 000. How much can you pass to reinsurers on this risk and what will be your

gross acceptance?

Answer

Six x 1 million can be reinsured, or Shs 6,000 000. Net retention of Shs 1,000 000 plus cession to

surplus treaty of Shs 6,000 000. Therefore, gross acceptance is 7 million.

This illustrates the cardinal rule in surplus treaties, which is that reinsurers will accept as a

maximum the multiple of a net retention agreed in the treaty, in this case, six.

Example 2

Another insurer has a six line surplus treaty and a maximum retention Shs.2million. It is offered

a risk with a sum insured of Shs 1.5million. What is the minimum amount that it can reinsure

under its surplus treaty?

Answer

Normally there is no minimum amount, only a maximum as outlined above. This illustrates the

flexibility of a surplus treaty compared with a quota share. Under a quota share an insurer must

cede a portion of all risks great and small. Under a surplus treaty, an insurer can retain all amounts

up to its surplus point and so keep more premium.

3.2.1 Capacity and actual cessions

The flexibility of surplus treaties is a significant advantage for an insurer. A practical consideration

however is the difference between the capacity offered by a treaty and the amount of risk which is

actually ceded to that treaty.

46

For example

An insurer fixes its net retention at Shs.2,000 000. It then arranges a ten line first surplus treaty

and a five line second surplus treaty. Five risks are accepted with sums insured of 1.8 million, 3

million, Shs.15 million, Shs. 30 million, Shs. 32 million. The pattern of cession will be as follows.

Risk SI(M) Net Retention Cession to 1st

Surplus

Cession 2nd

Supply

1 1.8 1.8 - Nil

2 3 2 1 Nil

3 15 2 13 Nil

4 30 2 20 8

5 32 2 20 10

A number of points are illustrated here:

• As mentioned above, the second surplus treaty is not normally involved until the first surplus has

been filled to capacity;

• Only in the last case, risk five, are both treaties full. This means that Shs 32,000 000 is the largest

gross amount the insurer can accept; and

• An insurer will establish treaties with enough capacity to cope with the vast majority of its risks.

It follows that risk five above is the exception. In risk one no cession was necessary, but in risk

two, three and four the full capacity of the treaties was not needed.

The last point above is very important. A surplus treaty protecting an underwriting account could

contain many hundreds or even thousands of individual cessions.

Consider the following factors:

The net retentions for different classes of risk in the account vary. In the simplified fire account

mentioned above, there were five different risk types with five different net retentions. A real

account could see considerably more classifications;

• Sums insured on different risks within an account vary. Each underlying risk is unique and so in

anyone underwriting account there will be a great variety of sums insured;

• The treaty capacity has been arranged to cater for the majority of risks within the account. Most

risks will not need the full capacity of the treaty. In the last example quoted, only risk five used

the full capacity of both treaties.

This means that each individual cession to a surplus treaty is unique and has to be individually

calculated. It is quite possible for a treaty to embrace hundreds of original risks, everyone of which

could be reinsured for a different proportion or percentage. When the five risks considered above

are apportioned between net retention and surplus treaties the percentage relationships can also be

calculated.

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3.2.2 Calculating cessions

Surplus treaty cessions will always necessitate a calculation for each risk individually. In

proportional reinsurance the percentage relationship between retention and cession must always

be ascertained.

In the case of quota share treaties this is very easy. A quota share is a fixed, given percentage of

all the risks within the account.

With surplus treaties the position is not so clear. As each risk is unique, the net retention / cession

relationship must be individually calculated for every risk.

Example

An insurer has a ten line surplus treaty for its theft account. A theft policy is issued to a client for

Shs. 2 million for all contents. The insurer retains Shs. 400,000. A claim is agreed for Shs. 200

000. What recovery, could the insurer make from reinsurers

Solution

The classic mistake would be to say that a Shs 200 000 claim is within the retained amount of

Shs 400, 000 so the insurer would pay it all without any reinsurance recovery.

However, the capacity must first be checked:

Net Retention Shs 400 000

Surplus (10 x retention) Shs 4,000,000

Total capacity Shs 4,400 000

Then the apportionment of the particular risk must be calculated: the sum insured Shs.2,000 000,

therefore it is within the insurer's capacity:

Net Retention Shs.400, 000 or 20% of the sum insured

Surplus (within capacity) Shs.1,600,000 or 80% of the sum insured

Shs.2,000,000 or 100% of the sum insured

A Shs. 200,000 claim will be paid as follows:

Net Retention 20% = Shs.40, 000

Surplus 80% = Shs.160,000

3.2.3 Advantages

i. The insurer retains more premiums if the size of a risk is within the insurer's

retention.

ii. It is not bound to share the risk with reinsurers as is the case with a quota share

treaty. This means that the entire premium for those risks is retained by the cedant.

48

iii. The insurer's retained portfolio remains consistent. This follows from the insurer

retaining a fixed monetary limit as opposed to a fixed proportion under a quota

share treaty.

iv. As it retains a greater proportion of what are perceived to be good risks and a small

amount of poor risks, an insurer can retain more profitable business for itself.

From a reinsurer's point of view, the advantages of surplus treaty are much less than for quota

share. This is reflected by a generally lower level of reinsurance commission payable. In this

respect a surplus treaty could be said to be advantageous to a reinsurer.

3.2.4 Disadvantages

i. From the reinsurer's point of view, as the cedant retains a larger part of good risks the

reinsurer receives a higher proportion of poorer risks.

ii. Reinsurers will also acquire a larger share of target risks as the insurer will be retaining

either the whole or a large proportion of the smaller risks for its own account.

iii. Reinsurers can often experience a widely fluctuating loss experience. This is particularly

the case when there is intense competition by insurers for original business.

iv. From the insurer's point of view, a surplus treaty is far more complicated to administer than

a quota share. Each risk's apportionment has to be calculated individually and this requires

knowledge and experience which are both expensive commodities.

v. As risks are individually apportioned, there is far more scope for error in the calculation of

cessions to a surplus treaty which would give rise to disputes.

vi. Not all risks are acceptable to some treaty arrangements An insurer may have to arrange

facultative protections for some of its account.

vii. The biggest issue for reinsurers is the imbalance between premium ceded and capacity at

risk.

On balance, the advantages lie very much with the insurer. Some of the disadvantages for

reinsurers pose potentially serious problems. Sometimes insurers are encouraged to set up small

quota share as well as surplus treaties. Surplus reinsurers can then participate in both. The intention

is to allow reinsurers to acquire a more balanced book of business.

3.3 FACULTATIVE OBLIGATORY TREATY

Facultative obligatory reinsurance arrangements combine some of the principles of both the

facultative and the treaty methods of reinsurance.

Like the surplus treaty, the capacity is generally a multiple of the cedant's net retention. The big

difference, between the two is that under the latter the cedant has no compulsion to cede business.

The risks ceded to a facultative obligatory arrangement are likely to be both fewer and larger than

those ceded to a surplus treaty. This results in a less well balanced portfolio of business for

reinsurers.

Under a facultative obligatory treaty an insurer has the option to cede business to reinsurers. It is

not bound to cede under the treaty. This is where the facultative element of the name of these

treaties arises. The insurer has complete freedom of choice in cessions just as it would have under

a facultative arrangement.

49

For its part, the reinsurer is bound to accept any cession made to it under such a treaty provided

the risks are within the scope of the treaty. This is where the obligatory element of the name of

these treaties arises.

Facultative obligatory treaties provide an insurer with considerable flexibility. They are normally

used after a surplus treaty's capacity is exhausted and provide further automatic reinsurance

facilities to an insurer. It acts, therefore, as a further surplus treaty except that the insurer might

not cede to it if other arrangements can be made which are of greater advantage to the insurer.

A high degree of trust must exist between the contracting parties to ensure that the reinsurers

receive a reasonable amount of spread of risk.

The advantages of facultative obligatory treaties are primarily for the insurer who:

i. Has an immediate facility to call upon, without uncertainty as to whether cover is available,

or the administration cost problems of ordinary facultative reinsurance; and

ii. May be able to expand and develop its account by utilising the arrangement. Additional

capacity is provided, easing the handling of either target risks or particularly hazardous

risks.

The disadvantages weigh most against the reinsurer:

i. It has no control over the business which is ceded to the arrangement;

ii. There is no guarantee of a regular flow of business as would be the case under a surplus

treaty or even more under a quota share treaty; and

iii. There is a danger of selection against the reinsurer with the insurer using the facility to

cede for high hazard and high value risks only.

3.4 REINSURANCE COMMISSION

Reinsurance commission is a financial advantage arising out of reinsurance business. Insurers

benefit from contributions by reinsurers towards their acquisition and management costs.

Reinsurers acquire business without the expenses of underwriting primary accounts.

Reinsurance commission usually applies solely to proportional business, which is why it is

considered here.

Reinsurance commission is paid by a reinsurer to an insurer.

If reinsurance is arranged via a broker then the latter's remuneration is described in the reinsurance

market as brokerage. Brokerage is also paid by the reinsurer as a fixed percentage of the

reinsurance premium for the cover.

Example

An Insurer would like as much reinsurance commission as possible. What problem would the

reinsurer's face with a very high rate of reinsurance commission?

Answer

A high rate of reinsurance commission will be a loss of revenue to the reinsurer. More significantly,

however, the provision of a high flat or fixed rate of commission might separate the interests of

50

the parties. An insurer could write business with a view to gaining commission on the cessions,

relaxing its normal underwriting standards.

Questions

1. When is Quota share treaty used?

2. What are the advantages of Quota share treaty?

3. What are the disadvantages of Surplus treaty?

4. What is Reinsurance Commission?

5. What are the advantages of Facultative obligatory treaty?

51

SUMMARY

Basics of proportional reinsurance

In proportional reinsurance, the reinsurer will allow a ceding commission to the insurer, known as

acquisition commission.

Quota share

The reinsurer receives a fixed proportion of all the original premiums and pays the same fixed

proportion of all the claims.

Surplus treaty

A surplus treaty is an arrangement whereby reinsurers will accept an amount of a risk surplus to

an insurer's net retention

Facultative obligatory treaty

Facultative obligatory reinsurance arrangements combine some of the principles of both the

facultative and the treaty methods of reinsurance. Under a facultative obligatory treaty an insurer

has the option to cede business to reinsurers.

Reinsurance commission

Contributions by reinsurers the insurer’s acquisition and management costs.

52

CHAPTER 4

NON-PROPORTIONAL REINSURANCE

Learning outcomes:

After completing this Chapter, the reader should be able to understand:

Non proportional reinsurance

Non proportional treaty

4.0 NON PROPORTIONAL REINSURANCE

Non proportional reinsurance is also known as Excess of Loss reinsurance.

XL is the abbreviated form for ‘excess of loss ‘and Xs is the abbreviated form for ‘excess’.

Under Excess of Loss contracts, the reinsurer agrees to indemnify the reinsured for losses that

exceed a specified monetary amount identified by the reinsured. Such an identified amount is the

deductible amount also known as ‘excess’ or ‘priority’ or ‘underlying’.

The reinsured bear all amounts up to the deductible and the reinsurer pays the balance of may loss

that exceeds the deductible, up to an agreed limit. An excess of loss reinsurance arrangement with

deductible of Ugx. 25,000,000 and agreed limit of Ugx. 1,000,000,000 will be expressed as

Shs. 1,000,000,000 Xs Shs. 25,000,000.

The excess of loss contract is not concerned with any proportionate shares of the original sum

insured, premium and claims on any one risk, but is concerned with the amount of loss being re-

insured.

4.1 STATUS OF CEDING INSURER

The status of the ceding insurer is that of a reinsured. He doesn’t cede risk and proportional

premium. He seeks protection to mitigate a loss beyond his chosen limit of loss retention.

Thus, excess of loss reinsurance contracts are formed on a basis much different from proportional

reinsurance.

Example

If cover limit is of Ugx.95,000,000 in excess of Ugx. 5,000,000 in respect of losses arising out any

claim, then share of loss will be as follows:

Amount of loss Reinsured Excess loss (XL) Reinsurer

Ugx.3,000,000 Ugx.3,000,000 Nil

Ugx.5,000,000 Ugx.5,000,000 Nil

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Ugx.25,000,000 Ugx.5,000,000 Ugx.20,000,000

Ugx.1,060,000,000 Ugx.5,000,000 Ugx.95,000,000

Plus Ugx. 960,000,000 ( not insured)

Balance of loss

Balance of loss over and above the total of retention and agreed XL reinsurance cover limit (Ugx.

960,000,000 in the above example), reverts to the reinsured.

4.2 DIFFERENT TYPES OF EXCESS OF LOSS REINSURANCE

4.2.1 Working (risk) Excess of Loss (XL)

This reinsurance is intended to limit losses that arise on the reinsured’s day to day operations. It

caters to the reinsured’s need for protection against number of losses that arise out of a single

accident, occurrence or event.

4.2.2 Risk excess of loss

Adverse underwriting results of proportional treaties and resultant shrinkage of proportional

reinsurance capacities, may force the reinsured to increase per risk retention levels beyond what

their financial strength may justify. Under such situations the “per risk” Excess of Loss provides

protection for the increased retention levels. This form of reinsurance is manly used in protecting

property loss exposures.

4.2.3 Catastrophe Excess of Loss (CAT XL) Reinsurance

This reinsurance protects a reinsured against an accumulation or aggregation of losses arising from

an identified event such as Earthquakes, flood, cyclone, riots, etc… which maybe affect a large

number of risks. Such accumulations or aggregation may far exceed their reinsured’s retention on

an “any one risk” basis.

4.2.4 Stop Loss or Excess of Loss Ratio

This form of reinsurance limits the aggregate amount of loss the reinsured would lose on a given

class of business in an annual period. It responds if an accumulation of losses exceeds the

deductible selected.

The cover is normally expressed in percentage terms. In the event of the reinsured’s net loss for a

given year rises above a certain percentage, this reinsurance pays in excess of that figure up to a

higher agreed percentage beyond which the reinsured retains the loss.

In short, this is a method that mitigates the impact of an unbearable net loss ratio. This method

applies to the loss ratio of reinsured for any one class of business. This doesn’t apply on the basis

of per risk (working) or catastrophe.

The trigger can be a pre-agreed percentage of net written premiums.

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Example

The trigger is designed to stop the loss from claims of the reinsured for that class of business at,

say a pre-agreed 80% of the net written premium. Aggregate excess of loss cover selected is

90% of excess of loss ratio 80% subject to maximum loss ratio of 130%.

YEAR LOSS RATIO RETENTION XL 90%

2007 65% 65% Nil

2008 70% 70% Nil

2009 85% 80%+0.5% 4.5%

2010 100% 80%+2% 18%

2011 130% 80%+5% 45%

2012 140% 80%+5%+10% 45%

In the above example the reinsurer bears 90% of loss ratio in excess of 80%. The balance reverts

to the reinsured and is retained by him. In the year 2012, the loss ratio exceeds the upper limit of

the excess loss cover. The excess 10 % reverts to the reinsured fully and retained by him.

4.2.5 Aggregate Excess of Loss Reinsurance

Aggregate excess of loss cover is on the similar lines as Excess of Loss Ratio reinsurance for a

defined class of business, but the cover parameters (i.e. the limit and deductible) are expressed in

amounts rather than percentages. In Aggregate Excess of loss, the amount applies as a trigger for

cover instead of loss percentage/loss ratio. This can be written excess of an Ushs. amount in Ushs.

Example

Ugx. 50,000,000 in the aggregate excess of Ugx. 5,000,000 in the aggregate. The trigger can also

be a pre-agreed limit of cover of accumulation of net retained losses. For example, if a reinsured

retains Ugx. 5,000,000 on each life and there is accumulation from an accident with loss of 10

lives. The reinsured could protect such accumulation by an aggregate excess of loss limit of, say

Ugx.40,000,000 excess of Ugx.10,000,000.

The reinsurer indemnifies the reinsured for an aggregate (cumulative) amount of losses in excess

of losses in excess of a specified aggregate amount. This can also be written with an interior

deductible, i.e. to apply only to individual losses excess of a stated Ushs amount (e.g. Ushs.

40,000,000 in the aggregate excess of Ushs. 10,000,000 in the aggregate applying only to losses

greater than Ushs. 50,000,000 per loss).

4.2.6 Whole Account Excess of Loss Cover

There are variants to stop loss and aggregate Excess of Loss covers. A reinsured may wish to

protect his whole book of business. A simple composite cover could be installed protecting at one

go the whole business of the reinsured incorporating all classes of business. Such an arrangement

is known as Whole Account Excess of Loss Cover. This method is common in miscellaneous class

of business wherein limits and priorities are set for each different sub class.

4.2.7 Umbrella Excess Of Loss Cover

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Another variant is the Umbrella Excess of Loss Cover. This is installed to assist to cover any gap

in the various reinsurance arrangements made by a reinsured. In

addition it offers additional limit for protection when in a catastrophe reinsurance arrangements

are exhausted in their limits and there is a huge financial accumulation of net retained losses from

various classes of business.

Example

ABC insurer wants to protect his whole book of business. Hence he enters into an arrangement

where a single composite cover is installed for protection of its whole business, incorporating all

classes of business. This arrangement is known as ……………………..

A. Excess of loss

B. Aggregate excess of loss

C. Whole account excess of loss

D. Umbrella excess of loss

4.3 NON PROPORTIONAL TREATY

The reinsured can split & structure his total XL requirement in layers depending on market

conditions, availability of capacity and cost effectiveness.

These layers would sit on top of each other consecutively; each can be placed with different

reinsurers and get triggered only after capacity of the previous layer is exhausted e.g.

The fire layer would cover up to the agreed limit in excess of the amount of deductible by the

reinsured. The second layer would commence where the fire ended and continue to its cover and

so on.

Example

Excess Layer Cover limit Xs point

(deductible)

Total capacity

First Ugx. 20,000,000 Ugx.5,000,000 Ugx.25,000,000

Second Ugx.75,000,000 Ugx.25,000,000 Ugx.100,000,000

Third Ugx.150,000,000 Ugx.100,000,000 Ugx.250,000,000

4.4 IMPORTANT FEATURES OF NON PROPORTIONAL REINSURANCE

4.4.1 Ultimate net loss

Because the reinsurer becomes interested only when a loss exceeds the retained loss, definition of

ultimate net loss that requires to be protected is necessary. The ultimate net loss has to exceed the

net retained loss after recoveries from all other reinsurances and before the excess of loss reinsurer

becomes interested.

The amount of the ultimate net loss consists not only of all sums paid in respect of the claim, but

also all expenditure incurred by the insurer in connection with the claim, such as;

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a) Survey reports

b) Assessor’s fees,

c) Salvage costs,

d) Legal costs, interest, etc…

Salaries of employees and office costs of the insurer, however, are not included in the calculation

of the claims’ costs. Recoveries from the proportional reinsure Ushs. salvage, subrogation and

contribution are deducted from the claims costs.

4.4.2 The Reinsured’s Retention

One of the most difficult decisions the reinsured has to make is the setting of his retention for the

excess of loss cover. The ideal level of retention has been vaguely stated as being low enough as

not to be involved in the majority of the claims and yet high enough to keep the insurer from being

too greatly exposed in any one loss.

The fixing of the retention will also depend on what types of loss cover is required;

Working capital

i. Working capital

ii. Catastrophe cover

iii. Stop loss or aggregate loss

iv. Who account or

v. Umbrella excess of loss

a) Retention per risk

These are used to reduce the insurer’s loss in respect of a single risk. For this reason the retention

under the excess of loss will be fixed at an amount less than the amount which they accept for their

net account on any one risk under proportional reinsurance arrangement.

b) Retention per Event

Catastrophe covers protect the insurer against unknown accumulations arising out of the event.

The retention under this type of excess of loss is normally more than the amount retained under

each individual risk. This means that two or more risks have to be involved in a single loss before

the excess of loss is affected. In practice a ‘Two Risk Warranty’ is included within the contract to

denote minimum accumulation from two risks.

4.4.3 Minimum & deposit premium

The XL reinsurer does not know in advance what the final premium will be and hence calculates

the amount of premium to be paid in advance as deposit premium by the reinsured. Such deposit

premium when prescribed as minimum premium for the cover, it is termed as ‘Minimum & Deposit

Legal Premium (Mindip).

4.4.4 I.B.N.R. (Incurred but not responded) Losses

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These refer to the anticipated loss provisions in respect of individual claims which may take long

time to get reported and even longer time to get fully settled (e.g. complicated legal liability

claims).

4.4.5 Premium for XL cover

The larger the deductible (also termed as under lying or priority) the smaller is the exposure to &

premium for excess of loss covers. But how much smaller is the question that has baffled

reinsurance underwriters’ since excess of loss began.

The premium for an excess of loss cover is usually expressed as a percentage (the rate) of gross

premium income written by the reinsured for the type of risk or class of business covered.

Gross premium income is usually considered as being all premium written by the reinsured during

the contract period less return premiums, cancellations, premiums on excluded risks and premiums

on reinsurance which reduce the reinsurer’s exposure (facultative reinsurance and underlying

reinsurances). This is termed as Gross Net Premium Income-GNPI.

The calculation of a rate presents considerable problems. Although it is not possible to draw up a

table of rates to be consulted with the same actuarial certainty as may be found in certain types of

direct insurances , the reinsurer’s intention behind the calculation of a suitable rate is the same as

rating direct insurance namely, to cover;

a) The normal claims expected to occur

b) Reserve for worsening experience _including inflation and I.B.N.R claims

c) The reinsurer’s management expenses

d) Surplus that maybe termed a profit

Several general factors affect the rate, the main ones being the;

a) Level of excess point;

b) The limit and exposure to the reinsurer;

c) The class of insurance business;

d) The exclusions;

e) The underwriting limits of the reinsured; and

f) The past experience of the treaty.

.These may be considered more fully as follows:

a) The lower the retention of the reinsured the larger the number of claims the reinsurer can

expect to exceed it, therefore the higher will be the rate. The greater the limit to the insurer

the greater his exposure and the higher the rate.

b) The range of insurance a business covered also affects the rate. Where a treaty covers a

number of classes of business or where there is only little exclusion the risk assumed by

the insurer would be greater.

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c) The types of risk insured and the size of the sum insured would affect the degree to which

the reinsurer would be exposed to claims.

d) The effects of the above would vary from reinsured to reinsured because of different

underwriting policies and areas of business

Therefore the reinsurer attaches great importance to the past experience of the reinsured. The

past experience will assist for an indication of the amount of risk the insurer can expect to

undertake for various levels of retention. The reinsured provides information covering a period

of years stating his annual premium income and the number and cost of all claims which have

exceeded the proposed retention.

The claims amounts will include both amounts paid and amounts outstanding and each claim will

be related to the year of occurrence – no matter when it was paid. This total amount of claims in

excess of the retention is expressed as a ‘percentage of the insurer’s gross premium income’.

4.4.6 Burning Cost

Burning cost is the basis of rating working excess of loss treaty;

a) The rate for the first year of treaty is based on historical experience of losses “as if” the

reinsurer “paid” them in the past.

b) At the beginning of the treaty year an estimate is made of premium to be collected by way of

deposit. The rate of premium is agreed as range:

(i) Minimum rate payable by reinsured; and

(ii) Maximum rate chargeable by the reinsurer.

c) At the end of the treaty year the actual loss experience is established. Based on the loss

experience, the rate of premium as agreed is reviewed;

(i) If the experience is lower than minimum rate as agreed then the reinsured pays the

minimum rate of premium.

(ii) If the loss experience is more than the maximum rate as agreed then the reinsurer

collects the maximum rate.

d) The premium so calculated is adjusted against the deposit premium.

It is usual to note that the deposit premium is also the minimum premium.

e) Pure burning cost

The formula for calculating pure burning cost is;

The pure burning cost is loaded by a suitable factor to cover costs of acquisition, expenses of

management, reserve for catastrophe, and element of profit. It is usual to note in practice a

loading of 25 to 30%. Loading is done as follows;

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Pure burning cost = (paid losses outstanding losses ) * 100

Treaty period GNPI 70

Or

Pure burning cost = (paid losses outstanding losses ) * 100

Treaty period GNPI 75

The above produces the rate of premium to be applied to determine the treaty premium for

adjustment at the end of the treaty year.

4.4.7 Reinstatement

In practice a non- proportional treaty provides that the cover would deplete or cease upon

payment of loss. It provides for automatic restoration of limit of cover subject to mutually agreed

additional premium.

The number of reinstatements and the basis for additional premium are subject to negotiation.

Typically reinstatement provisions are relevant for categorized excess of loss covers. However

this facility is extended to Risk Xl cover on free of cost basis for the first or the first two

reinstatements with ant subsequent reinstatements bearing stiff additional premium.

The additional premium may also follow the treaty premium and be;

(i) Prorated for the amount reinstated or

(ii) Prorated for the balance of treaty period or

(iii) Prorated for a combination of both amounts reinstated and balance of treaty period.

Any basis would be as negotiated and as agreed with the treaty reinsurer. In the case of excess of

loss treaty based on “Burning Cost” the GNPI for purpose of reinstatement would need to be agreed

at the time of inception. As the reinstatement is pro-rated to amount and period it assumes the

GNPI of the full year for purpose of reinstatement.

4.4.8 Claims

A claim falling within the scope of the treaty will be calculated subject to the provisions of the

ultimate net loss clause which are applicable. All reinsurers participating bear their respective

share. The reinsured cannot collect the whole loss from one reinsurer.

Example

If a treaty is covering Ugx.40,000,000 excess of Ugx.10,000,000 , then the loss will be

distributed as under, between three reinsurers taking 10%, 40% & 50% shares respectively.

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Loss Ugx. 15,000,000

Legal costs Ugx. 1,000,000

Total Ugx. 16,000,000

Loss of the XL cover Ugx. 6,000,000

Reinsured pays Ugx. 10,000,000

Reinsured A (10%) Ugx. 600,000

Reinsured B (40%) Ugx. 2,400,000

Reinsured C (50%) Ugx. 3,000,000

Total Ugx. 6,000,000

Since excess of loss reinsurance is designed to be a source of funds at the reinsured’s immediate

disposal, an expeditious system for reporting and collecting losses is required to be in place.

Generally, the reinsured is required to advice his reinsurer as soon as he has reason to believe a

claim will exceed the retention.

Due to escalation of certain types of claim, there may be a provision that the reinsurer be advised

as soon as the claim exceeds the retention. The reinsurer will settle the claim within a few days

of being advised that the claim has been paid by the insurer. In practice the reinsurer receives

advice of losses outstanding at the end of the contract period. This enables the reinsurer to

ascertain his outstanding commitment and to check on the developing experience.

4.4.9 Inception and Termination

As the contract addresses cover for loss it is important to specify hour and time zone. For

catastrophe treaty use time zone of reinsured and others; “standard time”

Contract terms would include date of commencement and date of termination

Example

“This contract shall incept at 12:01 A.M. Uganda Time on July 1, 2010 shall apply to losses

occurring during the term of this contract and shall remain in force until 30th June ,2011, both

days exclusive”

As with proportional treaties, there must be a definite method for determining which claim falls

within the scope of the excess of loss cover. The two methods are:

a) “Losses occurring” basis and

b) “Risk attaching” basis

a) Loss occurring basis

On the “losses occurring” basis, all losses occurring within the contract period are covered, no

matter when the original policy was issued.

The fact that the original policy was issued before the inception date of the present contract, and

while another excess of loss treaty was in force does not relieve the present reinsurer liability.

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Similarly, at termination, the reinsurer is not liable for losses occurring after the contract ends,

although the original policy may remain in force.

He does, however, remain liable for losses which occurred during the period of the contract but

which had not yet been settled-whether or not the insurer is aware of these claims at the date of

termination.

The merit of this system is its simplicity. Each contract year is self contained.

There is no portfolio taken over at inception, no portfolio withdrawn at cancellation, and no

checking when a claim occurs to see when the policy was issued and what contract was affected.

b) Risk attaching analysis

The “risk attaching “basis is used to avoid the hazard of the reinsurer cancelling a contract and

leaving the insurer without cover for the duration for the policies.

Under this method, claims under policies issued or renewed during the contract period are

covered no matter in which year they may occur. Thus a claim may involve the previous contract

or the present one depending on the date on which the policy was issued.

The reinsurer will be at risk until all the policies covered by the contract for that year of account

have expired and all losses settled. Thus, if the business has a long run- off, the reinsurer has

along run-off.

The defects of this system are the long run-off and the difficulty of assigning a claim to the

proper excess of loss contract year.

Marine and aviation excess of loss contracts, because of their nature to transact insurance on the

basis of underwriting year, use “risk attaching” method.

Questions

i) Name two types of retention

ii) We have a working excess of loss, what the the other two excess of losses

iii) Differentiate between loss occurring and risk attaching

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SUMMARY

Different types of excess of loss reinsurances

Working (risk) Excess of Loss (XL)

Risk excess of loss

Catastrophe Excess of Loss (CAT XL) Reinsurance

Stop Loss or Excess of Loss Ratio

Aggregate Excess of Loss Reinsurance

Whole Account Excess of Loss Cover

Umbrella Excess Of Loss Cover

Important features of non proportional reinsurance

Ultimate net loss

The Reinsured’s Retention

Minimum & deposit premium

I.B.N.R. (Incurred but not responded) Losses

Premium for XL cover

Burning Cost

Reinstatement

Inception and Termination

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CHAPTER 5

PROCESSING INFORMATION FOR REINSURANCE

DECISIONS

Learning Outcomes

Upon completion of this chapter, readers should be able to:

A. Understand the importance of statistics in reinsurance

B. Know the use of communication and information technology

C. Understand the organization of a reinsurance department

5.0 IMPORTANCE OF STATISTICS IN REINSURANCE

From the IRA Regulations for Reinsurance:

Every insurer is required to submit to the Authority statistics relating to its reinsurance transactions

in such forms as the Authority may specify, together with its annual accounts.

Every insurer shall make outstanding claims provisions for every reinsurance arrangement.

The more important data that should be capable of being made available from a good information

system used by the primary insurer should be.

a) Direct premium data to calculate the reinsurance premium payable to the reinsurers;

b) Data for individual losses needed to apply treaty limits and excess retentions;

c) The above data for accounting purposes;

d) Codes generated for catastrophe losses;

e) Codes for identifying occurrences under casualty' clash' coverage;

f) Data to determine the portion of policy/ies ceded to each surplus share reinsurer.

g) Separate data on retention, limits, rates and reinsurer involved for each facultative placement.

h) Information on risks included in treaty, but not ceded for preserving profitability of treaty.

i) Data on risks excluded under the treaty, but underwritten by the primary insurer so as not to

include the same in the reinsurance bordereau;

An accurate and efficient information system helps in increasing credibility of the primary insurer

and helps in renewal of treaties. The primary insurer must make available his books of account for

inspection by the reinsurer.

Maintenance of accurate statistics relating to acceptances and their speedy and timely availability

is vital for the successful conduct of reinsurance business.

These are necessary for periodically monitoring the performance of each reinsurance arrangement

and to take remedial action where necessary.

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Some examples of reinsurance statistics required by managements for effective control are:

(i) Treaty wise quarterly statistics

(ii) Broker wise statistics

(iii) Country wise statistics

(iv) Insurer wise statistics

(v) Proportional and non-proportional statistics

(vi) Class of business statistics

(vii) List of overdue accounts

(viii) List of outstanding balances

The basic statistics relating to a treaty are collated from accounts statements as sent and received.

Information can be processed from these basic statistics for any type of review requirement

considered as important including an assessment of cash flows.

Review of acceptances is to be done periodically and in any case at least one major review must

be done in a year. Such review is of importance and is part of the duties of executives in charge of

underwriting and administration.

The review must be done well in advance of the notice period, that is, if a treaty provides for notice

of cancellation to be given by 30th September, the review would need to be conducted in July-

August, with the up-dated accounts based information.

5.1 UNDERWRITING ISSUES IN REINSURANCE TREATIES

The essential features of a review are whether:

a) The accounted premium is consistent with the estimated premium taking into account the

development normally to be expected. A sudden increase or decrease calls for review with the

insurer or reinsurer concerned;

b) The profit commission statement agrees with the accounted figures;

c) The release of reserves and portfolio movements are in accordance with the treaty provisions;

d) The overall result of the treaty is a profit or loss, due attention being paid to outstanding loss

provisions;

e) The rendering of accounts and settlement of balances is prompt;

f) Treaty document was received or not.

In case of treaties where the above review show signs of deterioration, it may be necessary to

tender a provisional notice of cancellation to the ceding insurer, keeping in mind

the current trend of business,

other business from the insurer,

overall relationship and

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any other special considerations.

The results would be normally watched over 3 to 4 years period when the quality of the treaty

would be definitely known to the underwriter.

If there is a reciprocal exchange, all the business exchanged with the insurer or reinsurer is

summarised in a sheet, showing cessions on one side and matching acceptances on the other side.

Premiums, commissions, incurred claims and net results for each contract year are shown.

The statistical summary assists for an assessment of historical exchange of results and impact of

changes in rate of exchange upon these results. Any imbalance in premiums or profit may call for

adjustment in terms.

In reviewing excess of loss reinsurance, due regard is paid to check the validity of assumptions

made while making the acceptance, regarding GNPI, exposures involved, adequacy of rate, etc. A

follow-up action is necessary on the provisional notice of cancellation. Such notice may also be

given by the ceding insurer to review the terms for the ensuring year.

Generally, the ceding insurer will send well in advance renewal terms for the following year along

with up to date statistics. Where a notice has been given. the reinsurer must decide on continuation

with the business. If he decides to terminate his participation, a definite notice of cancellation is

given.

On the other hand, if the study of renewal terms justifies continuation, provisional notice will be

withdrawn and acceptance conveyed to the ceding insurer. The accounts department is to be kept

duly informed of all definite cancellations and changes in terms.

5.2. PROVISION FOR OUTSTANDING LOSSES

At the end of the accounting year, a provision is required to be made for outstanding losses in

respect of all cessions and acceptances. Generally, in respect of acceptances the ceding insurers

are not in a position to provide an estimate of outstanding losses to their reinsurers in time for

inclusion within their annual accounts.

Therefore, reinsurers all over the world have devised their own methods for making estimates of

outstanding provisions. The underwriter has to review each of his acceptances and make a

reasonably accurate estimate of outstanding losses.

Some of the methods followed are:

a) Estimated losses as advised by the ceding insurer as at the date of closing. If this is not available

estimates at the latest available date plus large losses intimated subsequently, but not paid;

b) Where there is a provision for portfolio entry in the treaty concerned, the same amount is to be

included as estimate for outstanding claims;

c) Where the ceding insurer has provided renewal statistics, information on outstanding losses

will be available therein. If latest statistics are not available, then the trend of incurred claims

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ratios over a period would assist to estimate the incurred claims for the current year and a

provision for outstanding claims can be made after deducting the paid claims for the year;

d) The underwriter may also decide to make an additional "ad hoc" provision for claims incurred

but not reported (IBNR), say, addition of 10 % of outstanding claims as IBNR.

It is emphasized that none of the methods enumerated above is totally satisfactory, but a

combination of the methods and consistency of practice in making provisions ensures reasonable

and acceptable procedure.

5.3. CONTROL OF ACCUMULATION

Accumulation hazards form an inherent part of reinsurance business and a careful control is

required to be maintained on exposures due to earthquake, storms, tornados and other catastrophic

perils in different parts of the country and the world.

The frequency, timing and severity of such phenomena can vary from area to area and such

variations can be found even in one location. Some areas are liable to very occasional but severe

earthquakes but some others may be liable to more frequent shocks of lower intensity. Similarly,

cyclones can hit a coastline otherwise free from the strong winds associated with temperature and

latitude.

The data base in this respect is created at the time of issue of a policy or acceptance of reinsurance.

It calls for the underwriter to seek such information and include it for control.

5.3.1 Earthquakes and Accumulation of Hazard

Insurers as well as reinsurers are primarily concerned with the damage caused to property as a

result of an earthquake. It is possible to obtain reasonably accurate instrumental measurements of

magnitude, depth and location for earthquakes from the network of seismometers operating around

the world.

The magnitude (M) of an earthquake is measured on the Richter Scale and the scale of intensity.

which is a measurement of the severity of the event, is expressed in the Modified Mercalli Scale.

The effect of an earthquake on a structure depends on various factors such as its magnitude, the

depth of its epicentre, the distance and direction of the epicentre as well as the type of construction

of the structure and the type of subsoil in the surroundings.

Zones highly exposed to earthquake are:

a) West Coast of U.S.A., Central America, Caribbean Islands, West Coast of South America.

b) Southern Europe i.e. Italy, Spain, Yugoslavia, Rumania, Greece and Turkey

c) North Africa i.e. Morocco, Algeria, Tunisia

d) Iran, Iraq and Afghanistan

e) Nepal, Assam, Burma

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f) Japan, Taiwan, Philippines, Indonesia, Fiji and New Zealand.

The underwriter must first determine the zones which may be affected by damage from a single

event with the aid of seismic map. These zones are fixed separately by each insurer and reinsurer

according to his underwriting policy.

Then he has to work out a uniform system dividing an area into earthquake accumulation control

of zones according to which the commitments may be ascertained.

5.4. ASSESSMENT OF CUMULATIVE COMMITMENTS

The assessment of commitments has to be done zone wise and for this purpose accumulation

control sheets are maintained. All liabilities for risks coming under the zone are listed in such

sheets.

The Proforma may show the:

Zone,

Class of business,

Ceding insurer,

Treaty name,

Earthquake liability for the reinsurer's share in terms of sum insured and

the relevant date.

This information has to be kept up-to-date with changes in liabilities under the various acceptances.

By assessment of the total liabilities in each zone, an underwriter will be in a position to control

his future acceptances as well as arrange suitable catastrophe protection for his existing

commitments.

5.5. SYSTEM AND PROCEDURES

Both ceding insurers and reinsurers need periodical statistics of their business for decision making

and review purposes. Review of past trend for renewal of the reinsurance business depends on

statistics which must be reconciled with reinsurance accounts. It is therefore necessary to have

efficient data processing arrangements to gather and analyze data.

The insurer or reinsurer must be clear about his basic objectives in the business of reinsurance and

establish a decision support system.

A reinsurer in the main has to monitor the performance of

individual treaties,

the main classes of reinsurance business,

the business obtained from different countries and regions;

claims trends and provisions;

exposures etc.

Most of this information is also equally valuable to a ceding insurer because both parties to a

reinsurance treaty should be equally well-informed regarding its performance.

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There is little homogeneity in business written and the requirements from statistics tend to be wide-

ranging.

As with other insurance statistics, there are various factors which affect underlying statistical

trends, which include:

Class of business;

Type of reinsurance contract;

Legislation of country of origin;

Types of claim;

Currency;

Inflation.

Secondly the information is used by various categories of employees in the insurer's or reinsurers'

organisation which includes:

Underwriting staff;

Accounting staff;

Marketing;

Claims staff;

Management

The uses of the information produced from a statistical base include ,

Production of accounts;

Production of marketing information;

Production of rating information, either for individual ceding companies or portfolios;

Premium and claims trends;

Assessment of outstanding claims and IBNR reserves;

Financial planning.

All these needs should be satisfied from a good statistical system, although the types of output can

differ considerably depending upon the user's requirement

5.6. GUIDELINES FOR DEVELOPING A SYSTEM

The following are the main aspects to be looked in developing a statistical system:

a) Production of statistics for each of the outward treaties;

b) Preparation of outward accounts and various other books of records;

c) Requirements of reconciliation of balances and review of cash flow;

d) Marketing information required for outgoing treaties;

e) Review of business accepted for the purpose of ascertaining its profitability;

f) Review of reciprocal exchanges for the purpose of ascertaining profitability;

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g) Statistical requirements for complete analysis of the portfolio underwritten and to ascertain

exposures;

h) Statistical and accounting requirements for retrocession treaties;

i) Information on large claims;

j) Ascertaining aggregate loss amount due to one catastrophic event, which may affect the

reinsurers through several treaties;

5.7. USE OF INFORMATION TECHNOLOGY

The wider use of computers and telecommunications has led to a growing preference for simplified

administration procedures. At one time the insurer passed copies of all papers to reinsurers /

brokers who then did all the necessary work to produce the reinsurance accounts themselves.

Today, Electronic Data Processes (E.D.P) techniques have made it possible for insurers to produce

reinsurance accounts themselves at a minimum cost thus saving the reinsurers / brokers a great

deal of administrative effort. The saving made by the reinsurer is passed on to the insurer in the

form of more competitive rating.

The application of electronic data processing methods in reinsurance business is advanced and

gained acceptance in countries all over the world. In some offices, EDP system is being used for

the first time, whilst in others it is in a second or third generation environment with on-line systems

and with terminals in the place of work.

There are detailed procedures to be followed from an initial corporate decision to investigate the

need for a new system, through;

i) Feasibility studies,

ii) Tendering,

iii) Outline and detail systems design,

iv) Leading to programming,

v) Testing and

vi) User acceptance.

The Reinsurance Manager is concerned with the service that the EDP system gives, the assistance

it provides to help him function in a more efficient way and in the timing of the service. EDP has

gone forward from this point to web based access and use.

With the simplest of arrangements in data processing which is using a PC to turn out word, excel

or power point files and to send these via e-mail desktop to desktop is the most efficient method

of communication, data sharing and data storage.

This facilitates complex data on risk proposals to be transmitted within seconds anywhere in the

world and complete transactions with overseas contacts within the space of hours

The above is the simplest assessment of communication for reinsurance. Add to this voice mail,

teleconferencing and video conferencing one is never away from a face to face meeting across the

world at any time.

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Data processing, access to process data and data transfers introduce complex processing

requirements based on networking with a mainframe in one part of the world with the network of

offices connected to it and to each other through hardware arrangements like hubs and routers.

This manageable complexity has given rise to intranet, extranet and back office applications.

Further, turnover in communication apart from being instantaneous has less paper work associated

with it than through conventional means and electronic means to store and retrieve files and emails.

An organization can internally connect all its executives and offices through a private internet

arrangement which is called "intranet ". While it will be possible to access the public internet

through an intranet freely, it is not possible to access an intranet facility except through password

restricted access.

This restricted access has increased commercial opportunities to service providers who provide

database access to their customers as an extension of the intranet to download and use certificates

of insurance or to ascertain their own account balance status, etc. This access is called' extranet.

Major and significant developments have occurred in terms of web based portals, online

reinsurance exchanges and electronic data interchange (EDI). These have now permitted insurers

and reinsurers to get to know each other through their websites and with such information

confirmed by video / teleconferencing.

Once a business is finalized, electronic records are generated from information input made only

once and which instantaneously pops up in technical, accounts and statistical departments.

Statements rendered for confirmation to settle are followed up by EDI settlements and through

online payments.

With reinsurance capacity being provided by traditional and capital markets the use of

Communication and IT technology creates real time connectivity with customers and solutions are

driven, so to say, by the speed of thought. Bill Gates, founder of Microsoft, called this the Digital

Nervous System where everyone has access to data that enriches his job and performance.

Communication and Information Technology would be superior in processing volumes of data

from worldwide operations in no time and make it available to intended users with accuracy and

reliability. This real time availability of data is a powerful catalyst to performance and growth.

5.8. ORGANIZATION OF THE REINSURANCE DEPARTMENT

A reinsurance department can, depending on the organization of the company have the following

principal tasks:

To coordinate the application of the cedant’s reinsurance programme between management and technical department then company and Reinsurers.;

To carry out or supervise the administrative work of reinsurance;

To prepare the information statistics to serve as a discussion basis between the cedant and reinsurer.

Depending on the volume of business and the administrative organization of the company, the

reinsurance work will be more or less centralized. In an extreme case there would be only one

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employee to coordinate the activity of the technical departments, which would themselves

administer the reinsurance, in line with the following diagram

At the other extreme, one finds a reinsurance department which is responsible for all the work,

from the accumulation control to the preparation of the reinsurance treaties.

The underwriter must have an exact description of his acceptance authority, i.e.:

Category of risks

Amounts the company can accept

For this reason it is indispensable to give him, with his job description, an extract of the reinsurance

contract which expressly mentions:

The business covered;

The exclusions;

The risks which have to be placed facultative; and

The proportional and non-proportional covers (table of underwriting limits)

As soon as the underwriter receives a proposal which exceeds the amount provided for in the

underwriting table of limits or if the risk is excluded from the automatic cover, the case must be

submitted to the reinsurance department with the necessary information to make a facultative offer

to the reinsurer). The underwriter must know that neither policy nor cover not may be issued until

confirmation is received from the reinsurance department that the facultative officer has been

accepted by the reinsurer.

Management

Reinsurance

Administration

Fire Miscellane ous Risks

Marine Motor Public

Liability Accounts

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In surplus reinsurance, experience has shown that retentions are fixed with more precision in the

underwriting department where the risks are better known. It is also recommended that the

accumulation control, which is inseparable from the calculation of the retentions, be done at the

same time as the underwriting.

Companies that have chosen the system of centralization of all reinsurance work must give their

underwriters smaller acceptance limits than the automatic capacity of the treaties in order to have

a certain margin in the event of accumulations. The underwriting powers delegated to branches

and general agents should be handled in the same manner; the limits should be even lower and the

list of excluded risks more extensive in order to take into account the difference in technical

knowledge between head office and the branches.

When the policy is issued, after the accumulation control and the possible arrangement of

facultative reinsurance, the amounts of retention and reinsurance per treaty and per facultative

cession are indicated on a copy of the policy which is then sent to the reinsurance department.

5.8.1. Insurance Policy and reinsurance register

In most countries legislation is such that insurance companies have to keep a register of policies

issued. This register has to contain precise information on the issue, renewal, increases and

decreases in the sums insured and cancellation of policies. The same is often the case for

reinsurance operations.

In order to simplify this administrative work, the information required by law can be combined

and manually registered in one book or a single computer programme. Furthermore, it should be

possible for the company to use this register for the statistical analysis of its portfolio (structure of

the amounts at risk, major categories insured, etc).

The register can be kept in the issuing department or in the reinsurance department. However, in

those companies where the reinsurance cessions have been delegated to the underwriter, the

obvious thing to do is to keep the register in the reinsurance department which, in this manner,

exercises a control over the work carried out at the point of issue.

For proportional treaties, the reinsurer receives a copy of the register of the list prepared on-line.

5.8.2 Claims

The employee in the claims department who examines the claims advices sent in by the insureds

or the agent should immediately inform the reinsurance department of cases where the amount of

the claim exceeds the limit for claims advises fixed in the treaty. The Officer should keep an up-

to-date control of the claims advised so that at the end of the quarter or year, lists of pending claims

can be drawn.

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The reinsurer is called upon to make cash payments for those losses which the company has settled

with the insured and which exceed the cash loss limit indicated in the treaty.

All claims paid are entered manually or by computer in a claims register: extracts of the relevant

claims affecting the ceding company’s reinsurance treaties are then forwarded to its reinsurers.

The information is tabulated in such a way that statistical analysis can be done with ease. Claims

which could affect the excess of loss covers (per risk, or per event in case of a catastrophe), are

the subject of a special control which enables the reinsurers to be advised in any probability that

exists of the threshold of the cover being reached.

The evaluation of the claims reserve at the end of each quarter or year must be done thoroughly,

case by case, by a claims specialty and not by an employee of the reinsurance department.

5.8.3 Quarterly accounts

Considering the Policy register and the claims paid, the reinsurance department should prepare

quarterly accounts per branch, treaty and currency. In general, they are prepared for 100% of the

contract and only mention the reinsurer’s share or the balance at the bottom of the account.

Facultative cession and cash loss payment made by the reinsurer must not be forgotten.

5.8.4 Additional commission accounts

They are prepared annually, at the close of the accounting period, on the basis of the quarterly

accounts and the last of outstanding claims for those treaties which foresee the payment of an

additional commission and are drawn up even if the claims ratio is higher than the limit foreseen

under the treaty. In this manner, both cedant and reinsurer are always clearly in the picture.

If an excess of loss for common account or for the reinsurer’s account exists, then it is included in

the calculation of the additional commission.

5.8.5. Profit commission statement

This is an annual statement, established on the basis of the quarterly accounts (bearing in mind any

additional commission and XL protection for common account) and the list of outstanding claims.

It is sent to the reinsurer even if the business is showing a loss, as most treaties provide for a deficit

to be carried forward for a given number of years. In other respects, this statement permits one

last verification of the quarterly accounts and is useful as a statistical basis in negotiations between

cedant and reinsurer.

5.8.6 Non-proportional treaties premium accounts

At the beginning of the year, or each quarter for premium payable quarterly, the c company sends

a provisional account and the deposit premium. At the end of the financial period, normally with

the fourth quarter accounts, the cedant adjusts the definite premium by applying the rate given in

the treaty to the volume of premium, realized. The difference between definite premium and the

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premium(s) already provisionally paid is credited or debited to the reinsurer, having taken account

of the minimum premium fixed in the treaty.

5.8.7. Special accounts for portfolio movements

These are necessary when the portfolio calculation presents certain difficulties (unequal

distribution of business during the course of the year, long-term policies). On the other hand, if

there is a flat rate in the treaty, the portfolio movements are indicated in the account for the fourth

quarter.

5.8.8. Correspondence with reinsurers

This can be listed under the following headings:

Contractual business (treaty conditions);

Sending of bordereaux, accounts, claims advices

Payment of balances and cash calls;

Facultative business; and

Exchange of technical information.

In order to ensure the consistency of the company’s technical and reinsurance programme, it is

necessary to coordinate all contacts with the reinsurers by centralizing them.

5.8.9. Preparation of statistics

It is obvious that an insurance company must be able to set out its reinsurance programme on the

basis of statistics, the preparation of which should be directed and controlled by the reinsurance

department. Here are a few examples:

5.8.10. Contractual results sheets

All the data contained in the profit commission statements is registered on this sheet for each

consecutive year.

5.8.11. Analysis of the portfolio structure (risk profile)

This is done by taking the reinsurance register as a basis to determine whether or not the obligatory

covers are adequate and sufficient. It shows whether or not it is possible to modify the retentions,

if a change in structure will give better balanced treaties and, as a result, more stable and

advantageous reinsurance conditions.

5.8.12. Comparison of results between branches

In the long term, reinsurers cannot continually support negative results in a branch without

receiving compensation from other profitable business. This boils down to the fact that the cedant

cannot claim top conditions for its good treaties without reorganizing those branches showing a

loss. Consequently, a comparison of reinsurance results between the different branches would

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show whether, and probably to what extent, corrections should be made at the direct insurance

level.

5.8.13. Comparison of reinsurers’ results

This statistic is very difficult to interpret as the results do not always reflect the risks run by the

reinsures or the services rendered. For example, although all the treaty reinsurers might have

suffered a heavy loss during an accounting period, the reinsurers who accepted facultative business

may have made a profit. This does not, however, show the facultative reinsurers’ risk exposure.

5.8.14. Loss analysis (loss profile)

This statistic is established for excess of loss business and must include both the losses paid and

those still outstanding. In this way it is possible to follow the development of the reinsured

portfolio, to judge if the reinsurance structure is adequate and to see if the loss reserves have been

sufficient from the first year.

5.8.15. Catastrophe risks

The company must keep a very tight control of the accumulation of catastrophe risks (earthquake,

hurricane, riot, etc) for its retention as well as the different reinsurance treaties. These figures

enable the cedant to calculate its catastrophe cover needs, on the one hand, and, on the other, to

monitor the participation of its reinsures in relation to their solvency.

5.8.16. Taking on Reinsurance

A number of insurance companies endeavor to increase their volume of business by accepting

facultative and obligatory reinsurances, with the aim of decreasing their overall percentage of

administration costs and balancing their portfolio.

It is obvious that the techniques of selection in reinsurance is perceptibly different from that in

direct insurance. Besides, the volume of business is not always the solution to the problem. The

acceptance of reinsurance presupposes a thorough knowledge of the markets from a political and

economic as well as technical point of view, the characteristics of which can change very quickly.

For this reason then the majority of companies concentrate their reinsurance activities on the

acceptance of local business which they are able to judge and which they can keep for own account.

Indeed, any retrocession involves supplementary administration costs, as well as the problem of

finding retrocessionaires willing to accept the business.

Here are a few points which should be clarified by the company before accepting reinsurance

business from other markets:

Political and economic climate

Insurance and reinsurance legislation

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Licence to work or legal representative

Fiscal system

Technical reserves and their investments

Structure of the insurance market (tariffs, policies)

Technical statistics of the market

Is the country situated in a natural castrophe area? If so, what is the scope of insurance cover granted?

Condition of the potential cedant (reputation, financial soundness underwriting methods, management, sales organization, loss settlements, administration accounting,

etc).

5.8.17. Information required for a Reinsurance Quotation

a) Proportional reinsurance

Assuming that the reinsurer knows the market, the following information should in general suffice:

Object of the treaty (business to be covered)

Structure of the cover (retention, number of lines and reinsurance limit)

Statistics for the previous five years, indicating for each financial period the premiums, the paid and outstanding losses

Explanation of any abnormal deviation in the losses

Underwriting material (policies, tariffs)

Technical details of each branch (for example in fire the earthquake underwriting limits for each treaty).

b) Non-proportional reinsurance

Normally the reinsurer sends the company questionnaires which are filled and sent back before

quotations are made.

It should be stressed that the more detailed the information, the more the price of the cover can be

adapted to reality; in other words the reinsurer can reduce his loading for unknown factors.

Questions

1. What is the importance of statistics in Reinsurance?

2. Name four zones which are exposed to Earthquake.

3. What are the factors that affect underlying statistical trends?

4. You are appointed a Reinsurance Manager in Company X. Give the areas you would divide

your department for effective operation.

SUMMARY

Importance of statistics in reinsurance

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Every insurer is required to submit to the Authority statistics relating to its reinsurance transactions

in such forms as the Authority may specify, together with its annual accounts.

Every insurer shall make outstanding claims provisions for every reinsurance arrangement

An accurate and efficient information system helps in increasing credibility of the primary insurer

and helps in renewal of treaties.

Underwriting issues in reinsurance treaties

The accounted premium is consistent with the estimated premium

The profit commission statement agrees with the accounted figures;

The release of reserves and portfolio movements are in accordance with the treaty provisions;

The overall result of the treaty is a profit or loss, due attention being paid to outstanding loss provisions;

The rendering of accounts and settlement of balances is prompt;

Treaty document was received or not

Provision for outstanding losses

The methods followed are:

Estimated losses as advised by the ceding insurer as at the date of closing.

Where there is a provision for portfolio entry in the treaty concerned, the same amount is to be included as estimate for outstanding claims;

Where the ceding insurer has provided renewal statistics, information on outstanding losses

will be available therein.

The underwriter may also decide to make an additional "ad hoc" provision for claims incurred but not reported (IBNR)

Guidelines for developing a system

The main aspects to be looked in developing a statistical system:

Production of statistics for each of the outward treaties;

Preparation of outward accounts and various other books of records;

Requirements of reconciliation of balances and review of cash flow;

Marketing information required for outgoing treaties;

Review of business accepted for the purpose of ascertaining its profitability;

Review of reciprocal exchanges for the purpose of ascertaining profitability;

Statistical requirements for complete analysis of the portfolio underwritten and to ascertain exposures;

Statistical and accounting requirements for retrocession treaties;

Information on large claims;

Ascertaining aggregate loss amount due to one catastrophic event, which may affect the reinsurers through several treaties;

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Use of information technology

The wider use of computers and telecommunications has led to a growing preference for simplified

administration procedures. The application of electronic data processing methods in reinsurance

business is advanced and gained acceptance in countries all over the world.

Organization of the reinsurance department

The following principal tasks:

To coordinate the application of the cedant’s reinsurance programme between management

and technical department then company and Reinsurers.;

To carry out or supervise the administrative work of reinsurance;

To prepare the information statistics to serve as a discussion basis between the cedant and reinsurer.

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CHAPTER 6

RETENTIONS

Learning Outcomes

Upon completion of this chapter, readers should be able to understand:

Setting retentions

Types of retentions

Retentions for property and engineering reinsurance

Retentions for different lines of reinsurance

Special factors for different lines of reinsurance

6.0. SETTING RETENTIONS

Proportion of risk that is retained by the cedant is known as retention. Insurers have different

systems of retention and reinsurances for different risks and their related insurances.

Management of an insurer set the retention limits at a level they can afford to risk their solvency.

i. If management sets retention limits too low, they may find they are ceding too large

a part of their premium income to their reinsurers.

ii. If the retention limits are set high they expose themselves to retaining more when

claims occur.

The limits for retention are set out by the management and approved by it. These limits are the

basis for implementing reinsurances as arranged and are referred to by the underwriter in his day

to day decisions for determining retention for each policy as issued by his insurer. Reinsurance

therefore follows the approved treaties and arrangements and decided through approved methods.

There are no clearly defined formulas or rules to enable an insurer or indeed a reinsurer to decide

on his retention. Experience shows that insurers and reinsurers have a wide variety of levels of

retention without there being an evident reason. In the absence of technical formulas or rules,

insurers and reinsurers lay different emphasis to various factors that go into the calculation of

retention and reach different conclusions.

Within an insurer's (reinsurer's) office the acceptable level of retention will be seen differently by

different officials.

i. The Finance manager: whose priority is to protect the insurer's liquid

assets,

ii. The direct business Underwriter: whose priority is to contain fluctuations

in the insurer's results, and

iii. The Shareholder: whose primary concern is preservation and return on

capital,

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All have different subjective assessment on the level for risk taking.

There is therefore no concept of a correct retention, but only an optimum retention acceptable to

the diverse interests.

6.1. FACTORS INFLUENCING RETENTION

a) The Insurer's Assets, Capital, Free Reserves

The owner's assets are inevitably low at the time of commencement of business and builds up over

time. On the one hand, the owners do not want to lose the money they have invested. On the other,

they expect an adequate return on capital in the form of dividends to themselves and other

shareholders.

The retention therefore is assessed in the light of the need to preserve the asset base and the need

to generate adequate profit. The insurer has to decide as to what percentage of its free assets is it

willing or can afford to lose in anyone year.

b) The Portfolio of risks

It can be objectively shown that the larger the portfolio the smaller the degree of fluctuation. On a

very large portfolio, it is probable, on the basis of experience to predict within a few percentage

points the technical result. On a small portfolio, the experience may be very bad or imperfect _

there will be substantial differences from one year to the next.

The Reinsurance manager, with due approval of his management must establish his retention and

his reinsurance programme in such a way, as to limit the fluctuations to a degree that is acceptable.

The stability of a portfolio as it grows and in contrast to the relative volatility of a small portfolio

is referred to as balance.

In theory, "As the portfolio and its degree of balance grows, the retention could increase

proportionately - maintaining the same theoretical estimate of acceptable fluctuation". In practice

the growth of the portfolio is more than the growth of retention, reflecting both conservatism to

retain less in the face of growth and a seeking of diminution in fluctuation.

c) Corporate liquidity

The Reinsurance Manager also assists for corporate liquidity when in consultation with his

management and the Finance Manager he sets cash loss limit for his proportional reinsurance

arrangements to make available cash when the immediate loss payout is estimated to exceed

available cash. Every insurer wants to maximize the return from his capital which is invested in

financial assets.

He must however balance the portfolio of investments against the potential need to pay for

admitted claims.

(i) Long term investments: Evidently, investments of a long term nature are likely to yield

higher interest, but such an arrangement would mean illiquid asset or loss of higher

interest due to premature closure.

(ii) Stock market investments: Investment in the stock market increases the:

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Cost of administration and .

Exposure to capital loss

But at the same time investors can earn higher return depending on their risk taking ability. Given

this characteristic, stock market investments are used to leverage capital gain for a better return

from the investment portfolio.

(iii) Investment in liquid assets: Liquid cash are important, as it can be extremely

embarrassing for an insurer to have insufficient liquid assets with which to pay a claim.

Neither should it be necessary, nor even would it be desirable to have to sell assets - perhaps stocks

and shares for this purpose. It may not be the best moment to sell and in some cases the cash would

not be quickly realizable.

Faced by this dilemma, the Finance Manager must be in a position to assess his optimum retention

according to the liquid assets which he is willing to make available and given the support of cash

loss from reinsurers.

The three decisions on what should be optimum retention from each of the three sources as

discussed above are highly unlikely to be the same. Each represents a balancing of priorities by

the individual for a department. The management would weigh the alternatives in order to arrive

at the retention which represents the best solution for the insurer.

Having done this, there would need to be adjustment by the departments in question. Apart from

the obvious compromise required between these elements of the insurer, other factors of a more

general nature will come into the equation, such as:

d) Competition and rating in the market

In highly competitive markets or markets where there is a discernible competitiveness, the whole

calculation of profitability and fluctuation is distorted. If the portfolio increases in size, setting

aside inflation, then it is probably because business has been obtained by cutting the rates of

another insurer. In these circumstances, despite the "growth" the retention would be better left at

existing levels.

e) Inflation

To preserve the calculated acceptable degree of fluctuation of results an increase in retention

exactly equivalent to the economic inflation is called for.

Failing this the insurer's retention is effectively falling back. Inflation also tends to cause higher

claims without compensatory increase in sums insured.

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f) State of the reinsurance market

In times of bad results, reinsurers would normally tend to require higher retentions with the clear

intention of causing the insurer to have a greater involvement in the losses and, by implication,

provoke them to initiate some remedial action.

There will however also be times when the supply of reinsurance exceeds demand. At such times,

an insurer may be able to reinsure at terms which are so advantageous to him that he may consider

it a shrewd financial move to reinsure as much as possible.

g) Legal imposition

Whatever an insurer's perception of his prospects there are many countries which lay down rules

and regulations intended to guarantee that an insurer will always be able to meet his liabilities,

Uganda is one of them

Briefly, this normally imposes a framework to ensure that his liabilities are not excessive in

proportion to his assets. This is called "solvency margin" regulation and relates the free reserves

and assets of the insurer to the written premium income. Every risk written must be met with

adequate assets.

Therefore, working within the legal framework, an insurer may well have to reinsure more and

retain less anyway.

In addition to the regulation on solvency margin the law may determine that some assets are not

allowable for calculation of solvency margin. It also stipulates certain minimum rules with

reference to reserves.

h) Other regulations

In some countries, the lack of hard currency to pay for reinsurance sometimes compels an insurer

to adjust its retention upwards and with need for government to act as reinsurer of last resort.

Stock market investments: Investment in the stock market increases the: ,

Cost of administration and

Exposure to capital loss

But at the same time investors can earn higher return depending on their risk taking ability.

Given this characteristic, stock market investments are used to leverage capital gain for a better

return from the investment portfolio.

6.2 TYPES OF RETENTIONS

In practice, retention is a combination of the financial consequences of risk and event based losses.

This incorporates requirements of rating, liquidity and return. In this the Actuary plays a

determining role and takes responsibility to certify solvency of his insurer to the regulator.

There are two types of retention that are required to be managed:

1. Per Event

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2. Per Risk

6.2.1 Per event retention

The Per Event retention is managed through reasonable estimation of financial consequences and

by allowing a catastrophe reserve for funds to accumulate and be available over the long term.

Example

Examples of event-based exposures can be:

Possibility of accumulation within one branch .

Possibility of accumulation between branches.

6.2.2 Accumulation within a branch

a) Fire

Accumulation between risks- 2 or more Fire policies.

Accumulation between policies - Fire/Loss of Profit

Accumulation arising from perils - Windstorm / Earthquake / Flood

b) Marine

Accumulation between - Hull/Cargo .

Accumulation between - Cargo/Cargo .

Accumulation between - Hull/Hull

Certain categories of insurance are exposed to high levels of accumulation potential that the market

resorts to pooling such as for hail damage to crops, nuclear risk and terrorist attack e.t.c.

In this context, attention is drawn to geographical distribution. When a portfolio is widely

distributed geographically, then the result will be more stable. Conversely, a geographical

concentration will expose a greater proportion of the portfolio to one large catastrophic event.

In some branches, notably hail damage to crops, a balanced portfolio can be better achieved

through international exchange of risks. In this way, the adverse experience of one country can be

offset by good experience elsewhere.

6.2.3 Accumulation between branches:

a) Fire Liability / Engineering

b) P.A. Liability / Aviation

c) Fire / Cargo

d) Fire / P.A . / Life / Motor

e) Motor / Third Party / P.A.

If a branch can be involved with another branch in a single event more often, then retention will

have to be lower taking into account the potential combined loss of both branches.

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6.2.4 Per Risk Retention:

The Per risk retention can be managed through controlled and informed decisions. The Per Risk

retention relates to the number of individual risks that could be hit by one event. The retention is

scaled down accordingly.

Retention per risk = Retention per event

P.M.N

P.M.N. = Probable Maximum Number of individual risks involved in one event.

Retentions are inevitably scaled down in a variety of ways. A uniform retention on poor risks and

good risks alike would not be in the insurer's best interests. The level of retention is scaled down

in a manner relevant to the quality of the risk in question with retention on a first class risk being

much higher than that on a perceptibly poor risk.

Some alternatives can be as follows:

Fixed retention according to category of risk

Retention in inverse proportion to the applicable premium rates.

Entirely discretionary level of retention from zero to maximum retention per risk

The insurer (reinsurer) will calculate his retention to achieve his corporate objectives such as

market penetration and share. The prevailing characteristics of the reinsurance market will

determine whether the limits of retentions will be acceptable to his prospective reinsurers. Often

the proposed capacity is regarded as excessive and limits of retentions reviewed for refixation. On

the other hand, if the reinsurance market is "soft", then the insurer may have a virtual "carte

blanche" to set its own terms with due care as to credit rating of the reinsurer. The reinsurance

market has no controlling influence on an insurer in such circumstances.

The level of retention is largely a subjective assessment of a series of factors, ranging from the

certain, the insurer's asset base, to conjecture:

Will inflation increase?

Will crime increase?

Will competition hit premium levels? etc.

In some cases, a simple guess or feeling will guide the individual concerned. There are as much

optimal retention as there are insurance companies, but even if the "correct" figure is

unidentifiable, it might reasonably be said that serious and considered judgment leading to the

appropriate level of retention is arguably the most important decision that any insurer is called

upon to make. Regulatory direction for solvency is a guide to an insurer in correcting the limits as

he continues to write business over the years.

6.3 RETENTIONS FOR PROPERTY AND ENGINEERING REINSURANCE

Fixing retentions for Property insurance

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(a) Schedule of retentions

Each insurer draws up his schedule of retentions in property insurance.

The first step is therefore to determine the level of optimum retention. Even though retentions are

expressed in terms of sums insured, the logic leading to the determination of the schedule of

retentions takes note of the loss exposures.

The usual schedule of retentions is based on the following risk factors:

(i) Location

(ii) Separation

(iii) Process carried on

(iv) Class of construction and fire protection.

The retention amounts in sums insured are so graded as to bring about similar loss exposure per

risk.

When dealing with large risks, it is not possible to apply a standard schedule of retentions to the

best advantage. It is customary in such cases to have the risks inspected and to fix retentions

individually.

Statistics teaches us that the claims experience of any portfolio of risks will vary from one year

to another. Stability in the claims ratio will depend on:

i. The number of individual risks constituting the portfolio,

ii. The standard deviation or, to put it more simply, the expected variation in the

frequency of loss occurrences, and

iii. The ratio of probable maximum loss by one event to the premium of the portfolio.

While a great deal of research has been made into the underlying mathematics, the majority of

insurers still follow a subjective method to determine what probable maximum loss exposure per

event they should carry.

The schedule of retentions is designed to control exposures per risk. Hence it is usual to modify

the schedule for cases where more than one risk can readily be affected by one event such as in

congested areas and where catastrophe perils like:

Earthquake

Hurricane

Flood or

Even riot and strike are covered

The modification may either be:

In the form of scaling down by a percentage the normal retention or

By fixing aggregate limits area-wise.

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Operating a schedule of retentions expressed in sums insured may involve a recalculation of the

reinsurance position with change in sum insured. Sometimes the companies simplify the

procedures by keeping margins to absorb such changes and fixing retentions in terms of

percentages. Again, a schedule of retentions provides one standard sum insured retention for each

type of risk.

b) Probable, maximum loss (PML)

In respect of industrial risks, within similar insured's, the PML exposure will vary materially

from one case to another. This would mean that:

On a better risk a smaller PML will be in order with higher retention and

On an inferior risk, a higher PML will be in order with lower retention.

Gradually the practice has grown of expressing the retentions and reinsurance cessions in terms of

PML (Probable Maximum Loss). This gives some elbow room to the ceding insurer in

underwriting a risk.

In respect of the large risks, reinsurers insist on full underwriting data (including Risk Survey

Reports) together with sums insured so that they can make their own assessment of PML before

accepting specific reinsurance.

In respect of automatic arrangements they may accept a smaller share than what they can, and

there are even reports of reinsurers trying to introduce warranties tying down the ceding insurer to

his PML estimates in the event of major losses proving the PML wrong.

c) Catastrophe cover protection

Ignoring for the moment the catastrophe hazards, a well-drawn schedule of retentions will give the

anticipated loss exposure and there will be no need or any further reinsurance protection for the

retained account.

However, catastrophe hazards do exist and cannot be ignored in designing the protection for the

net account. Considering the conflagration hazard, it’s usual to watch the total net retention within

each conflagration area, Also, the retention per risk is fixed lower than the normal scheduled

retention.

Where the number of risks underwritten in an area is large, this may result in unduly depressing

the net retained premium of the insurer. Therefore, in practice, the exposure per event is

controlled through a catastrophe cover protecting the net account and an increased aggregate

limit per conflagration area is taken.

In considering catastrophe perils such as:

Earthquake

Hurricane

Flood, etc.

The problem is the difficulty to determine accumulation.

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The first question will be demarcating the area which can be considered as exposed to one event.

The next problem will be the administrative effort of ascertaining the total net commitment within

such area. If we consider sums insured, such figure may appear staggering.

It is much more difficult to ascertain the PML. Even for one risk the PML for fire and the PML

for earthquake can be far different. However, assisted by data processing, insurers have considered

it expedient to draw up and monitor their total commitment zone-wise.

This brings us to the problems of fixing values for the following:

i. Net sum insured retention per risk for various types of risks;

ii. The aggregate sum insured retention per conflagration area or catastrophe peril

exposure zone;

iii. The net loss retention to bear under the net account catastrophe cover protection; and

iv. The extent of catastrophe cover protection required.

d) Accumulation of risk

What is described so far would entail looking at every policy in order to determine the retention.

As an insurer grows in size, his retention capacity grows to such an extent that he is able to retain

fully a large proportion of simple and commercial risks. Considering the expenses of

administrative work, it is found worthwhile to discontinue the exercise of risk-booking such

documents and instead to retain them blindly. For practical reasons it is necessary to fix a sum

insured limit up to which all policies will be retained 100%.

When operating such a system, one comes across the problem of accumulation of values at risk

through more than one policy and accumulation of risk in conflagration areas.

This is solved by either:

i. A quota share reinsurance on such policies or

ii. By a working excess of loss cover or both

The most suitable method will depend on the circumstances of the case.

In the illustration given above, if the insurer can afford to carry a maximum retention of only Shs.

20billion, he would be ceding out much of his gross premium. In such a case, the insurer is enabled

to obtain working cover in excess of PML exposures at an economic cost.

The cost of such cover would of course be a major consideration in determining the utility of the

exercise. It is common practice to convert such working covers to "per event" basis.

In the early years of an insurer's development it is necessary to monitor and revise the retention

upwards with growth of business. Such an exercise is administratively cumbersome. So the

insurers sometimes augment their retention by keeping a share of their first surplus treaty for the

net account. Such share can be increased progressively until it is time to revise the schedule of

retentions.

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6.3.1 Factors affecting retentions for property and engineering insurance

Engineering insurance business covers:

a) Machinery Breakdown,

b) Boiler Explosion,

c) Erection All Risks and

d) Contractors' All Risks business.

Many insurers do not have a sizeable premium in these types of risks.

Often, the sums insured for EAR or CAR policies are high and the exposures get further aggravated

if Advance Loss of Profit (ALOP) / Delay in Start-Up (DSU) coverage's are associated with the

material damage covers.

Hence in this class of business it is customary to have a close liaison with specialist reinsurers in

matters of rating and other technical matters.

Retentions are generally small and, although surplus treaties are formed, they remain unbalanced.

Commission terms are negotiable. It may appear as though reinsurers make a substantial profit or'

the treaties and facultative business, but one must remember the technical service they provide.

It is also likely that the reinsurers may prescribe minimum level of retentions at .which they would

be comfortable to accept cessions. It is sometimes possible to keep an increased retention protected

by excess of loss cover, but the size of such retention and the cost of such cover are more difficult

to standardize.

6.4. RETENTIONS FOR DIFFERENT LINES OF REINSURANCE

Motor insurance department produces modest own damage claims, but third party claim amounts

can rise to quite high figures. Even the own damage claims are subject to accumulation hazard in

respect of vehicle depots and catastrophe perils such as hurricane or flood. The most common

method of reinsurance is through excess of loss cover. The loss retention is generally fixed higher

than the value of total loss of one vehicle. With the costs of fittings going up, buses can cost quite

substantial amounts.

Also special- purpose vehicles such as dumpers, cranes, bulldozers, etc., cost much. The portfolio

of business may not be large enough to absorb the entire own damage loss on such vehicles to the

net account and in that event excess of loss provides a working protection. The excess of loss cover

is rated on the burning cost. Following the high level of court awards and the delayed advice of

claims reinsurers suffered substantial losses on such covers.

Concepts of IBNR, allowing for inflation and linking the cover with the cost of living index, etc.,

were considered. In earlier years, it was possible to obtain unlimited cover, but this practice was

discouraged. These covers continue to be rated on burning cost basis with some adjustments. if the

burning cost is consistently more than a particular percentage, it will help to save premium

equivalent to the loading on the burning cost if, in addition to the per event deductible, an aggregate

deductible is also borne by the insurer.

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Workers compensation insurance is another class of business well suited for protection by excess

of loss covers. Accumulation hazard is much greater here because a large number of workers will

be exposed to risk at one place. Subject to this, the comments made in respect of motor insurance

apply here also.

It should be remembered that when the whole account is protected by a working excess of loss

cover with a short payback period, the gross underwriting result gets fully reflected in the net

results over a period. Hence it is wise to reinsure out on proportional basis any risks carrying high

exposure or risks where the rate level is considered inadequate.

Among the other classes of miscellaneous accident business, perhaps the more important are:

Personal Accident, (PA)

Cash·in·Transit and

Burglary.

The normal method of reinsurance in the Miscellaneous Department is surplus basis. While

burglary is capable of reinsurance on excess of loss basis, the other classes will require

substantial premium on excess of loss basis.

Personal Accident business carries catastrophe exposures in respect of certain types of risks such

as group PA policies and passengers in a vehicle or aircraft.

The level of retention is based on the total miscellaneous accident premium base. It is usual to

keep reduced retentions for the more exposed classes with small premiums such as cash-in-

transit, jewellers' block, etc. Usually a single surplus treaty is able to absorb the entire available

surplus.

6.4.1. Fixing retention for marine - Cargo reinsurance

a) Analysis of gross portfolio

Before considering the best suited reinsurance arrangement, one must analyze the gross portfolio.

The following aspects are important in such analysis:

i. Whether the cover granted in the majority of cases is on all risks terms or

limited terms.

ii. Whether the pattern of exposures per vessel shows a wide variation or is

clustered around a certain level with a minority of cases showing

materially different exposures.

iii. What is the nature of cargo insured and, if possible, a breakdown of the

total premium by broad categories of cargo.

iv. A breakdown of the premium by the age and size of the vessels carrying

the cargo.

v. Whether the rates of premium are generally satisfactory.

vi. The number of reporting offices and the feasibility of fully recording

commitments in the voyage register.

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b) Quota share arrangement

A quota share treaty can be a satisfactory solution only where the pattern of exposures per vessel

shows clustering around a certain level.

In all other cases a quota share arrangement does not permit full utilization of the retention

capacity of the insurer.

c) Determination of the retention that can be supported by portfolio of ceding insurer

The first step is to determine the retention which can be supported by the portfolio of the ceding

insurer. Loss exposures fall into two distinct classes, viz.

i. Total loss and

ii. General Average(GA) which affect all cargo on board the vessel and particular average claims

which need not affect all the cargo.

Cases of several consignments suffering damage in one voyage either by a common cause or

independent causes are not unknown, but these do not take the same magnitude as GA or total loss

claims. Retentions are fixed at aggregate sums insured per vessel through all documents. Since the

probability of total loss or GA claims by a smaller or older vessel is higher than by a larger or new

vessel, the retention is normally scaled down for smaller and older vessels.

This then gives us a schedule of retentions with limits per bottom for different sizes and ages of

vessels. It is not usual to distinguish retentions by type of cargo in the schedule of retentions

although it is an important factor in the original process of underwriting.

d) Excess of loss protection

Assuming the absence of any excess of loss protection for the net account, the top retention will

be fixed with reference to the net premium income of the portfolio, maybe at 1% or 2% of the net

premium. This will mean that retentions on individual consignments will be very small and the

full capacity of the insurer will not be used except in the event of a total loss.

Where the majority of consignments are insured subject to wider terms such as all risks only, the

Free of Particular Average (FPA) portion of the premium will carry the higher exposures. This has

given rise to the practice of insurers raising their retention per vessel to higher figures and

protecting the retained liability against the larger claims through working excess of loss covers.

We can visualize an insurer raising his retention to say 5% or 6% of the net premium and protecting

it by excess of loss cover in excess of say 1 % or 1.5% of the net premium.

What the net retention subject to excess of loss protection should be is again a question to be

decided after studying the pattern of exposures in the portfolio. If, for instance, raising the net

retention per vessel from say Shs. 5,000,000,000 to Shs. 7,500,000,000 results in only a 5%

increase in net premium the exercise may not prove worthwhile after taking into account the

additional cost of excess of loss protection.

It is common practice to place the excess of loss cover on per voyage per event basis so that it also

provides protection for accumulation on shore. The extent of cover necessary is determined after

taking into account the pattern of exposures.

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It may be found expedient to split the cover into layers. A technical rating of the basis cover would

require a study of the working exposures and a calculation of the pro-rata premium for total loss

cover and a suitable extra "x for the large General Average (GA) claims. A further premium is

added on for the shore accumulations. Such data is rarely forthcoming in practice and reinsurers

have to fall back on the claims record to derive their rates.

It is possible in such cases to secure a premium for the excess of loss cover which does not

adequately provide for the larger losses or exposures on shore. Again, the impact of inflation on

the increasing values and size of claims may not be reflected in the premium which is based on

past loss record. The higher layers are rated on a subjective assessment of the accumulation hazard

at ports.

6.4.2. Fixing retention in marine - Hull reinsurance

Marine hull insurance portfolios of most insurers in the developing countries are very much

unbalanced. Hull insurance falls into two broad categories, viz.

a) Ocean-going vessels, including bulk carriers, tankers and

b) Local crafts such as barges, lighters, launches, tugs, dredgers, trawlers etc.

The problems of reinsurance are different for these two classes of vessels. While reinsurers are not

that particular to control the rating or claims processing of local crafts, they are keen to look into

these aspects for the larger vessels. Only some countries have been able to achieve the freedom of

rating and handling claims for the larger vessels, but their approach in the matter is kept under

review. Reinsurers, especially in the London market, like to be reassured that the Joint Hull

Formula will be followed.

Insurers with a substantial hull premium are able to exchange business against their first surplus

hull treaty while others have to be content with obtaining the best possible terms for their business.

The first surplus hull treaty limits are determined at the highest possible level consistent with the

objective of securing the best possible terms. There is an agreement existing in the London market

although not strictly followed, limiting the total permissible commission on hull reinsurance. Profit

commission terms are negotiable, and fairly high P.C. terms for business with good profitability,

can be achieved.

Insurers generally operate a schedule of retentions based on the tonnage and age of the vessel. The

top retention may be 1 % to 2% of the net premium although a higher retention may be necessary

based on the combined cargo and hull premium where the hull portfolio is small.

It is rare to see an insurer carry high retention protected by a working excess of loss cover because

a very substantial portion of the hull premium is required to pay total loss and large partial losses.

Hence the excess of loss cover will cost a pro-rata premium like a quota-share. In normal course,

when this premium is ceded under the surplus treaty, it imparts greater stability to the results, and

in years of good total loss experience, this section of the premium adds to the profit under the

treaty and earns profit commission.

6.4.3. Fixing retention in aviation insurance

Aviation and special types of liability business call for rating expertise not available with many

ceding insurers. These risks therefore tend to be rated in consultation with reinsurers and bulk of

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the reinsurance cover is placed facultatively with low retention. Though the utility of group

underwriting arrangements and pooling arrangements involve loss of individual freedom to some

extent, the benefits which accrue to small and medium size companies are far more important.

It enables the insurer to enhance its retention capacity and improve the spread of its net account at

one go. It also enables the companies collectively to create technical expertise so necessary for the

special classes of business. Finally, it tempers competition for business with due regard for

maintaining proper rate level.

Questions

1. What do you understand by the term Retention?

2. Name the factors that influence setting of Retention.

3. There are two types of retentions, name them.

4. What is considered while fixing retention for Marine Hull reinsurance?

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SUMMARY

Setting retentions

Proportion of risk that is retained by the cedant is known as retention. Management of an insurer

set the retention limits at a level they can afford to risk their solvency. There are no clearly defined

formulas or rules to enable an insurer or indeed a reinsurer to decide on his retention.

Factors influencing retention

The Insurer's Assets, Capital, Free Reserves

The Portfolio of risks

Corporate liquidity

Competition and rating in the market

Inflation

State of the reinsurance market

Legal imposition

Other regulations

Types of retentions

There are two types of retention that are required to be managed:

Per Event

Per Risk

Retentions for property and engineering reinsurance

For property:

The usual schedule of retentions is based on the following risk factors:

Location

Separation

Process carried on

Class of construction and fire protection.

For industrial risks:

The retentions and reinsurance cessions are based on the PML (Probable Maximum Loss).

Other factors considered are:

Catastrophe cover risks

Accumulation of risk

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CHAPTER 7

REINSURANCE UNDERWRITING

Learning outcomes:

After completing this Chapter, readers should be able to know:

• The factors involved in and the process of reviewing a reinsurance programme.

• The issues involved when a reinsurance contract is negotiated.

• The factors involved in underwriting reinsurance business.

7.0 REVIEWING A REINSURANCE PROGRAMME

Every year an insurer will need to review its reinsurance programme because circumstances

change. Insurers will see alterations in both the size and type of risks they accept. Loss experience

varies, reflecting wider economic factors. Governments change and develop their statutory

regulation of Insurance and reinsurance. Finally there are social, political and economic changes

which inevitably impact on insurance and insurers.

Non-proportional reinsurance is normally arranged on an annual basis and subject to an annual

review. Proportional reinsurance treaties are normally arranged on a continuous basis.

Nevertheless, they need to be renewed and so a review is necessary if any changes are being

considered. In the case of proportional treaties, any review must be carried out within the period

of provisional notice of termination which is usually three months.

One consideration for an insurer re-negotiating its reinsurance programme will be whether it will

continue with its existing reinsurers or seek to make changes. Provided that reinsurers remain

financially sound and have given satisfactory service, there are advantages of loyalty, stability and

security in maintaining relationships. If, however, an insurer has enjoyed good results in its

underwriting it may be able to obtain improved terms and conditions for its reinsurance with new

reinsurers. The balance has to be drawn to consider whether any improved price or conditions on

offer are worth the change of reinsurers. There is of course no reason why an insurer cannot

negotiate improved terms with existing reinsurers.

A change of reinsurers would be a particular risk if an insurer had established credit balances with

existing reinsurers as a result of a number of years' good experience. A change of such reinsurers

would risk relatively harsher treatment from a new panel of reinsurers should the insurers

underwriting performance deteriorate. New reinsurers would have neither past financial benefits

nor any fund of goodwill to cushion the blow.

A reinsurance broker involved in the review process would have specific tasks to perform. The

broker should be able to advise the insurer about what reinsurance possibilities are available in the

market. This will help in reviewing alternative strategies. In addition, a reinsurance broker will be

able to advise upon the financial standing of prospective reinsurers. Most reinsurance brokers have

a security committee which will monitor the financial status of different reinsurers. The broker

will also be able to advise upon other aspects, such as the general reputation and technical

competence of different reinsurers.

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One important aspect of a review is ensuring that the insurer continues to enjoy adequate current

reinsurance arrangements in the light of possible changes. These could be either in its underwriting

policy or in the business which it accepts. The insurer must ensure that its underwriters remain

fully aware of the treaty limits and any treaty exclusions. Staff must also ensure that claims

reporting procedures and administrative requirements continue to be observed.

Finally, the insurer will have to consider the overall cost of its reinsurances. The commissions

received on proportional reinsurances will need to be re-examined. On its non-proportional

reinsurances the insurer must ensure it is not paying away a disproportionately high amount of its

original premium income. It will need to consider this in comparison to its overall retention either

on a per risk, per event or aggregate basis. Although any well run insurance organization will be

price-conscious, this consideration should not be allowed to take a totally predominant role. The

ability of an insurer's reinsurers to pay claims when they occur, and to provide a correct and

efficient service, must, within reason, override any price considerations.

7.1 NEGOTIATING A REINSURANCE CONTRACT

Whatever type of reinsurance is involved, and regardless of whether it is negotiated directly by an

insurer direct or through a broker, the most important aspect of any negotiation is information. The

more data provided to the quoting reinsurer, the better the chance of obtaining cover and

satisfactory terms and conditions. Good faith is of paramount importance. If an insurer provides

incomplete information which results in a reinsurer quoting terms that prove to be inadequate, the

insurer's chances of obtaining renewal of the reinsurance would be prejudiced and its reputation

damaged.

7.1.1 Details of the insurer

When a reinsurer is approached by an insurer previously unknown to it, the former needs to

ascertain the following concerning that insurer:

The date of establishment

Its ownership and capital structure;

The trading results as published in recent income statements or balance sheets; and

It’s underwriting knowledge and experience and the business acumen of the management.

7.1.2 Details of the portfolio to be reinsured

The following details of the portfolio to be reinsured are required by the reinsurer.

(i) Class or classes of business to be covered

The insurer must provide the reinsurer with precise details of the risks to be protected under the

treaty. Wherever possible the precise nature of original cover should be outlined and original

policy wordings should be provided.

(ii) The insurer's experience

Information will be required concerning the insurer's experience in the particular classes of

business to be reinsured. This concerns the ability of the insurer to underwrite those classes

successfully. For example, are the individual underwriters employed experienced in the particular

lines of business involved and does the insurer have a competent claims department.

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The insurer's premium income development over five or ten years will indicate the rate of growth

of the portfolio to be covered and may indicate whether an aggressive or conservative approach

has been adopted. This information is of even greater value if it is supplemented with a count of

the number of individual policies.

(iii) Claims experience

This information will form the basis of price negotiations; that is, the premium required for non-

proportional treaty or the commission allowed on proportional business. Claims statistics should

be presented in as detailed a manner as possible.

For example, an insurer may want to arrange an excess of loss reinsurance layer of Shs10million

excess Shs5million It will not be sufficient simply to advise the reinsurer that there have been no

losses in excess of the proposed deductible. To do so would be misleading if, for example, the

insurer has increased its policy limits or had changed its general underwriting policy only a short

time beforehand. Also, claims that were settled below the deductible some time ago may cost more

today because of inflation.

Losses should be shown on an incurred basis, split between paid and outstanding amounts, for

sums considerably lower than the proposed deductible. In the example above, it would be

preferable to know all losses in excess of Shs. 2.5 million.

If the insurer is able to provide details of losses from the ground up, then the reinsurer is even

better able to analyze the results.

Because of the protracted loss reporting and settlement of long tail business and the need for

reinsurers to project the eventual loss experience for each underwriting year, development, or

triangulation, statistics should be provided.

These provide, on an individual claim basis, paid and outstanding, or reserved, loss figures as at

annual review dates. Not only is such information required for the rating of the business, but also

in assessing the insurer's claim reserving expertise and/or philosophy.

(iv) Proposed exclusions

The insurer should provide an exclusion list detailing within each class of insurance those types of

business which it does not underwrite and for which reinsurance is not required. These would be

in addition to standard exclusions such as war or nuclear risks. Even if the insurer does not

nominate its own exclusions, it is inevitable that reinsurers will impose their own. This aspect

assumes particular importance in when imprecise business class definitions are adopted within the

treaty wording.

7.1.3 Price

The price to be paid for reinsurance is a vital consideration both to the insurer and the reinsurer.

Different considerations apply to proportional and non-proportional covers.

(i) Proportional reinsurances

If a reinsurer is prepared to accept a proportional reinsurance it will receive a pro-rata share of the

original premium for each risk ceded. Therefore, negotiations on the price of proportional

reinsurances centre on the reinsurance commission that will be paid.

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Obviously the insurer will seek to cover its original acquisition costs which will include

commissions paid to brokers and agents, together with any taxes for which it is liable.

In addition, the insurer will allocate a percentage for its general overheads and administration, and

will then try to obtain some form of an additional over-rider from the reinsurer.

If the insurer is confident of producing good results it may propose a sliding scale commission

structure, instead of accepting a flat rate of reinsurance commission. This would adjust commission

in accordance with loss ratios.

Alternatively, an insurer might elect for a lower flat rate of commission coupled with a reasonably

high profit commission.

In the negotiation of price for proportional reinsurances, commission remains the primary

negotiating area.

(ii) Non-proportional reinsurances

The negotiation of price is entirely different in relation to non-proportional reinsurance. The

reinsurer does not participate in all losses arising under business protected by the reinsurance. The

reinsurance premium cannot take the form of a pro-rata share of the original premiums. It is

necessary, therefore, to devise some method to arrive at a premium which fairly reflects the loss

expectancy transferred to the reinsurer. This will need to include allowances for the degree of

fluctuation in losses, the reinsurer's expenses and profit and, where appropriate, brokerage.

7.2.PROPERTY PROPORTIONAL REINSURANCE

Reinsurers have to make underwriting decisions often under considerable time pressure. A major

factor in any reinsurance placement is that each party sees the transaction largely from its own

point of view. It is important that sufficient information is obtained at the time of negotiation to

avoid misunderstandings in the future.

In addition to the general points outlined in section 4.2 above, a property reinsurer accepting

proportional business will need to consider the following factors.

7.2.1 Details of the Portfolio to be insured

The following are the details required by the reinsurer for the portfolio to be insured:

Composition of the insurers account, whether it is composed of simple, commercial, industrial risks or is a mixed portfolio;

Extent to which the insurer's portfolio is direct business and the amount of any indirect business. Inwards treaty or facultative business presents a greater degree of risk to the

proportional reinsurer;

Relationship between non-hazardous and hazardous risks in the portfolio, including

additional aspects such as consequential loss, riots, earthquake, windstorm and any other

perils which might be covered under the insurer's property portfolio;

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Underwriting decisions of the insurer. The skill, competence and foresight displayed by their underwriters, plays a decisive role in determining the reinsurer's view of the insurer's

business.

7.2.2 An insurer's retention and reinsurance capacity

Decisions regarding retentions provide an insight into an insurer's philosophy. Whether it is

cautious or adopts a broader underwriting policy, the relationship between an insurer's net

retention, the reinsurance treaty capacity and the overall premium income is vitally important in

judging a proposed reinsurance arrangement.

Reinsurers will want to know:

the amount of the insurer's maximum net retention;

the pattern of the insurer's retentions for each risk classification;

the relationship between the net retention and the treaty capacity;

whether the net retention, and therefore any treaty limit, is fixed on the basis of original sums insured; and

whether the net retention and the treaty limit is fixed on an estimated maximum loss

(EML) basis.

A reinsurer would much prefer retentions and cessions based on sums insured. If EML's are used,

a reinsurer must be confident about the accuracy of the insurer's calculations.

In a mixed portfolio, the reinsurer will require the premium and liability breakdown across the

different classes. This allows consideration of potential losses and comparison with the past

experience of other similar treaties.

7.2.3 Reinsurance spread of business

As in direct business, a reinsurer will try to spread its portfolio across as wide a range of risks and

countries as possible. Therefore a reinsurer considering a new treaty will take account of factors

such as:

the territories covered by the treaty;

potential aggregations of loss from perils such as earthquake or windstorm;

exchange controls' and

Particular trading features or restrictions in the territory under consideration.

The wider the spread of business, the greater the probability of offsetting poor results from one

business area against profitable results from another.

7.2.4 The insurer's performance record

The insurer must produce evidence of its underwriting record which will enable the reinsurer to

ascertain the proposed treaty's potential profitability. This assessment will take into consideration:

the treaty premium development from year to year;

the level of incurred losses:

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premium reserves:

commission, taxes and fire brigade charges;

profit commission; and

changes in underlying rates.

7.2.5. The contract terms

Some features of proportional treaties have been previously explained. From a reinsurer's

standpoint, many of these features have a bearing upon the potential profitability of the treaty such

as:

If premium reserves are withheld from reinsurers there will be a cash-flow loss. Even if interest is received on withheld balances it is often a nominal rather than a market rate;

If loss reserves apply then there is a similar cash-flow problem to that of withheld premium

reserves;

If a premium portfolio applies it is vital that the incoming portfolio premium is adequate for the risks that are being transferred. Similarly, the outgoing portfolio should be consistent and

adequate;

If a loss portfolio assumption and withdrawal applies, similar considerations arise as in the case of a premium portfolio. The incoming and outgoing amounts must be adequate and

consistent for the transfer of losses to be equitable;

The provision for cash losses needs to be reasonable given the circumstances of the particular

treaty. The concept of cash losses is acceptable, but there are cash-flow implication for the

reinsurer

Accounts should be regularly forwarded with cash balances following soon thereafter. Any

financial restrictions which impede cash flow such as government restrictions on the settlement of

balances will reduce a reinsurer's chances of profitability.

7.2.6. Commission

There are three proportional reinsurance commissions

Flat commission;

Sliding scale commission; and

Profit commission.

The intention of reinsurance commission is to allow the insurer to recover from the reinsurer a fair

contribution towards the insurer's acquisition and management expenses. Too high a level of

reinsurance commission can separate the interests of insurer and reinsurer with the former possibly

profiting at the latter's expense. A major underwriting decision by any proportional reinsurer is

how much commission to allow and what system to apply. This is also determined by the insurer's

loss ratio of the portfolio being protected.

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7.3. PROPERTY NON- PROPORTIONAL REINSURANCE

Effectively excess of loss reinsurance involves the reinsurer only in losses which exceed an agreed

amount held by the insurer for its net account.

The reinsurer, therefore, does not share proportionately in the premiums and claims, which may

leave it exposed to loss. This is particularly true in the early years of a non-proportional contract

when the reinsurance funds are inevitably low to set off against a major loss.

In considering an excess of loss reinsurance programme required by the insurer, many factors for

assessing the portfolio of business for proportional reinsurance protection are the same, though

subject to different emphasis.

7.3.1 Deciding the type of excess of loss programme

An excess of loss programme may be composed of catastrophe and risk excess of loss protection,

each of which may be placed in various layers, depending on the amount of cover required.

In establishing such protections, the following underwriting factors should be considered.

The nature of the business. Does the insurer operate in one specific class or in many?

The territorial scope of cover. This is particularly significant for natural perils such as earthquake or windstorm, which may cause catastrophic loss.

Whether the insurer fixes retentions on a sum insured or estimated maximum loss (EML)

basis. Errors in EML may cause significant losses for reinsurers.

Whether the insurer classifies its risks according to their level of hazard and varies its retentions accordingly. Low retentions on poor quality or hazardous risks expose reinsurers

to potential loss.

The insurer's attitude towards acquiring premium income. An insurer who reduces rates is likely to experience poor results.

The amount of excess of loss protection required. Too little exposes the insurer to loss. Too

much might indicate a cavalier attitude and will certainly result in a loss of premium to the

insurer,

The insurer's experience in the class of business reinsured, This will affect the reinsurer's potential exposure to major and sustained losses.

7.3.2 Deciding the excess of loss treaty terms

The deductible retained by the insurer will depend on:

Its financial strength:

liabilities in anyone area;

The level of any upper or lower layers of cover; and

Historical claims patterns,

Whatever deductible is chosen, it must be at a level which ensures that the insurer takes sufficient

interest in its own business to ensure responsible underwriting, an insurer might be expected to

keep, 5% to 10% of the total amount of catastrophe covers as a retention.

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7.3.3 The extent of reinsurance cover and layering

Two viewpoints have to be considered:

what cover the insurer requests and

what cover reinsurers are willing to provide,

Both aspects involve the ultimate cost to the insurer and the risk of running out of cover when a

major loss Occurs,

A large amount of excess of loss cover is often split into different layers; the cover provided by

each layer will be negotiated by the parties. Care must be taken by the reinsurer in deciding its

participation; there may be disparity in rating across the layers.

7.3.4 The basis of cover

Excess of loss cover can be arranged for anyone event or anyone risk. In both Instances reinsurers

will attempt to apply limitations or restrictions for example, event covers the hours clause operates

and in risk covers there are event limits.

Both types of restriction impact on a reinsurer's potential exposure and will be an important part

of its consideration of whether to accept a risk and if so at what premium.

Event excess of loss covers also provide for reinstatement after a loss. This has a cost implication for the insurer.

The number of reinstatements and the terms and cost for reinstatement will also be important to

the reinsurer in considering an excess of loss proposal.

7.3.5 Exclusions

In a property excess of loss reinsurance cover, there are few exclusions. The most common are:

Territorial exclusions, such as USA and Canada. The reinsurance cover may be specifically

extended to include such areas.

War and civil war.

Nuclear energy risks; and

Classes, such as hail, which are more appropriately reinsured under a more specific

protection.

Certain perils or types of risk may also be excluded; for example, target risks where reinsurance

accumulations could occur, or growing and standing crops. Normal practice is to exclude claims

which the insurer pays ex gratia. Alternatively these may be referred to reinsurers.

7.4. ACCIDENT PROPORTIONAL REINSURANCE

Many of the principles and issues relevant to this section are similar to those outlined in above.

Nevertheless, there are differences arising out of the nature of the underlying business in this

account.

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The business that falls within the accident class includes:

Motor, public liability, products liability, employers' liability, professional indemnity,

contingency, personal accident, contractors' all risks, fidelity guarantee and bonds, money, theft,

accidental damage, business all risks, goods in transit and livestock insurance.

A treaty offer may be made on the basis of all business written in the accident department.

Nevertheless, reinsurers would require a detailed breakdown of the insurer's business within each

category outlined above. Following is the information that should be obtained for some of the

classes mentioned above.

7.4.1 Motor

Limits for bodily injury or property damage.

Natural perils exposure.

Insurer's approach to high risk drivers, those with serious convictions or young inexperienced drivers.

The exclusion list, for example petrol tankers, coaches and buses should be excluded otherwise further investigation into the insurer's underwriting criteria and rating would be

required.

Whether cover is mainly third party, or comprehensive.

Whether fleets are covered or if there are concentrations of vehicles at one location.

Loss statistics on a triangulation basis and whether outstanding losses include incurred but not reported (IBNR).

7.4.2 Public Liability

Past loss history on a triangulation basis.

Whether cover is on a claims made or losses occurring basis.

Limits for bodily injury or property damage.

Whether pollution is restricted to sudden and accidental events.

Full details will be required of any North American exposure.

Nature of classes written, for example, small commercial or large industrial.

Whether IBNR is included in statistics.

If products liability cover is provided.

The insurer's exclusion list will be required.

7.4.3 Products Liability

In addition to the points mentioned under public liability, the following will also be required

Details of cover provided for exports to North America.

Full details of quantities exported to North America expressed as percentage of turnover plus the insurer's evaluation of exposure.

The exclusion list.

Maximum / average acceptance limit in the aggregate.

Whether defective design cover provided.

If so confirmation that cover is granted on an aggregate basis.

Confirmation that both products recall and products guarantee are excluded.

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7.4.4 Employers' Liability / Workers Compensation

Whilst these covers are similar in intent, they are different in operation. Compensation is automatic

under WC whilst it is actionable in tort' or breach of statute under Employer's Liability. Note that

in South Africa the COID Act restricts the ability of an employee taking legal action against the

employer.

Details of Classes of risk ceded

North American exposure

Limits of liability: not all countries have unlimited liability as does the UK.

Details of loss history with full details of largest losses

Whether benefits can be increased retrospectively (applicable to WC only)

The exclusion list

7.4.5 Professional Indemnity / Errors and Omissions

Whether on Claims made or losses occurring basis

The exclusion list

The estimated development trail for an average claim

The cover limit

This class of business is very specialized and reinsurers need to be certain that the insurer is

competent to write this class.

7.4.6 Personal Accident

A split of premium income between personal accident, travel, sickness and medical expenses, divided between individual and group policies.

How the insurer's limits are structured according to the type of policy.

Information regarding any risks included which are in the reinsurer's standard exclusions list. Permanent health insurance is usually reinsured by a reinsurer's life department

because of the funding requirements for such long term business.

7.4.7 Contractor's All Risks, Erection All Risks, All Risks and Engineering Business

The type of portfolio written; for example, building, civil works, and major projects or annually

renewable covers:

Types of engineering classes written; for example boiler, crane, machinery breakdown, computer all risks, loss of profits and increased cost of working.

A copy of the standard policy wordings used.

Maximum contract period,

Table of limits used by the insurer.

If limits are on an estimated maximum loss (EML) basis, the guidelines for assessment and minimum EML used.

Major territorial concentrations and exposures to natural perils.

Inspection and survey facilities.

Full details of risks which may fall within the reinsurer's standard exclusions.

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7.4.8 Fidelity Guarantee and Bonds

An indication of the portfolio split between individual and group commercial fidelity guarantee.

The policy limits and whether limitations apply for different risks.

Bonds are excluded by the standard exclusion list, together with certain other risks. Bonding, and

contractors' bonds in particular, is an extremely specialized class of business because they are not

policies of insurance and are often solvency guarantees.

Reinsurers require comprehensive underwriting information:

a full list of the types of bonds issued by the insurer; for example, custom bonds, administration bonds, contractors' bonds, detailing the various types;

How the accumulation of bonds to one guaranteed company is controlled and how this is incorporated into the insurer's limits. For example, on contractors' bonds:

Shs 2,000,000, 000 anyone bond;

Shs 4,000,000,000 anyone contractor.

7.4.9 Livestock Insurance

This is a specialist class of business requiring considerable expertise.

The split of income between livestock and bloodstock, if written.

The types of livestock written within the portfolios.

The territories from which business is accepted.

What veterinary expertise or facilities are available to the insurer.

The insurer's underwriting limits: per animal per farm or accumulation per location.

Which business is susceptible to epidemic, for example foot and mouth, and how

accumulations are controlled.

7.4.10 Other Issues

In addition to the technical and business issues, reinsurers will also consider the territories from

which business originates and general market conditions. They will also consider the insurer in

detail and form a view on the quality of its management, underwriting and claims capabilities and its business philosophy.

Like property proportional reinsurance, the relationship between retentions and cessions is

important as is the scope of the proposed reinsurance cover.

Premium and loss reserves, cash losses and commission terms will be the vital financial issues for

the reinsurer in deciding whether the proposed cover is worthwhile.

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7.5 ACCIDENT NON- PROPORTIONAL REINSURANCE

Excess of loss reinsurance on the property type accident insurances follows property excess of loss

reinsurance practice outlined above. The remaining classes of accident business which involve

liabilities are now considered.

7.5.1 Motor

In order to decide the rates and treaty terms, reinsurers will require full information on the portfolio

of business to be reinsured under the following three broad headings:

gross premium income;

a full description of the portfolio; and

a full claims history.

(i) Gross premium income

Details will be required by class of business and by territory as follows:

last completed six years, or more;

the current year's estimate; and

the next year's estimate.

This information enables the reinsurers to see how the portfolio is developing and to what extent

the past history of the portfolio is representative of the current portfolio.

(ii) Full portfolio description

Details will be required by class of business and territory. In addition to the information provided

regarding gross premium income, reinsurers will scrutinize the insurer's proposed underwriting

development policy. Reinsurers will need to know if they can expect a similar pattern of results in

the future as in the past.

The split of the account between private cars and commercial vehicles will also be required. A

portfolio of predominantly private car business should produce a lower claims frequency at the

excess of loss level than one with a similar gross premium income, but substantial commercial

vehicle content.

Another piece of important analysis is the split of the account between comprehensive and third

party policies. A portfolio with a higher third party element can be expected to produce a larger

claims frequency at the excess of loss level. This is because the excess of loss treaty is usually only

affected by the larger third party injury claims. Property damage claims will not normally exceed

the deductible.

Finally, reinsurers will require original policy limits, what high value vehicles an insurer may

accept. What concentration of vehicles might be insured at anyone location and whether the insurer

accepts any particularly hazardous risks.

(iii) Full claims history

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Details must be obtained of individual paid and outstanding losses, normally for the past six years.

Losses which exceed 50% of the proposed deductible should be listed on an underwriting year

basis with gross figures, from the ground up.

Details should include:

The date of the accident;

The type of policy;

Brief details of the loss;

The territory of the claim; and

The year to year development of the claim.

The claims are required on a year by year development basis, at 50% of the proposed retention, in

order to assess:

The accuracy of the insurer's claim reserving: this can be difficult to achieve on long-tail

business;

The amount of Incurred but not reported claims (lBNR);

The type of portfolio being underwritten. Claims will reflect the type of business written and indicate potential problem areas.

7.5.2 Public Liability

For public liability classes, excess of loss reinsurers would need to ascertain the following:

A full description of the portfolio of business, Whether the portfolio consist of relatively

simple business or includes heavy industrial accounts;

The insurer's policy limits and a profile of the number of policies and premiums which fit into the programme;

For example

Policy limits (Shs) Number of policies Total premium

5,000,000-10,000,000 1,250 10,000,000

10,000,001-25,000,000 3000 45,000,000

25,000,001-50,000,000 2000 37,500,000

If the insurer accepts co-insurance and/or layered business, an indication of the type of

business and limits written;

Whether the insurer accepts particularly hazardous risks likely to pose problems for reinsurers;

Full information regarding the insurers underwriting attitude towards North American exposures.

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7.5.3 Employer's Liability

For employers' liability and worker's compensation business, the reinsurers should ascertain

similar information to that required for public liability classes. In addition, the reinsurers should

be familiar with the following:

The benefits specified in the workers compensation law of the countries for which reinsurance is required.

Whether, if benefits are increased retroactively, do the new limits apply to existing

claimants and not just to workers sustaining injury after the date of the benefit increase.

How exposed the account is to high accumulations of workers in hazardous environments.

7.5.4 Problems associated with long tail business

It is essential that long tail excess of loss business is written on an underwriting year basis. By

maintaining statistics on an underwriting year basis, it is possible to acquire some understanding

about the result of anyone year's business. Usually it will take at least five years for the

development pattern of losses to become clear. Claims on pharmaceutical products have

sometimes been made ten years or more after the start of a treaty underwriting year.

There is also the problem of incurred, but not reported losses (IBNR). The IBNR factor will vary

from one insurer to another, depending upon the type of portfolio and territories in which business

is written and the skill and awareness of the insurer's claims staff.

This is a major consideration for excess of loss reinsurers. Detailed analysis of the development

of past years' results from year to year is a vital part of the reinsurance underwriting process

Another issue for the excess of loss reinsurer to consider is the effect of inflation on long

outstanding claims. Present practice is for the Index Clause, or Stability Clause, to be incorporated.

Finally the potential effect of currency fluctuation on this type of reinsurance business must be

catered for. The Currency Fluctuation Clause will be included when necessary in an attempt to

share the effects of currency movements between insurer and reinsurer.

7.6 LIFE REASSURANCE

There are number of fundamental principles which apply uniquely to life reassurance business as

opposed to general reinsurance:

Life reassurance business is long term.

Most treaties are agreed with only one reassurer.

Life treaties are set up without a formal cancellation date.

In number of cases some records of individual risks are kept, although ‘simplified’

administration is becoming more popular.

Cover is given on a surplus or less commonly a quota share basis. Non-proportional and

catastrophe treaties are relatively rare.

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The ceding company chooses its reassurer and the subsequent relationship between the

companies is quite close. Little business is placed through broker.

Losses in life business are always total, although some disability benefits may produce

partial losses.

Smaller sums reassured are more common in life business than in general reassurance.

7.6.1 Need for Life Reassurance

The primary purpose of life reassurance is to protect a company’s life fund against particularly

adverse mortality/morbidity fluctuations.

In the early years following the setting up of a new life operation, mortality experience may

fluctuate significantly and it is therefore prudent for a life company to limit its exposure to a

sensible level so as to produce stable results. The company should therefore fix what they refer to

as a ‘retention level’. This retention level is calculated by the actuary in the light of the size of the

life fund, the level of free reserves, the mix of business and the age distribution of policyholders.

Insurance companies will reassure amounts in excess of this retention level, although they may

retain the right to impose a ‘retention corridor’ enabling them to augment their normal retention in

order to avoid very small cessions.

7.6.2. Large Risks

More established companies are likely to find that their main need for reassurance arises in

connection with large risks.

Although only a few cases may exceed the retention level of an established office, the effect of a

particularly large claim may be injurious to the emergency of surplus from the life fund. Therefore

reassurance is required to prevent this happening.

7.6.3. Multiple Deaths

An insurance company may suffer particularly adverse experience from one event, such as an air

crash or an industrial accident. In terms of individual business, a company usually tries to ensure

that it develops as wide a spread of risk as possible. Nevertheless some companies choose to

effect a special catastrophe cover which protects the office against a number of deaths occuring in

one incident.

In group business, companies tend to reduce their retention on schemes where there is a significant

concentration of risk, thereby reducing their overall exposure.

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7.6.4. Sub-standard lives

Reassurers tend to specialize in the underwriting of impaired lives. Very few companies see a

high enough proportion of sub –standard cases to enable them to proceed with particular

confidence in relation to the rating of these cases for their own account. Therefore, they are happy

to take the second opinion of a reassurer who has developed a substantial and diverse portfolio of

this business. The spread of risk which a reassurer can obtain on its sub-substandard portfolio

enables it usually to offer competitive terms on impaired lives.

7.6.5. Bases of Reassurance

We will now examine original terms and the risk premium bases of life reassurance.

7.6.5.1.Original Terms

If the reassurance is effected on original terms (‘coinsurance’) this implies that the ceding company

will pass the risk to the reassurer at the rate of premium applicable to the original policy. The

proportion of the premium which the reassurer receives is therefore equivalent to the proportion

of the risk which it reassures. The reassure then follow the liability of the ceding company in

relation to death claims, bonuses attaching, surrender values and maturities. The coinsurance

method allows the tax base of the reassured policy to reflect that of the original contract.

Most policies reassured on original terms are term assurances of one sort or another and, unless

the direct company wishes to lessen the direct effect of new business strain, few permanent

contracts are reassured on an original terms basis. This is because direct companies,

understandably, wish to retain as much of their original premiums as possible and pure reassurers

have difficult in marching the investments of direct companies issuing with-profits contracts. To

cater for the situation where the cedant wishes to reassure a permanent contract, the risk premium

method of reassurance has been developed.

7.6.5.2.Risk premium

This method of reassurance specifically deals with the provision of cover for the death strain which

arises under reassured policies.

When a first premium is paid to a direct insurer, a considerable part of this premium will be held

as a reserve under the policy and as time progresses a considerable policy reserve will be built up.

This reserve gradually increases and is available to offset any loss which the company may suffer.

The direct insurer therefore pays to the reassure a risk premium based on the age of the life assured

and the initial sum at risk. The sum at risk decreases over the years as the reserve under the policy

grows.

Although amounts at risk are normally calculated in relation to the reserves applicable to the

reassured portion of the risk, this practice can be varied so that the full policy reserve can be taken

into account. In this instance the direct insurer will keep a level retention and the period of cover

necessary will be of shorter duration than that of the original contract.

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Risk premium rates are a series of annually renewable term rates costed on a single premium basis.

The rates of premium increase as the age of the life assured increases.

The advantage of this method of reassurance is that the direct insurer only pays for the cover it

requires on a year by year basis and yet receives full coverage against poor or fluctuating mortality

experience. The costs of obtaining reassurance cover are low relative to the total premium

received.

Where reassurance is placed internationally, the use of risk premium reassurance enables a

company to ensure that most of its funds are invested locally, while obtaining protection against

the mortality.

7.7. TREATY REASSURANCE

7.7.1. Quota Share

A quota share treaty is an agreement whereby the ceding company must cede and the reassurer is

bound to accept a fixed proportion of every risk accepted by the ceding company.

This approach is often used by new life companies or those developing a new line of business. It

is much simpler to administer and, as it usually provides a significantly greater volume and spread

of risk for the reassurer, better terms are usually available from the reassurer because of the smaller

degree of anti-selection experienced in this arrangement. It is also appropriate in some ways as a

means of alleviating new business strain and it can increase the solvency ratio of a ceding

company.

The disadvantage of this type of treaty to the direct company is that it often results in the company

reassuring unnecessarily large amounts of business.

7.7.2. Surplus

Surplus treaties entail a commitment from the ceding company to reassure the liability over and

above its retention. The reassurer agrees to provide an amount of automatic cover (usually a

multiple of the direct company’s retention) to the direct office. The premium for the risk is

allocated in the same proportions as the sum insured. A ceding company active in the protection

market may have a number of surplus treaties (e.g. first, second and third) enabling it to accept

risks substantially above its own retention. It is usual for surplus reassurers to pay overriding

commission to the ceding company in order to defray some of the direct costs of writing

7.7.3. Group Reassurance

Group reassurance (both life and disability) is complicated by the provision of ‘free cover’. Free

cover is protection afforded by the direct company without medical selection. Free cover levels

are significant on large schemes and in many instances part of this free cover limit needs

reassurance.

As in a large number of cases the higher benefits are on a number of older lives, and as on a surplus

basis the reassurer is unlikely to obtain anything like the spread of risk available to the direct

company the usual practice is to ‘slice’ the benefit.

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7.7.4. Non-Proportional Reassurance

Neither excess of loss nor stop loss covers are particularly popular in life reassurance. As these

approaches to reassurance are developed on a short-term basis they are not ideally suited to a long-

term contract like a life assurance policy. As non-proportional reassurance premiums will rise if

experience is bad, a direct company employing this approach may find itself unable to obtain

cover, or only able obtain it at a much higher premium just at the time when reassurance protection

is especially required.

7.7.5. Catastrophe Reassurance

Some companies do like to effect catastrophe cover in the event of a large loss arising from

multiple deaths occurring from one event such as a plane crash, fire or earthquake.

The usual procedure is for the direct company to retain a multiple of its own individual retention

(usually double) and to reassure a large proportion, typically 90%, of the excess over this retention.

The cost of this method varies according to the size, maturity and homogeneity of the direct

company portfolio and any particularly adverse features which pertain to the fund, for example a

significantly high proportion of lives with hazardous occupations.

This type of cover can be attached to any part of any company’s business. The liability covered

by the reassurer is determined on a ‘net basis’ following the deduction of any reassurances effected

in respect of the life and any mathematical reserves which may be held.

The reassurance premium may be a fixed amount or may be variable with a retrospective

adjustment made to an initial deposit premium after calculations of the net sum at risk.

Question

1. What information does a reinsurer need from an insurer before entering a contract with?

2. Whilst fixing retention, what does an insurer consider?

3. There are three types of commission in proportional treaty. Name them.

4. What are four consideration undertaken in arranging Motor reinsurance programme

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SUMMARY

Reviewing the reinsurance program

The insurer will have to consider the overall cost of its reinsurances. The commissions received

on proportional reinsurances will need to be re-examined. On its non-proportional reinsurances the

insurer must ensure it is not paying away a disproportionately high amount of its original premium

income.

Negotiating a reinsurance contract

The important information required by a reinsurer are:

Details of the insurer

Details of the portfolio to be reinsured

Price be paid for reinsurance

Life reassurance

Fundamental principles which apply uniquely to life reassurance business as opposed to general

reinsurance are:

Life reassurance business is long term.

Most treaties are agreed with only one reassurer.

Life treaties are set up without a formal cancellation date.

In number of cases some records of individual risks are kept, although ‘simplified’ administration is becoming more popular.

Cover is given on a surplus or less commonly a quota share basis. Non-proportional and catastrophe treaties are relatively rare.

The ceding company chooses its reassurer and the subsequent relationship between the

companies is quite close. Little business is placed through broker.

Losses in life business are always total, although some disability benefits may produce partial losses.

Smaller sums reassured are more common in life business than in general reassurance.

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CHAPTER 8

BASICS OF REINSURANCE ACCOUNTING

Learning Outcomes

After completing this chapter, readers should be able to understand:

Special nature of reinsurance accounts

Formats and methods for reinsurance accounting –

Exchange control regulation

8.0 REINSURANCE ACCOUNTING

Definition

American Accounting Association defines accounting as "Accounting is the process of identifying,

measuring and communicating financial information to permit informed judgments and decisions

by users of the information".

People who are interested in the financial information are:

a) Within the insurer - owners or shareholders, management and employees,

b) Outside the insurer government regulatory bodies, taxation authorities, creditors, those with

whom the insurer deals or trades, etc.

c) Others such as financial analysts, trade associations and competitors.

Reinsurance accounting is comprehensively connected with technical, financial, legal and

underwriting aspects of reinsurance.

The significance of accounting for reinsurance trading techniques must be understood and

appreciated with reference to:

the class of business,

the type or combination of types of reinsurance methods as used and ,

the forms of arrangements as placed directly and through brokers.

Uninsurable natural perils such as earthquakes, floods and windstorms became insurable owing to

spread of risk through reinsurance. Is profit earned on such business really a profit? Is it not a

reserve against a future liability for a disaster? If one loss in 25 or 30 years can wipe out the entire

profits of these many years how does one tax such profits? Legal issues and tax matters are

significant to reinsurance accounting.

8.1. TYPES OF PREMIUM INCOME

Premium income can be categorized into three forms:

Written premium income;

Earned premium income: and

Debited or accounted premium income.

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8.1.1 Written Premium Income

Original risks have an attachment or inception date. The idea of written premium income for a year

relates the premium activity for risks to the inception dates of those risks. The written premium

income for a year is the total of all the premiums (original, adjustment, additional or return) for

policies which have their inception or renewal dates in that year. It does not matter when the

premiums are calculated or paid. Written premium relates to premium written for the year and not

necessarily the premium received during the year.

Example 1

An insurer accepts a risk on 26 November 2009 which has an inception date of 1 January 2010.

Which year will that policy premium be written for?

Answer

Although the risk is written in advance, its inception date and, therefore, its written premium will

be 2010.

Example 2

A policy runs for 12 months from 1 January 2009. An adjustment premium is calculated and

processed in July 2010. For which year is the adjustment premium written?

Answer

The adjustment relates to cover which ran for the 2009 underwriting year with an inception date

in that year. Therefore the adjustment premium is for 2009. The fact that the transaction was

processed in 2010 is irrelevant.

8.1.2 Earned Premium Income

If all policies incepted on the first day of an underwriting year and ran for exactly 12 months,

earned premium income would be an easy calculation at the year end. At the last day of the

underwriting year all the risks would expire and so underwriters could take credit for the entire

premium on those risks. In reality, there will normally be an overlap where policies incept in one

year and run over into another.

Figure 8.1

A

B

1.1.2008 1.1.2009 1.1 2010

C

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Earned premium income on any policy during a year is the proportion of the total policy premium

attributable to that year. This is calculated by the time that the policy has been on risk during that

year.

In figure 8.1

Risk A incepts 1 January 2008 and so most of its premium can be regarded as earned on 31 December 2008.

Risk B incepts around the middle of the year 2008 and so runs approximately half in 2009.

Risk C only runs a small portion of the time in 2008, the bulk being attributable to 2009.

On a written premium basis all three risks would be for 2008. The earned premium basis

attempts an equitable split of premiums over 2008 and 2009 to reflect the risk exposure in

those years. Risk A's premium would be approximately 90% for 2008 and 10% for 2009. Risk B might be split 50% 2008 and 50% 2009. Finally, risk C's premium might be split 10% for

2008 and 90%% for 2009.

Example

A risk incepts on 1 September 2008 and runs for twelve months. The original premium is Shs

5,000. What would be the earned premium income at 31 December 2008?

Answer

At 31 December 2008 the risk has run for 122 days or one third of a year. One third of the premium

of Shs 5000 would be earned in 2008 with the remaining two thirds to be earned in 2009.

8.1.3. Debited or accounted premium income

This is almost the opposite of the written premium system. Debited premium income is that

premium accounted in the year regardless when the policy incepted or renewed. Risks may be

written earlier than their inception and adjustments processed after the period of cover has passed.

A debited premium Income will usually include premiums relating to insurance policies which

incepted in earlier years. It will probably not include late accounted premiums for some policies

incepting during the year.

8.2. UNEARNED PREMIUM RESERVES AND PORTFOLIOS

The following are basic methods of calculating earned premiums:

a 50% or half system:

an eighths system:

a twenty-fourths system:

a pro rata system.

8.2.1. The 50% system

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The 50% system or half system presumes that at the end of an underwriting year the average policy

is half way through its period of insurance, as in risk B of figure 8.1.

Therefore half the total premium income for the year is regarded as earned in the current year with

half being carried forward to the next underwriting year.

8.2.2. The Eighths System

A more accurate method of calculating the necessary split of premiums looks at the annual

premium income of an underwriting account split over the four quarters of the year.

The eighths system retains premium for the current year and passes premium to the next year as

follows:

Quarter Portion of premium

earned in the current

year

Portion of premium unearned

in the current year and passed

on to the next year

January ,February , March 7/8 1/8

April, May, June 5/8 3/8

July, August, September 3/8 5/8

October, November, December 1/8 7/8

Policies incepting in the first quarter, January, February and March, run most of their risk exposure

by the end of the year. Accordingly, 7/8 of the total premiums are regarded as earned by the end

of the year, with only 1/8 left to run in the following year.

Conversely, policies incepting in the last quarter of the year are expected to run the bulk of their

risk during the subsequent year. Accordingly, only 1/8 of those premiums are regarded as earned

by 31 December with 7/8 of the premiums being transferred to the next year.

8.2.3. The Twenty-Fourths Method

The next system which is used by many reinsurers is the twenty-fourths method. This is based on

the assumption that all policies incept at the middle date of the various months throughout the year

and that the risk exposure is reasonably equal throughout the year. There are no peak-periods for

losses. The policies which incept in December, therefore, will have a half a month to run before

the close of the year. Half a month is 1/24th of a year. The earned premium for the December

policies will therefore be 1/24th of the December written premiums with 23/24th being transferred

to the next year.

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Inception or Renewal date of the policy

Fraction earned in the current year

Fraction unearned in the current year and transferred to

the next year

January 23/24 1/24

February 21/24 3/24

March 19/24 5/24

April 17/24 7/24

May 15/24 9/24

June 13/24 11/24

July 11/24 13/24

August 9/24 15/24

September 7/24 17/24

October 5/24 19/24

November 3/24 21/24

December 1/24 23/24

8.2.4. The Pro Rata system

The pro rata system is the most accurate method of splitting premiums as it looks at the fraction

of earned to unearned on a daily basis. The calculation at year end is performed on each individual

policy, multiplying the premium for the risk by the fraction.

Number of days that the policy has run at year end

Total number of days of cover under the policy

A twelve month policy incepting on 17th March 2009 will run for 290 days in 2009 and 75 days in

2010. The earned premium calculation for 2009 will be:

290 the written premium for that policy, while

365

75 of the premium will be regarded as unearned at 31 December and

365 transferred to the next year, i.e. 2010

All these systems are designed to cope with the situation where risks overlap different underwriting

years. They are an attempt to ensure that as each underwriting year is exposed to loss from a policy,

then it receives a portion of the premium commensurate with that risk. That is why the timing

factor is so important.

8.2.5. Calculation of Unearned Premiums under Treaties (Annual Policies Only)

In normal circumstances reinsurance treaties run for a year at a time so a calculation may be

required for transferring premiums, depending upon the basis of premium income for the treaty.

Where a treaty is accounted on an earned premium basis, one of the four methods outlined above

will have been used for the calculation.

Example

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What are the four basic methods for calculating earned premiums?

Answer

50% or half; eighths: twenty-fourths: and pro rata.

At any time the earned to unearned premium relationship can be calculated. If the insurer performs

the calculation it may retain the reinsurer's portion of the unearned premium at each accounting

date. In other words, the insurer is reserving premium for future liabilities. In this case those future

liabilities are the unexpired part of each premium for the risks that have been ceded.

The accounting of a treaty on an earned premium basis means that an unearned premium reserve

automatically remains in the hands of the insurer. As risks run through their allotted span, the

unearned premium reserve will gradually be released each quarter as a greater portion of the

premium is earned by the reinsurer. This means that, where a treaty is accounted on an earned

basis, the unearned premium reserve is automatic.

If a treaty is accounted for on a written premium basis then no automatic unearned premium reserve

is retained by the insurer. Reinsurers, having received their proportion of written premiums, will

have received both earned and unearned premiums. If those reinsurers were to become insolvent

or be prevented from paying future claims for some other reason, then the insurer would be in

trouble. Having paid over all the premiums and it would be unable to recover claims. This would

result in a significant financial loss to the insurer.

As a precaution against such difficulties, treaties accounted for on a written premium basis will

normally make provision for the insurer to retain an unearned premium reserve. Very often a figure

of 40% of written premiums is used.

Every year a reserve will be calculated quite separately from the ordinary, quarterly accounts. Once

established, the reserve will be withheld by the insurer for 12 months. The following year the

reserve will be recalculated. The old reserve will be released and the new reserve retained.

One important point concerning unearned premium reserves on this basis is that the money

withheld belongs to the reinsurers. It is merely deposited with the insurer which holds it as security

against the possible problems outlined above. Accordingly, the insurer normally pays the

reinsurers interest on the balance of money withheld.

In some countries, the insurance regulatory authorities insist that insurers within their jurisdiction

retain unearned premium reserves on all treaties.

8.2.6. Premium Portfolio Transfers

Circumstances may arise where it is necessary to discontinue the liability of one or more reinsurers

at the end of a particular treaty year. If there is no replacement reinsurer or the whole treaty ceases,

there is no particular difficulty. No new cessions would be made and eventually the treaty would

simply cease by the running off to a natural expiry of the underlying business.

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Generally. Treaties are intended to be continuous and so a withdrawing reinsurer would normally

be replaced by another. This creates a problem.

The underlying business overlaps different years so a decision is needed as to which reinsurer

receives what amount of premium. The clean-cut system is the technique used for this purpose.

A premium portfolio transfer involves transferring premium from the existing reinsurer to the new

reinsurer. The amount transferred is the unearned portion at the time of transfer. Any of the

methods of calculating unearned premium could apply. The overall objective is to find a method

whereby insurers do not have to calculate the unearned premium applicable to each individual risk.

An equitable amount must be transferred to the incoming reinsurer to reflect that portion of

unexpired risks it is accepting. Another common technique is to transfer 40% of the whole

premium ceded to the old reinsurer during a year to the new reinsurer.

Example

Reinsurer X's line on a treaty for the 2015 year is being replaced by reinsurer Y for 2016. Assuming

a 40% premium portfolio transfer and quarterly premium for X as shown, calculate the transfer

from X to Y at the end of 2009.

X's premium for 2015:

First quarter Shs.8,000,000

Second quarter Shs.12,000,000

Third quarter Shs.7, 500,000

Fourth quarter Shs 8,500,000

Answer

X's total premium for the year is Shs 36, 000,000

40% of Shs.36, 000,000 = Shs.14, 400,000 so that amount would be withdrawn from reinsurer X

in the fourth quarter account for 2015 and paid to reinsurer Y in the first quarter account for 2016.

The big advantage of the clean-cut system is its administrative simplicity. Both the insurer and the

reinsurer are able to close the preceding year of account as soon as the necessary transfers have

been made. It does depend, however, upon the two parties to a treaty agreeing upon a realistic

proportion of the premium being transferred. It must accurately reflect the degree of risk of future

losses.

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8.3. OUTSTANDING LOSSES AND IBNR

An insurer will receive premiums for an underwriting year and will also pay claims in respect of

risks for that year. The total of premium income less claims and expenses of management provides

the underwriting result for the year.

In the case of premiums an adjustment has to be made for that portion of risks which are unearned

at the underwriting year end. For claims an assessment of outstanding losses and calculation of

incurred but not reported claims (IBNR) must be made.

8.3.1. Outstanding losses

In anyone underwriting year incidents giving rise to claims will be reported to insurers. Those

claims which are negotiated, agreed and settled will appear in the account as paid claims.

Inevitably there will be claims still under negotiation at year-end.

Other claims will be the subject of dispute between insured and insurers as to either liability,

quantum or both. All these unsettled claims will appear in the accounts as outstanding claims.

Insurers will establish estimates of the amount they will ultimately have to pay for each claim,

when they are finalized. At that stage the losses will change their status from outstanding to paid

claims.

As with premiums, the difficulty is one of timing. If every single underwriting year ran-off to

natural expiry then the account would start off with premiums and paid claims. As outstanding

losses were settled they would be included in paid claims.

Ultimately, all outstanding losses would be settled and at that point the result for that underwriting

year could be ascertained. This process could take years and would create an expensive

administrative burden. In just the same way that earned premiums allow for continuity from year

to year, so does the transfer of outstanding losses from one year to the next.

If an underwriting account runs to natural expiry, the absolute accuracy of outstanding loss

estimates is less important. If a claim is settled for more than the amount originally estimated then

the underwriting result for that year will worsen by the increased cost. If a claim was settled for

less than its original estimate, the underwriting result would improve. Insurers will make their best

estimate of outstanding losses, but inevitably there will be some movement in values.

If, paralleling unearned premiums, outstanding losses are transferred from a closing underwriting

year into the following year, a clean-cut, the insurer can calculate the result of the closing year

much more quickly. The administrative cost burden can be reduced, but the problem remains the

accuracy of individual outstanding claims estimates.

If outstanding losses are transferred from one Reinsurer to the next then the existing Reinsurer

pays the next Reinsurer to assume the liability. Potential advantages and disadvantages for each

Reinsurer of account are as follows.

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Advantages

From the point of view of the

Current Reinsurer there is a transfer of liability at a known cost which cannot increase in the future. It pays a single amount and removes its potential liability permanently;

Accepting Reinsurer there is a transfer of funds which it may hold for some time before

the outstanding losses it accepts become due for payment. It can earn interest on those

funds.

Disadvantages

From the point of view of the

Accepting Reinsurer there is the possibility that the amount it has to pay in settling the claims it has taken over' is greater than the funds it received for the transfer. In other words,

outstanding losses were underestimated;

Current Reinsurer the opposite could apply. If outstanding losses were overestimated it would be paying too much away to the next year for the transfer of claims.

Clearly, this places a significant burden on an insurer to accurately assess its outstanding losses.

8.3.2. Incurred But Not Reported

Incurred but not reported (IBNR) claims are losses which have occurred and will attach to an

underwriting year. However, they are late-reported to that underwriting year, possibly by months

or even years.

At the end of an underwriting year, any assessment of the result of the underwriting account will

consist of premium less paid claims, outstanding claims and incurred but not reported losses.

Making an estimate of IBNR claims is even more difficult than estimating known outstanding

losses.

The possible reasons for delays in reporting losses vary.

The nature of the business may be such that claims notification will naturally occur late.

For example, Professional indemnity claims for architects or engineers and products

liability claims for pharmaceutical products.

The Insurer might not be aware of the significance of a claim. Such as a third party injured in a motor accident has a condition which deteriorates after five years to one of total

disability when the initial prognosis indicated a better outcome.

The insurers might not be aware of the final cost of a claim. Inflation may affect

longstanding claims. An estimate that was reasonably accurate at the time of notification

may be rendered inadequate by the effects of inflation over the years that the claim is

outstanding.

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The insurer might be inexperienced in handling potentially serious third party liability claims. This could result in inadequate initial estimates for outstanding losses.

The underwriting account could be affected by new developments. If, for example, a medical condition was decreed a new industrial illness, there would be late advised claims

to employers' liability or workers compensation accounts.

There is a relationship between outstanding losses and IBNR for anyone insurer. The IBNR factor

will vary, however, depending upon the type of business which an underwriter accepts, the territory

in which the business is written and the skill, experience and awareness of the claims personnel

involved.

If an insurer has a high volume of business, then an analysis of past claims development can

indicate what IBNR factors should have applied in the past. If the picture is consistent it may be

appropriate to apply the same factors going forward and assume that the position will remain

similar.

The biggest difficulty arises from long tail business. Most liability policies are underwritten on a

losses occurring basis and the victims of certain industrial diseases (for example, asbestosis) may

not discover for many years that they are suffering from the disease. The interval, that is the tail,

between exposure and manifestation can be anything from 10 to 20 years or even longer. Once

notified, the claim can then take a long time to settle. Another big problem of long tail is claims

connected with pollution and class actions.

8.4. LOSS RESERVES AND OUTSTANDING LOSS PORTFOLIOS

In the final section of this chapter we will consider the method by which claims are settled.

8.4.1. Loss Reserves

Reinsurers will pay the insurer their proportion of all the paid or settled losses. Losses outstanding

but not yet settled such as outstanding claims will be the subject of a financial provision in the

insurer's accounts. When the outstanding losses become settled claims, reinsurers will pay their

proportion. However how should an insurer account for its outstanding losses?

If outstanding losses are recorded gross, before any expected reinsurance recovery, this will cause

the result to deteriorate. If the outstanding losses are recorded net of reinsurance, there is a

presumption that all the potential reinsurance recoveries will actually be made at some time in the

future.

Part of an auditor’s role is to examine both outstanding claims and potential reinsurance recoveries

applying thereto. If the auditor is satisfied that all the reinsurance recoveries will be made, the

insurer is allowed to take into account net outstanding losses.

If however, the auditor detected insolvent reinsurers or disputed reinsurance recoveries, it would

disallow that element of the overall expected reinsurance recovery, so increasing the insurer's

expected net liability.

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In some countries the insurance regulatory authorities do not allow insurers to assume potential

reinsurance recoveries against outstanding losses. The insurer must account gross figures for

outstanding claims.

To reduce the impact of this financial penalty, the insurer needs to be paid in advance for the

reinsurers' share of outstanding losses. Payment in advance would be unfair on reinsurers so an

alternative is needed.

To achieve this, the insurer will hold reinsurers' money or perhaps their securities as a balance

against the latter are a proportion of outstanding losses. Such holdings constitute outstanding loss

reserves.

Apart from possible regulatory requirements, it makes good business sense for an insurer to hold

outstanding loss reserves. It provides an element of security against the possible collapse of a

reinsurer. Further, it provides a fund of money which can be used to pay reinsurers portion of

losses without the delay of collecting cash from them.

An outstanding loss reserve will usually be based upon the estimated amount of losses outstanding

at a given date. Usually the deposit is established and adjusted at the anniversary date of the treaty

but sometimes in the quarterly accounts.

The loss reserve may be drawn upon for settlement of claims. More commonly, the reserve is not

used for settlement of individual losses which take place in the treaty year. This is especially so

where loss reserves are a statutory or regulatory requirement. Then the loss reserve deposit is a

separate operation in the year. At the end of the year, the reserve is recalculated, the old reserve

released and a new reserve retained.

Since the money deposited by the reinsurers is their property, interest is payable by the insurer to

the reinsurer on the amount. The calculation and payment of interest is normally made annually

when the reserve is recalculated.

8.4.2. Outstanding Loss Portfolios

The result of a treaty year can never be finalized until all the losses and liabilities on that year's

business are settled. As well as constituting a considerable administrative burden, the process could

take years to complete.

The practical response to the problem is for liability for outstanding claims to be transferred from

an expired treaty year into the subsequent new treaty year.

Reinsurers on the old year pay an amount of money to reinsurers on the New Year sufficient to

cover the outstanding losses. Liability for outstanding claims is then transferred from the old

reinsurers to the new. The amount of money paid to achieve the portfolio transfer is not necessarily

the same as the outstanding loss reserve.

An outstanding loss reserve is an amount of money which reinsurers deposit with the insurer. It is

intended to match reinsurers' proportion of the reserves shown in the insurer's accounts for

outstanding losses. A loss portfolio transfer is the amount of money that a reinsurer will actually

pay in order to discharge liability for losses.

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Payments of loss portfolios will depend upon different factors, the most important being the type

of underlying business involved. A property treaty covering fire damage will often see reserves

for outstanding losses larger than are subsequently required accordingly, outstanding loss

portfolios on fire business are often arranged at 90% of estimated outstanding losses.

Because of the problems associated with long tail business a treaty covering liability business, will

require an amount greater than 100% of reported outstanding losses for portfolio transfer.

Moreover, some years might elapse before a reasonably firm view can be taken on the value of

outstanding losses.

8.4.3. Proportional Treaty Accounts

Most treaties in practice are "blind", i.e. no details of individual cessions are supplied to the

reinsurer by the ceding insurer.

The reinsurer receives quarterly or periodical accounts showing:

premiums,

claims paid,

reserves released and

retained etc.

As per the terms agreed between the reinsurer and the ceding insurer.

As bordereaux is provided in very few cases, mainly in respect of contracts applying to specialist

classes of business, the preparation of the accounts is the responsibility of the ceding insurer who

alone possesses the requisite information. Some companies render half-yearly or even annual

accounts, in order to reduce the administrative cost in producing quarterly accounts.

However, quarterly accounting system appears to be advantageous because the reinsurer is in

better position to watch the development of the treaty results, which is vital to him should he be

required to make any decisions relative to that business. Secondly, if periodicity is longer than

quarterly, cash flow will be delayed and, as on average, balances tend to be payable to the reinsurer,

delay in the remittance of balances results in a loss of investment income for reinsurers as also

exchange gains or losses which may arise due to currency fluctuations.

Normally, there will be a provision in the treaty contract stipulating the period at which accounts

will be rendered by the ceding insurer, say, within three months of the close of the quarter. There

may be a further stipulation that the accounts will need to be confirmed by the reinsurer within a

month of receipt and settlement will be effected by the debtor party within one month following

confirmation of accounts. If the transaction is through a broker, there may be further delays

involved as accounts will be routed through the broker.

Therefore, it is the duty of the ceding insurer to ensure that the accounts are rendered to the

reinsurers within the time allowed by the agreement and also either party must settle balances due

to the other party within the agreed period. Since many transactions are effected through brokers,

they are involved in checking that accounts passing through their offices are contractually correct

and are rendered at the correct time.

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They also arrange settlement between the parties. This forms part of the overall service provided

by the broker to the ceding insurer and the reinsurer for which remuneration is by way of brokerage

paid by the reinsurer as an agreed percentage of ceded premium.

a) Fire and Accident Proportional Reinsurance:

The accounts for this type of business are normally rendered on an "Accounts Year" basis. The

premiums are usually shown at original gross rates and the reinsurance commission rate is then

applied.

b) Marine Proportional Reinsurance:

The accounts for this type of business are normally rendered on an "Underwriting Year" basis. The

premiums are usually shown net of acquisition costs, agency commission, brokerage and any

discount allowed to the insurer. Hence, the reinsurance commission will cover only the ceding

insurer's expenses. This is usually termed as overriding commission.

8.4.4. Non –Proportional reinsurance

No commission is payable under this type of business, as such factors will be taken into account,

when arriving at the rate for the treaty though brokerage is determined separately

8.5. FORMATS AND METHODS FOR REINSURANCE ACCOUNTING

8.5.1. Proportional Treaty Accounts

As a result of the international nature of the reinsurance market, coupled with the size and

resources of ceding insurers and reinsurers, formats of reinsurance accounts are many and varied.

Over the years a number of attempts have been made to introduce standard formats which would

greatly simplify the handling of accounts, but these have met with only limited success and have

not found universal acceptance.

Thus, there is no standard format as such for rendering of accounts, but it should take into account

the basic features as set out in the treaty contract.

A specimen of a treaty account is set out below:

Ceding insurer Insurance Co Ltd

Treaty First surplus fire treaty

Period of account 1st Quarter 2015

Reinsurer Reinsurance Co- Ltd

Reinsurers share 10%

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Debt Credit

Premium 100,000

Commission 40% 40,000

Claims paid 20,000

Balance due to Reinsures 40,000

100,000 100,000

Reinsurers 10% share 4,000

Some ceding insurers divide the account into two parts:

The first part called the technical account showing items relating to the reinsurer’s share of the technical result for the period and insurance

The second part called the financial account will include the balance brought forward

from previous account, premium and loss reserves and interest thereon, loss settlements

made, cash loss credit and the final balance which is due for settlement.

It is not necessary that all the items mentioned in the above specimen should appear in the

account for each accounting period.

Example

Portfolio premium and loss entries will appear in the first quarter's account, and portfolio

premium and loss withdrawals in the last quarter's account.

d) Premium

What is 'premium' may vary according to local practice, the terms of a contract or the class of

business. In some markets gross premium may be subject to deduction of such items as licence

fees, fire brigade charges, local taxes etc., whilst in others ,these will be accounted separately.

With marine and aviation business, it is usual for premiums to be accounted net of original

acquisition costs and therefore only subject to a relatively low reinsurance overriding commission.

b) Commission

Reinsurance commission is an item paid by the reinsurer to the ceding insurer and is expressed as

a percentage of the premium. The function of the reinsurance commission is to reimburse the

ceding insurer with pro-rata amount of what he has paid in acquiring the business - agency

commission and expense of management. The ceding insurer incurs considerable expenses in

obtaining his business.

The reinsurer benefits from such services. As he does not directly contribute to these particular

overheads, it is reasonable for the reinsurer to pay for these services indirectly through the

reinsurance commission.

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8.5.2 Methods of Reinsurance Commission

a) Flat Rate of Commission:

This is very easy to account as the commission payable is determined by applying the agreed

percentage of commission to the premiums ceded less returns and cancellation. There may be

different rates of fixed commission for different types of business within a treaty.

b) Sliding Scale Commission:

This is a method of arriving at a rate of commission based on the loss ratio of the treaty during

anyone treaty year or during anyone underwriting year. The loss ratio is usually calculated as the

percentage that the incurred losses bear to the earned premiums.

This is calculated as follows:

Loss = Incurred Losses x 100

Earned Premiums

Example of calculation of commission on sliding scale

This is normally based on the ratio of earned premiums to the incurred losses

Premium ceded during the year 178,436

Add incoming premium reserve 65,658

Less outgoing premium reserve (71,374)

172,720

Losses paid during the year 151,362

Add outgoing loss reserve 39,789

Less incoming loss reserve (64,499)

Total 126,652

Loss Ratio is: 126,652 x 100% = 73.33%

172,720

Commission rate is directly related to the loss ratio.

e) Earned Premiums

Definition

Premiums ceded and included in the accounts for the year in question Add

Reserve for unexpired risks (premium reserve) brought forward from the previous year (add or

deduct portfolio premiums)

Less

Reserve for unexpired risks (premium reserve) at the end of the current year.

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f) Incurred Losses

Definition

Losses paid and included in the accounts for the year in question

Add

Outstanding losses (loss reserve) at the end of the current year

Less

Outstanding losses (loss reserve) at the end of the previous year (add or deduct portfolio losses).

Variations to the formula given above and these are:

Incurred Losses x 100

Written Premiums 1

Losses Paid + Losses Outstanding Underwriting Year

Written Premiums Basis

As the information required calculating the actual rate of commission payable is not known until

the end of the year in question, there is always an arrangement for the payment of a provisional

commission.

The loss ratio, when calculated, is compared with an agreed scale and the commission rate will be

as indicated. There are however fixed upper and lower limits to the scale.

The operation of a sliding scale tends to stabilize the results under a treaty, reducing the profit to

the reinsurer in good years and likewise the loss in bad years. Table of "Sliding Scale of

Commission" given below is as an example.

The ratios and percentages will differ from Agreement to Agreement and also for type of business

and country of ceding insurer:

Example

Example of sliding scale of commission table

“Rate of commission” If agreed provisional commission chargeable, until actual commission is

determined, it would be a midpoint between minimum and maximum commission. In the example

below, 37% would probably be the provisional commission payable and adjustable at the end of

the treaty period.

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32% If loss ratio is 65% or more

34% If loss ratio is 61% but less than 62%

40% If loss ratio is 50% but not less than 51%

42% If less ratio is less than 46%

c) Overriding Commission

When a reinsurer receives business as an inward retrocession, the reinsurer will allow the ceding

insurer an additional commission (overriding commission, over and above any share of the original

commission that he may pay.

The overriding commission payable by the reinsurer may be calculated in various ways i.e.

on gross premium or .

on net premium or

partial net premiums

This must be clearly stipulated in the treaty agreement.

d) Brokerage:

Where a reinsurer receives a share of a treaty via a broker, he will normally agree to pay brokerage.

The broker will either include his brokerage in the actual statement of account for the business or

render a separate statement for brokerage due. The percentage of brokerage payable is applied to

premiums written on gross, net or partial net basis and this must be clearly stipulated in the treaty

agreement.

8.5.3. Profit Commission:

The various methods by which the profit commission is calculated are as follows.

Profit commission is an additional percentage payable to a ceding insurer on profitable treaties in

accordance with an agreed formula. It is therefore an incentive for ceding insurers to produce

profitable business.

There are two types of profit commission statements:

a) "Accounting Year" basis and

b) "Underwriting Year" basis.

Fire and Accident proportional treaties are usually on an accounting year basis and Marine and

Aviation proportional treaties on an underwriting year basis. It is rare for a non-proportional treaty

of any class to have a profit commission clause. However, if this is provided, it will usually be on

an underwriting year basis.

a) "Accounting Year" basis

A profit commission on an "Accounting Year" basis requires all transactions for the same treaty

period, without reference to underwriting year, to be included in the same profit commission

statement. A typical example would include the following items.

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Debt Credit

Commissions Premium reserve brought forward

Claims Loss reserve brought forward

Miscellaneous 33charges Premiums

Premium reserve carried forward

Loss reserve carried forward

Allowance for reinsurers expenses

Profit for the year

The reserves mentioned above are statistical reserves and do not relate to any cash reserves the

ceding insurer may be retaining from the reinsurer although they may be replaced by "Portfolio

Transfers". A profit commission on accounting year basis would not be adjusted in subsequent

years as long as the treaty continues without cancellation.

b) Underwriting Year basis

A profit commission on an "Underwriting Year" basis requires all transactions of an underwriting

year, without reference to accounting year, to be accounted to the same year for the purposes of

determining the profit of that underwriting year.

It is general practice, where this type of profit commission applies, to defer the preparation of the

first statement until at least one year after the end of the underwriting year. Readjustment

statements are then rendered in accordance with the treaty terms until all liability has expired.

There can be a provision to close an "Underwriting Year's" accounts after a specified period and

transfer any outstanding liability to the next open "Underwriting Year". All subsequent

transactions relating to all proceeding "Underwriting Years" are then included in the profit

commission statement for the current open "Underwriting Year".

An example of this type of profit commission would be the same as illustrated for the "Accounting

Year" statement except that there would be no premium reserve brought forward / carried forward

and no loss reserve brought forward.

c) Clean-Cut Method:

Portfolio premium withdrawal takes care of liability for unexpired risk at the cancellation date or

at the end of the treaty year. However, there may be claims outstanding as on that date, the liability

for which can also be withdrawn from the outgoing reinsurers.

This is done by debiting the outgoing reinsurers with their proportion of 90% or 100% of estimated

outstanding losses which is termed "portfolio loss withdrawal" .

The same amount is credited for their respective proportion to the incoming reinsurers, which is

termed as "portfolio loss entry". Should there be material difference between losses finally settled

and portfolio loss amount, such entries, can be reopened and adjusted by invoking the relevant

provision in the treaty contract.

Where both portfolio premium and portfolio loss are withdrawn from all the outgoing reinsurers

at the year end and corresponding entries are given to the renewing reinsurers on the treaty for the

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New Year the method is known as "clean-cut" method. This method is usually followed in most

of the property proportional treaties as it saves considerable administrative work.

Any premium reserves withheld are also released simultaneously with portfolio withdrawal and

the reserve corresponding to the premium of the previous year is withheld in the first account of

the next year.

8.5.4. Non-proportional Treaty Accounts

The requirements for preparation of accounts under non-proportional treaties are different to

those for proportional treaties and are generally of a much simpler nature.

Losses are usually dealt with on a cash loss basis and are payable by individual reinsurers upon

the rendering of appropriate information by the ceding insure. Therefore accounts under non-

proportional treaties are substantially in respect of premiums. They are not subject to premium or

claim reserves or profit commission.

a) Premiums

The premiums to be paid by the reinsured to the reinsurer will normally be calculated at a rate

which has been specified in the contract and that rate will be applied to the ceding insurer's total

net premium after ceding to proportional reinsurances. A flat rate of premium can also be agreed.

Normally provision will be made for payment of a minimum and deposit premium based upon an

estimated total net premium and the deposit premium will be subject to an adjustment premium

when the ceding insurer's final premium income becomes known. The deposit premium is usually

paid in quarterly installments. It can also be paid annually in advance.

b) Cash loss register

Generally treaties provide for specific advices of large losses and special settlements of such

losses by way of a cash settlement. All such advices should be checked with brief details to

ensure that they are in conformity with the underwriting information.

A register is to be maintained for all large losses showing,

Date of advice,

Brief particulars of loss,

Estimated Loss,

Paid amount,

Date of payment of cash loss and quarter in which credit is received.

For cash loss payments made to the ceding insurer, the reinsurer should ensure that a credit is

given in quarterly account, when the loss appears under paid losses.

Normally, such payments and credits are treated as financial transactions, as opposed to technical

items appearing in an account, and it is very important to maintain a close watch for credits to be

given for payments made.

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Question

1. Give two categories that premium can be classified.

2. What assumption is made in the 50% method of reserving?

3. Explain the reasons for portfolio transfers.

4. What are the advantages of having portfolio transfers?

5. Generally non-proportional treaties provide for cash loss payment. List four things that should

appear in the cash loss register,

6. Reinsurers receive four quarterly accounts on the proportional treaties yearly. What are

included in these accounts?

7. Portfolio premium and loss assumptions will appear in the ,,,,,,,,,quarters account while the

premium and loss withdrawals will appear in the …………………..quarters accounts.

8. What is the formula for loss ratio?

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SUMMARY

Reinsurance accounting

People who are interested in the financial information are:

Within the insurer - owners or shareholders, management and employees,

Outside the insurer government regulatory bodies, taxation authorities, creditors, those

with whom the insurer deals or trades, etc.

Others such as financial analysts, trade associations and competitors.

Types of premium income

Premium income can be categorized into three forms:

Written premium income;

Earned premium income: and

Debited or accounted premium income.

Unearned premium reserves and portfolios

The following are basic methods of calculating earned premiums:

a 50% or half system:

an eighths system:

a twenty-fourths system:

a pro rata system.

Methods of Reinsurance Commission

Flat Rate of Commission

Sliding Scale Commission

Overriding Commission

Brokerage:

Profit Commission:

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CHAPTER 9

REINSURANCE TREATY WORDINGS

Learning outcomes:

Upon completion of this chapter, the readers should be able to understand:

The main features of a proportional and a non-proportional wording and the main clauses in current use

The clauses common to both proportional and non-proportional wordings.

9.0. TREATY WORDINGS

Treaty wordings are signed agreements, which evidence contracts of treaty reinsurance between

an insurer and reinsurers. Wordings should be unambiguous.

One particular problem is that different organizations use similar vocabulary with different

meanings. This can be exacerbated when transactions are international, as much of reinsurance

business takes place internationally.

It is vital that the wording reflects the true intentions of the parties to the contract.

This part of the material provides links with other chapters of this subject. It explains how insurers

and reinsurers formally agree upon a number of aspects of mutual interest.

9.1 PROPORTIONAL WORDINGS

This chapter is concerned with the main issues and not with points of specific detail. There are

many complexities in reinsurance documentation which are beyond the scope of this chapter.

9.1.1 Business Covered

This clause provides a clear definition of what original business can be ceded to the treaty. It may

be specific such as "all business underwritten by the insurer in its Fire Department" or more general

such as "all policies underwritten by the insurer".

The need is for a clear definition. To allow a general form of wording, a reinsurer needs to be very

confident of its knowledge of the underlying account.

9.1.2 Territorial Scope

This clause sets out the geographical limits for underlying business to be protected by the treaty

and links with the business covered clause. Wordings will vary according to types of business. It

could be "property situated in"." for property insurance or "policies issued in"." for personal

accident insurance. Personal accident insurance will range over different countries, hence the need

for a different wording.

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For some forms of business the geographical area is a vital underwriting consideration. Wordings

for such covers will be very specific as to what is allowed. The important point is that accuracy of

definition is necessary if disputes are to be avoided.

9.1.3 Method of Cession

This specifies the nature and extent of cessions and will need to cover the following:

The form of the cession: whether it be quota share, surplus or facultative obligatory;

The maximum permitted cession. A quota share will be expressed as a percentage.

Surplus and facultative obligatory treaties will be expressed as a multiple of lines. In all cases there will be an additional monetary maximum limit expressed. This acts as a safeguard for

reinsurers;

The insurer's retention. If an insurer is allowed to arrange excess of loss protection for Its net account, this will be incorporated;

If cessions are made on a risk basis, what constitutes one risk will be specified.

Normally, the insurer is allowed to establish what it thinks is appropriate;

if the insurer has the right to arrange specific facultative protection prior to cession to the

treaty, this will need to be allowed for;

if the insurer has the right to arrange common account protection, this too will need to be allowed for in the wording.

9.1.4 Commencement of Cessions

This states how the cover applies:

for quota share treaties: simultaneously and automatically with the liability of the insurer under its original acceptance;

for surplus treaties: simultaneously and automatically with the liability of the insurer as

soon as the insurer's retention is exceeded;

for facultative obligatory treaties: as per surplus with a possible variation if the treaty is to be provided with an element of business other than in circumstances where capacity

demands it.

Normally the wording will allow the insurer to follow its normal practice in allocating the risk to

the treaty if a loss occurs before the reinsurance cession has been calculated.

If there is any limitation of retrospective cessions to the treaty or if the treaty is subject to

reciprocity, the details and mechanics of their operation will be described here.

9.1.5 Commencement and Termination of Treaty

This concerns the commencement of the treaty itself as opposed to the cessions there under. It also

describes the manner and circumstances in which the treaty can be cancelled. Normally, cover

allows for new and renewing business which means, a continuous treaty. The arrangement might

be on a clean-cut basis, however and so there may be a provision for portfolio transfer to be made.

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The clause will also specify the minimum period of notice for cancellation:

how business in force at cancellation will be dealt with;

what period is allowed for run-off business; and

whether and how, any portfolio withdrawal will operate.

Finally, special circumstances, such as:

Insolvency of one of the parties;

War between countries of domicile of the parties; or

Failure to observe the terms of the agreement, may give right to immediately termination

by the other party. The conditions in which this right may be exercised must be clearly

defined.

9.1.6 Business Excluded

Under this clause will be general exclusions such as those relating to war and nuclear risks,

exclusions specific to particular classes of business and excluded territories.

9.1.7 Original terms, conditions and rates

This clause confirms the mutual involvement of insurer and reinsurer by stating that cessions to

the treaty are subject to identical terms and conditions as under original policies. Normally,

premium is payable at the same rate, but if it were payable in some other way, such as on a net

rate basis rather than gross, the clause must specify how that would operate.

9.1.8 Commission

The wording allows either an agreed flat rate of commission or a combination of a flat commission

and profit commission. Alternatively, a sliding scale commission may apply.

Whatever commission is applicable, this will be expressed as a percentage of the reinsurance

premium and is made in recognition of the acquisition and administration costs carried by an

insurer.

9.1.9 Periodical accounts

This clause deals with the submission of accounts and settlement of balances between the parties.

The majority of treaties operate quarterly in arrears but half yearly, annually or even monthly

accounting sometimes applies.

Matters of detail covered will include:

how soon after the close of the relevant period the account is to be rendered;

how and when the account is to be confirmed and the balance settled;

whether the account is to be submitted on an annual or underwriting year basis; and

Any special currency provisions such as the submission of separate accounts for specified currencies.

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9.1.10 Losses: Advice and Settlement

All aspects of claims affecting the treaty are catered for under this clause. The following issues

will be dealt with:

Losses will normally be debited to reinsurers in the accounts.

Individual large losses above a pre-arranged sum can be submitted by the insurer for

immediate payment by reinsurers. These are called cash calls;

Reinsurers must be advised of large losses. The figure above which losses must be immediately reported to reinsurers will have been agreed in treaty negotiations;

The insurer has the sole right to adjust, compromise and settle claims, and reinsurers agree to be bound by the insurer's decisions. However many reinsurers wish to become involved

in claims and where they lead a treaty, A lead reinsurer is one that has actually negotiated

and agreed the final treaty terms with the insurer and who usually takes the largest share of

the treaty. Other reinsurers follow, usually for smaller shares, are insisting on a Claims co-

operation clause a sample is set out below:

Claims Co-Operation Clause - it is a condition precedent to the reinsurer's liability that upon the

reinsurer's request, the insurer shall co-operate with the reinsurer or any other person designated

by the reinsurer, in a timely manner;

Outstanding losses may have to be reported to reinsurers. This is often a requirement at the anniversary date of the treaty; the aggregated outstanding loss figure is usually advised to

the reinsurers together with the quarterly accounts; and

Any requirement for identifying individual losses which form part of a catastrophe, such

as a cyclone. This enables reinsurers to establish their total losses, from all sources,

attributable to a catastrophe and so trigger their own retrocession recoveries.

9.1.11 Premium Reserve Deposit

This sets out the terms under which the insurer may retain a proportion of the ceded premium.

The principle was developed at the beginning of the last century when, because of increasing

political instability, insurers looked for a safeguard to enable them to meet claims in the event that

reinsurers, for whatever, reason, could not meet their obligations. Apart from these considerations,

the insurer and the reinsurer may be on different sides of the globe and the transfer of monies may

be delayed at a time when the insurer urgently requires such funds.

The clause is a legal requirement in some countries. Many reinsurers strongly resist the inclusion

of this arrangement. Presently this should not be such a great issue with electronic transfer of

funds (ETF) available in most countries.

The clause may make provision for the following:

The proportion of the ceded written premium to be retained by the insurer;

How the reserve is to be calculated and when the amount is to be released to reinsurers. A common method is to withhold 40% of each quarter's premium and release that figure in

the corresponding quarter of the following year;

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Disposal of the reserve on termination of the treaty. It is usually used to pay the reinsurer's proportion of loss settlements, accruing after termination and any balance is

released on expiry of all liability; and

What interest, if any, is payable to the reinsurers on the amount of the reserve withheld.

9.1.12 Loss Reserve Deposit

This is a legal requirement in some countries. The deposit is based upon the estimated amount of

losses outstanding at a given date. Usually the deposit is established and adjusted at the anniversary

date of the treaty, but sometimes it is adjusted in the quarterly accounts.

The loss reserve may be drawn on for settlement of claims. More commonly, settled claims

continue to be debited in accounts and the reserve fund is held intact until it is adjusted in

accordance with treaty conditions.

Interest is usually payable to reinsurers on the amount of the reserve retained. Withholding Loss

Reserves is less common, but where it is practiced the outstanding losses are usually released the

following quarter and the new outstanding losses retained until the next quarter. Unlike the

premium reserve which is retained for a full year and then repaid to reinsurers together with any

accrued interest.

9.1.13 Premium and Loss Portfolios

As treaties are designed to be continuous, premium and loss portfolios are needed to cope with

changes or alterations. Transfer of portfolio can arise in the following circumstances:

Where an insurer requires a new treaty to cover some business already in force at the

inception of the treaty. Alternatively, a new reinsurer of the treaty covers the share of

business of a reinsurer which is withdrawing from the treaty;

In the case of premiums, the amount transferred will be a percentage of the preceding twelve months original premiums. For claims, a percentage of outstanding losses will be

transferred;

There may be an option in the treaty which allows the insurer to terminate the treaty.

This would allow for the withdrawal of portfolios by the insurer from the reinsurers,

allowing the latter to cope with the run-off of business;

The treaty may be on a clean-cut basis under which each individual year of business is calculated independently. Portfolios will operate to close the account at the end of each

year. The clause operates so that the old year will be debited and the new year credited

with exactly the same amounts. These will be agreed percentages of premiums and

outstanding losses;

a treaty may operate on an underwriting year basis designed to close each year after a certain number of years for example, three or five years, have elapsed. The idea is that after

this period the bulk of transactions relevant to an underwriting year should be completed.

Nevertheless, there may still be unexpired liability and outstanding losses. A portfolio will]

transfer these amounts into the next open underwriting year.

Premium portfolios for unexpired liability are a relatively straightforward matter. Loss portfolios

are however a more complicated issue.

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Question

Identify a potential problem in calculating loss portfolios

Answer

Loss portfolios are calculated on the basis of known outstanding losses. There could be big

differences between the amount of outstanding losses and how much they are eventually settled

for.

Where loss portfolios are included, a part of the wording normally allows for adjustment to a

portfolio if an individual loss is settled for an amount materially different from its outstanding or

reserve value.

9.1.14 Currency

A treaty may embrace business written in more than one currency. Usually separate accounts will

be maintained for each currency and settlement will be made in each. Sometimes different

currencies under a treaty are all converted to a single currency for account and settlement purposes.

In this case, the clause must identify the basis upon which conversion calculations are to be made.

Often the rate of exchange used will be that applicable on the date of original transaction in the

insurer's books.

9.1.15 Profit Commission

This clause sets out how profit commission is calculated. This varies, according to, for example,

the type of original business involved and the nature of the treaty. The clause includes a formula

to be used in calculating the profit commission and will also include a statement of the level at

which profit commission is payable.

9.1.16 Sliding Scale Commission

The clause will set out the method of operation including the actual scale which is to be used.

As in all clauses, the key element for either profit or sliding scale commission is clarity of

definition. There is always a danger of misinterpretation unless all the words and phrases used are

clearly defined. Both clauses will need individual tailoring to meet the variations arising from

different types of underlying business.

9.1.17 Loss Participation Clause

This is a form of reverse profit commission. Losses above an agreed amount are redistributed

between insurer and reinsurer to the detriment of the insurer.

The clause must explain the terms in use and set out the levels at which it operates. It must also

provide for the calculation and any limitation of losses and state when the calculations are to be

made.

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9.2 NON-PROPORTIONAL WORDINGS

As with proportional wordings this section deals with main issues and not points of specific detail.

9.2.1 Business Covered and Territorial Scope

These clauses share the same purpose as those in proportional wordings. The vital feature is clear

definition of what business is acceptable in which territories. The wordings must be drafted clearly

so that there can be no scope for misunderstanding and subsequent dispute.

9.2.2 Basis of Cover

This clause sets out in what circumstances a recovery is available to the insurer and the extent of

that recovery. The two necessary factors for a recovery under a non-proportional protection are

that the insurer has sustained a loss covered by the reinsurance and that this loss has exceeded a

previously agreed point: the priority or deductible.

The basis of cover clause will identify:

The amount of the deductible, or percentage for excess of loss ratio covers;

The reinsurers' limit of liability;

The basis on which the reinsurance applies; that is the two points above linked to:

each loss each risk for risk excess of Loss;

each accident for accident or third party excess of loss;

each loss occurrence for catastrophe excess of loss; and

the aggregate each annual period for excess of loss ratio and aggregate excess of loss.

9.2.3 Period of Cover

This clause will identify the dates of cover provided by the reinsurers. There are three different

methods, or bases, on which cover could be provided.

Question

What are the three bases of cover?

Answer

The three bases are:

policies issued or renewed;

losses occurring;

losses discovered or claims made.

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The clause must include the following:

reference to the basis of cover clause and link that with whichever method or bases applies:

the clause may need to be tailor made to cater for the various bases of cover; and

an allowance for run-off business if the reinsurance cover is cancelled or not renewed. Some risks may still have an unexpired portion.

Normally a provision allows for a loss in progress during the actual expiry of the reinsurance to be

fully covered by the expiring reinsurance even though some part of the loss might occur after

expiry date.

Finally, special circumstances, such as insolvency of one of the parties, war between countries of

domicile of the parties or failure to observe the terms of the agreement, may give right to

immediately termination by the other party. The conditions in which this right may be exercised

must be clearly defined.

9.2.4 Business Excluded

Under this clause will be general exclusions such as:

those relating to war and nuclear risks;

exclusions specific to particular classes of business; and

Territories excluded.

In personal accident, professional sports teams are usually excluded because of accumulation and

cost problems when players travel together. In liability insurance, underground mining and

explosives manufacturers' risks are usually excluded because of the high degree of hazard they

present.

9.2.5 Premium

This clause sets out how, when and what premium is to be paid by the Insurer to the reinsurer. If

a flat premium is to be paid for each period of cover, only a simple statement of the amount due

and the date of payment is required.

However, when the premium is to be calculated by applying a previously agreed rate to the

insurer's actual underlying premium for the protected business, the clause will be more complex

and must state the following:

the deposit premium to be paid, whether payable by installments and if so at what intervals:

whether a minimum premium applies to the reinsurance, regardless of the result of the rate calculation:

when the final rate calculation, also known as the premium adjustment, is to be made; and

a clear definition of exactly what element for example, gross or net, of original premiums, is to be used in calculation of the reinsurance premium.

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9.2.6 Ultimate Net Loss

This defines a loss as the sum that an insurer sustains following a claim after necessary adjustments

are made. The intention is that the reinsurer shall only be liable when the amount, probably

including legal costs and settlement expenses, actually paid by the insurer less all recoveries from

underlying reinsurances or other sources, such as subrogation, exceeds the deductible.

9.2.7 Net Retained Lines

This clause endorses that the excess of loss cover relates to a reinsurers net exposure, that is, the

loss after any proportional or facultative recoveries.

The clause stresses that the reinsurance applies only to that portion of any insurance which the

reinsured retains net for its own account. Without this clause, it is conceivable that the insurer

could recover the same loss from more than one reinsurer.

If the excess cover is for the common account of net and proportional reinsurers, the clause will

make allowance for this.

9.2.8 Loss Occurrence

The definition of what constitutes one loss for the purpose of an excess of loss reinsurance will

vary considerably according to the type of reinsurance and the nature of the underlying business.

The clause will state what constitutes an event or occurrence.

For property business, an hours clause will be used. This imposes time and/or geographical limits

on the event or occurrence.

It avoids dispute about, for example, whether a period of severe weather constituted one storm or

not. The insurer is allowed a specific period of time; for example, 72 hours for storm damage. It

does not have to show that its original losses arose from one event, merely that they all occurred

within the 72 consecutive hours allowed.

In Employers' liability insurance, claims can arise from occupational diseases such as asbestosis

or industrial deafness. Such claims are dealt with on the basis that each individual claimant shall

be considered as a separate occurrence or event unless there is a specific identifiable event causing

a number of claims.

Products Liability losses are often dealt with on a batch system. All claims arising from the

manufacture or distribution of one faulty batch or lot of a product are regarded as one occurrence.

Fidelity guarantee losses, which are covered on a discovery basis, can be limited to the acts of one

individual, or more than one if acting in collusion. This means that independent acts of fraud or

dishonesty, though brought to light by the same audit or investigation, would be regarded as

separate losses for reinsurance purposes. However it must be noted that the discovery and sum

insured limits of the underlying policy will still apply.

9.2.9 Index Clause

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The indexing of either the deductible only or both the deductible and the limit of liability is a

feature of excess of loss reinsurances, particularly for liability covers. This is designed to share the

burden of the inflation of claims payments between an insurer and reinsurers.

Without this clause, inflationary increases in long term claims under a non-proportional cover with

a fixed deductible would fall entirely to the reinsurers once the deductible had been excluded.

Some contracts use a Stability Clause, which provides for the same result.

The Stability Index clause is only applicable to non-proportional cover and is usually only for of

bodily injury losses.

9.2.10 Currency

In cases where the original business is underwritten by the insurer in more than one currency,

provision must be made to deal with the situation. If the reinsurance is expressed in one currency

and all transactions are made in that currency, it is sufficient to agree on an equitable basis for

conversion.

If, however treaty limits are expressed in more than one currency, then the wording must provide

for the following:

the conversion of losses in currencies other than named currencies into one of the named currencies;

the allocation of the limit and deductible if the same loss involves payment in more than one of the named currencies.

9.2.11 Currency Fluctuation

This clause covers a situation where the reinsurance expresses the limit and deductible in one

currency, but the original business covered is in a number of currencies.

The clause is designed to preserve the equivalent value of the limit and deductible in other

currencies against a variation in the exchange rate between the other currencies and the currency

used for the reinsurance contract.

9.2.12 Claims Series Clause

This clause is designed to define a claims series event. It relates all claims from the same specific

common cause involving one original insured arising from a product of the same design or

specification. It is an attempt to cope with the problems of defining one event or occurrence in

certain circumstances.

9.2.13 Commutation (The Exchange Of One Kind Of Payment For Another)

If the subject matter covered by the reinsurance includes business which could involve long term

disability awards against the insurer and, consequently, the reinsurer, then this clause may appear.

The wording may provide that an annuity may be arranged to provide for regular payments over a

period of years. The reinsurer is thereby relieved of any further obligation on a commuted claim.

The amount required to purchase the annuity for commutation can be arrived at by negotiation or

by an independent appraiser.

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9.2.14 Acts In Force (Change of Law)

This requires that the agreement, in which it is included, is made subject to the legislation in force

at that time. It is usually applied to reinsurances of employers' liability or COlD Act business. A

change in the law with retrospective effect can have a major impact on reinsurers' liability, without

any change to the insurer's involvement. In liability business, the length of lime needed to settle

claims makes it particularly vulnerable to such changes. The clause allows for a re-negotiation of

terms for the reinsurance in the event of such a change.

“Change Of Law Clause I Acts In Force Clause”

In the event of any change in the law by which the reinsured's or reinsurers' liability hereunder is

materially increased, or extended, the parties hereto agree to take up for immediate discussion, a

suitable revision in the terms of this agreement. In the event of failure to agree upon a suitable

revision, this agreement shall operate from the effective date of the change of law as if the change

had not occurred, or upon its termination the Reinsurers' liability will not be increased or extended

by any change of law affecting this agreement which has not been agreed to by the reinsurers.

9.3 COMMON CLAUSES

The following clauses are common to both proportional and non-proportional wordings:

Arbitration;

Inspection of Records;

Errors and Omissions;

Offset:

Insolvency

Intermediary.

9.3.1 Arbitration

Most wordings contain a provision that disputes which cannot be resolved amicably can be referred

to arbitration without resorting to litigation. There are various forms of wording in use but the

following should always be catered for:

The establishment of the court of arbitration consisting either of a single arbitrator or of three arbitrators, one appointed by each party and the third by the first two;

Provision for the failure of either party to name its arbitrator or of the two arbitrators to agree on the third. An independent body, or its chairmen or secretary, is normally

empowered to nominate the missing member;

The arbitration will be governed by the laws of the country in which it sits, particularly any law governing arbitration, but may usually establish its own procedures as to evidence and

submissions;

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When pronouncing upon the matter in dispute, the arbitrators should make an allocation as to costs; and

The seat of arbitration should be named and this is usually the domicile of the insurer.

The clause may also include provisions as to who is eligible for nomination as an arbitrator, time limits for submission of evidence and handing down of decisions.

9.3.2 Inspection of Records

This allows the reinsurer the right to make an inspection of the books and records of the insurer

where the reinsurer suspects misapplication of the treaty or mishandling of the business ceded. It

is a very serious step to invoke this clause as it implies doubt as to the efficiency and integrity of

the insurer. The clause will only be invoked by a reinsurer which is deeply dissatisfied with the

handling of a treaty. Prior notice must be given and inspection must take place during working

hours.

9.3.3 Errors and Omissions

This clause aims to ensure that neither party to a reinsurance agreement is disadvantaged by any

delay, error or omission of the other party. The intention of this clause is not to allow either part

to avoid its obligations for every mistake. The delay, error or omission must be unintentional, to

distinguish it from any intentional act that might benefit one of the parties. The clause should not

override any specific terms or conditions of the agreement, nor impose any greater liability on

either party than had the error or omission not occurred.

9.3.4 Offset Clause

This clause allows an insurer or reinsurer the right to deduct from any payment due to the other

party, any amounts owed to them by the other party, under the reinsurance. It is a practical

consideration aimed at easing the exchange of remittances between insurer and reinsurers.

Sometimes this is extended to apply to all reinsurance agreements between the two parties.

9.3.5 Insolvency Clause

This clause is usually restricted to the North American market, where it is a legal requirement

imposed by the legislation of most states in the USA. It is intended to ensure that the reinsurer's

liability under the treaty continues undiminished by the insolvency of the insurer. The intention is

to protect original insured’s as far as possible by allowing that some reinsurance monies are

available to meet their claims if their primary insurer fails.

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9.3.6 Intermediary Clause

Many treaties are arranged through reinsurance brokers so this clause defines their role. The broker

is not a party to the contract, but nevertheless fulfils an important role. One aspect of this clause is

that all communications between insurer and reinsurer must be conducted via the intermediary.

Questions

1. List three methods of Cessions.

2. What does Profit Commission mean?

3. What does the Premium Clause say?

4. When is Index Clause applicable?

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SUMMARY

Proportional wordings

Main clauses in proportional treaties:

Business Covered

Territorial Scope

Method of Cession

Commencement of Cessions

Commencement and Termination of Treaty

Business Excluded

Original terms, conditions and rates

Commission

Periodical accounts

Losses: Advice and Settlement

Premium Reserve Deposit

Loss Reserve Deposit

Premium and Loss Portfolios

Currency

Profit Commission

Sliding Scale Commission

Loss Participation Clause

Non – proportional wordings

Main clauses in non proportional treaties:

Business Covered and Territorial Scope

Basis of Cover

Period of Cover

Premium

Business Excluded

Ultimate Net Loss

Net Retained Lines

Loss Occurrence

Index Clause

Currency

Claims Series Clause

Commutation

Acts In Force (Change of Law)

Common Clauses to both proportional and non-proportional treaties

Arbitration;

Inspection of Records;

Errors and Omissions;

Offset:

Insolvency

Intermediary.

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CHAPTER 10

Learning outcomes:

After completion of this chapter, the readers should be able to know:

The buyers and sellers of reinsurance.

The functions of a reinsurance broker.

The components of the London Reinsurance market.

The Ugandan Reinsurance Market

10.0 THE NATURE OF REINSURANCE MARKETS

Risk spreading as promoted by reinsurance, has previously been stated. Many large and complex

risks need to be spread internationally. Many insurers that accept predominantly local insurance

or reinsurance accounts often participate in international reinsurance business.

There is no clear-cut division between local and international reinsurance markets. In some

markets only locally established insurers operate and the business is almost exclusively domestic.

In such markets, inwards foreign reinsurance business might be restricted to the reciprocal

exchange of reinsurance. At the other end of the scale is the London market where the reinsurances

of overseas insurers form a substantial part of the business transacted by both local and foreign

reinsurers which operate there.

Buyers, Sellers and Intermediaries

Two features of reinsurance markets that merit special comment are:

the role that intermediaries or reinsurance brokers, play in the London, New York and other markets: and

the fact that there is no clear separation between buyers and sellers, in that Lloyd's

syndicates, insurance companies and reinsurance companies operate in the market in both

roles.

Before examining the roles of the three parties, their inter-relationships will be considered in each

of the various market situations which can arise, that is:

Lloyd's underwriters as buyers and sellers of reinsurance from and to Lloyd's underwriters;

Lloyd's underwriters as buyers and sellers of reinsurance from and to insurers;

Insurers as buyers and sellers of reinsurance from and to Lloyd's underwriters;

Insurers as buyers and sellers of reinsurance from and to other insurers.

Business can be placed with Lloyd's underwriters only through an approved Lloyd's broker. No

such restriction applies to insurers, with whom such business is placed directly.

(i) Lloyd's underwriters as buyers and sellers of reinsurance

With the growth in many countries of local markets composed exclusively or mainly of locally

incorporated insurers, much of the business now placed in Lloyd's is received as reinsurance.

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The contact between Lloyd's underwriters and the insurer is the Lloyd's broker. A very heavy

burden of responsibility lies on the broker to provide the fullest possible information to the Lloyd's

underwriters.

The importance of the broker's role can be emphasized by the fact that there may be contact

between the seller, which is the Lloyd's underwriter, and the buyer, which is the insurer, throughout

the life of the contract, which may extend over many years. During this period, the Lloyd's

underwriter will built up both considerable knowledge of the buyer's operations in its territory and

confidence in its ability to handle its affairs. Without this, the relationship between the two could

not survive.

Lloyd's underwriters also provide reinsurance cover within their own market; that is, through

Lloyd's brokers. They offer reinsurance to other Lloyd's syndicates. There are advantages to a

syndicate in placing its reinsurance within the Lloyd's market because the percentage of premium

paid does not reduce the total amount of premium which a syndicate is permitted to cede by way

of reinsurance.

Because of the close proximity of Lloyd's underwriters to one another, and the flow of information

within the Lloyd's market, the employment of a broker may seem unnecessary. There are

advantages in using the services of a broker. They will be acquainted with the often complex

arrangements of the London market excess of loss (LMX) market.

Whilst a broker may be directed towards certain markets by a Lloyd's underwriter buying

reinsurance, if the broker is given freedom of action it will seek reinsurance from either insurers

or Lloyd's underwriting syndicates that can provide:

First class security;

The most favourable terms for the cover required; and

The prospect of continuity.

It will also have to consider the need to establish a leader who will meet these criteria and be

supported by other reinsurers of similar status.

(ii) Insurers as buyers and sellers of reinsurance

Direct insurers, acting as buyers or sellers of reinsurance, have the choice of either dealing direct

with the other party or dealing through a broker. Both methods have their advantages and

disadvantages.

Insurers that prefer direct contact with their reinsurer(s) and place their proportional treaties direct

may find it advantageous to obtain the expertise of a broker in arranging reinsurance programmes

and selecting reinsurers for non-proportional covers and those types of reinsurance where it is

necessary to use a substantial part of the worldwide reinsurance capacity. Brokers often act as

technical advisers to insurers and in every case, will present the seller of reinsurance with the facts

it requires regarding the buyer and the business to be reinsured.

Exchanges of treaties between insurers, either on a strict premium parity or profit basis, or on a

straightforward exchange of business basis, is highly developed in the London and overseas

markets. This leads to a very close relationship and often direct contacts between the insurers

involved, even where the exchange is negotiated through a broker. Personal contact between

buyers and sellers of reinsurance is beneficial to this relationship.

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Few insurers participate, in the reinsurance of Lloyd's underwriting syndicates for two reasons:

They find it difficult to accommodate both the generalized nature of the business and the dominance of business emanating from the USA in the portfolio written by the typical

syndicate; and

Insurers who do participate have to rely heavily on the broker to give them a fair spread of

such business, and on the leading underwriter to secure the correct terms and conditions.

(ii) Professional reinsurance companies

The term professional reinsurance company means that it writes only reinsurance business. They

sell reinsurance and obtain a large proportion of their business by direct contact and by establishing

direct relationships with their clients, rather than by dealing through brokers. Recently there has

been an increasing recognition of the role of the broker in obtaining and servicing business.

A reinsurer often employs teams to cover the world, their duties being assigned either according

to specific geographic zones, or perhaps by a common language or branch of business. Their

operations may also be divided between marketing and technical risk appraisal. Relationships with

insurers are often of long duration. Many reinsurance buyers may be reluctant to commit

themselves exclusively to one reinsurer because this may limit their future freedom of action.

There is a trend for insurers in certain markets to seek reciprocity for their outwards reinsurance

portfolio, and this puts professional reinsurers at a disadvantage.

Although a professional reinsurer needs to buy some retrocession cover to protect its portfolio

against accumulations of losses, it does not have the same sort of need for protection as an insurer. Moreover, unlike an insurer writing an inward reinsurance account, a professional reinsurer is

solely dependent upon inwards reinsurance as its source of income. It cannot afford to offer the

same level of reciprocity: 100% premium reciprocity would leave it with a premium income, net

of all reinsurance ceded, of zero.

Professional reinsurers are in a restricted market when seeking to buy reinsurance. They need the

retrocession market. If proportional retrocession cover is arranged, reinsurers often deal direct with

their retrocessionaires. Professional reinsurers rely mainly on excess of loss reinsurance, purchased

through a broker. As this is effectively the reinsurance of last resort, a close and friendly

relationship between the broker, the client and the retrocessionaires is essential.

10.1 BUYERS OF REINSURANCE

All types of organizations that write insurance, and reinsurance business, need to buy reinsurance.

10.1.1 Direct Insurers

Judged in terms of the volume of reinsurance business transacted, direct insurers form the most

important group of reinsurance buyers.

It is a very diverse group, ranging from the very small, newly formed insurer operating in a small

developing country up to the major American and European insurance groups with annual

premiums exceeding US$140 billion obtained from business transacted worldwide.

The total demand that such insurers place on both local and international reinsurance markets is

influenced by certain environmental factors and by those factors which an individual insurer takes

into account when fixing its own retention limit(s), and deciding its reinsurance programme.

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Amongst the latter, factors are:

the class(es) of insurance that the insurer transacts;

the volume of insurance business available to the insurer;

the size of the risk it must be prepared to accept;

the size and spread of its portfolio;

the size of contingency loading it can build into its premiums;

its capital and free reserves;

its corporate objectives;

the supervisory requirements, particularly the solvency regulations to which it must conform; and

the price of reinsurance.

There is a relationship between some of the above factors and the size, structure and practices of

local insurance markets. For example, the amount of reinsurance required for an individual large

risk would be far smaller in a large market (where such risks are spread by means of co-insurance

amongst a Substantial number of insurers) than in a small market composed of only one or two

insurers that alone may be required to provide 100% cover for the risk.

Conditions in insurance and reinsurance markets can also affect the demand for reinsurance by

insurers. Increased competition that forces down premium rates and so the loadings available to

meet claims fluctuations will tend to increase the need for reinsurance. Likewise, keen competition

in reinsurance markets that leads to lower reinsurance premiums will encourage insurers to

purchase more reinsurance.

The converse situation will encourage greater risk retention to reduce reinsurance costs, although

the balance between exposure and retention then becomes a more important factor in the equation.

Solvency regulations are an important factor in insurers' reinsurance purchasing decisions. As a

general rule, the more stringent the regulations, the more insurers will need to purchase.

The need for reinsurance from insurers covers all forms of reinsurance, embracing both facultative

reinsurance and treaties.

10.1.2 Lloyd's Syndicates

Lloyd's syndicates are very sophisticated buyers of reinsurance, not least because of the complex

business they themselves underwrite. A syndicate's account may include, for example, direct

insurances, facultative reinsurance acceptances and participation in top layer and catastrophe

excess of loss treaties from a number of countries. There is, therefore, a need to protect the account

from the risk of accumulations which, to a large degree, may be unknown in extent.

Syndicates are composed of individual underwriting members whose liability for underwriting

debts is sometimes unlimited. Consequently, some underwriting names buy stop loss covers to

limit their potential losses

All the transactions of the syndicates are handled by Lloyd's brokers, and a good proportion of the

reinsurance purchased is placed outside the Lloyd's market with London and foreign insurers

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10.1.3 State Insurers

State-owned insurers have been established in many countries, particularly in developing

countries. Some have a 100% monopoly of all insurance business. Others handle the insurances of

all organizations and enterprises in which their government has an interest but compete with other

insurers for the remaining business.

Some state owned insurers receive no special privileges and have to compete for business like

private insurers. To some degree, the reinsurance needs of state-owned insurers, reflects their

market status.

A monopoly state insurer is usually required to meet all of the country's insurance needs, including

the insurances of such organizations as state air and shipping lines. Consequently, in the smaller

developing countries, they will require very extensive reinsurance facilities to provide the required

underwriting capacity.

Accumulations of liabilities associated with natural hazards are another problem for state insurers.

Although these insurers are often formed to reduce a country's dependence on foreign insurers,

they need to reinsure, in the international markets, a substantial part of the liabilities they

underwrite. Many employ international reinsurance brokers to arrange and place their reinsurance

programmes.

10.1.4 Captive Insurers

Captive insurers, formed by large industrial and commercial companies primarily to write the

insurances of their parent companies and fellow subsidiaries, have become a well established

alternative to traditional commercial insurance.

The number of captives in existence worldwide today is close to 5,000. Of this number,

approximately 3,086 are domiciled in the western hemisphere. In 1998. 48 percent, or 240, of the

Fortune 500® companies had captives, with 73 having more than one; the 240 companies owned

and operated 349 in total.

DOMICILE CAPTIVE NUMBER PERCENTAGE

Bermuda 958 19.3%

Cayman islands 765 15.4%

Vermont 567 11.4%

British Virgin Island 409 8.2%

Luxembourg 262 7.5.3%

Barbados 256 5.2%

Guernsey 368 7.4%

Many captives have been set up in tax-friendly environments, of which the most significant

remains Bermuda. The above abbreviated table shows the position in 2008.

The formation of joint-venture captives by two or more companies and association captives by

members of a trade association, professional body of other groups is now an established practice.

Captives commonly use proportional reinsurance for covers that involve significant claim activity

as it helps provide protection which is especially important if a captive is thinly capitalized.

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Captives also use excess of loss and aggregate excess of loss covers, in the same manner and for

the same purposes as insurers.

10.1.5 Reinsurers

Professional reinsurers and state reinsurance corporations that operate in reinsurance markets as

sellers, also need to purchase reinsurance to protect their own portfolios against liabilities accepted

in excess of their own underwriting capacities.

Both types of organization suffer from the problem of accumulations, both in relation to individual

large risks and accumulations arising from events such as natural disasters. Reinsurers, therefore,

must buy protection, usually in the form of non-proportional reinsurance, against such

accumulation risks.

10.1.6 Reinsurance Pools

Reinsurance pools have been formed on both national and regional bases to handle particular types

of reinsurance.

As pools accept reinsurance from member insurers operating in a particular country or region, they

are usually exposed to an accumulation risk. Although a pool may retrocede back to its participants

some of the liabilities the pool has accepted, it will still usually need to purchase excess of loss

cover from international reinsurance markets to deal with the problems of accumulations.

10.2 SELLERS OF REINSURANCE

These are companies or Lloyd's syndicates who are in the business of accepting reinsurance and

are known as reinsurers, whether they act as leaders, or offer supporting capacity for the account

of reinsurance required by the buyers. The principal types of organizations operating as sellers of

reinsurance are detailed below.

10.2.1 Professional Reinsurance Companies

Many professional reinsurance companies are multinational, operating through branch networks

or subsidiary companies in different countries. Others are located in a single market, but they may

be offered a full international account, either direct by insurers or through brokers. Most of the

companies have formal ownership links with direct insurers, though generally they operate largely

independently of the latter.

Some major insurers have subsidiary companies operating as professional reinsurers, which as part

of their function can oversee both the inwards and outwards reinsurance interests of the parent

company and other members of the group.

The major professional reinsurers write all forms of reinsurance business. They establish direct

links with their clients, but also deal through brokers. Some of the services they can offer clients

include technical assistance in underwriting, claims handling, accounting and also the provision of

training facilities for staff.

10.2.2 Lloyd's Syndicates

Lloyd's are important sellers of reinsurance through the capacity offered by individual syndicates

which rely exclusively on accredited Lloyd's brokers to bring them their business.

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Within this market there are the major syndicates who will quote and lead risks, and the smaller

ones who will offer supporting capacity.

A major share of the premium income of the individual syndicates is obtained from the

underwriting of reinsurance business.

Lloyd's has a long-established reputation as a market for non-proportional reinsurance and other

specialist forms of cover.

10.2.3 Direct Insurers

Throughout the world there are many direct insurance companies that also accept reinsurance

business.

Like the insurers themselves, their scale and methods of operation vary considerably. The

reinsurance activities of some small domestic insurers are confined virtually to reciprocal

exchanges, whereas other local insurers underwrite an international account of facultative

reinsurance and treaty business.

Because of the special knowledge and expertise required to underwrite successfully an inwards

reinsurance account, many small and medium-sized insurers prefer to employ underwriting agents

to manage their inwards reinsurance business.

Normally, insurers acquire most of their reinsurance business through brokers, who can offer the

marketing and other services described in the next section of this chapter.

10.2.4 Underwriting Agencies

During the 1970's and 1980's there was a large increase in the overall capacity of the world

reinsurance market, particularly in London. This was through the formation of underwriting

agencies to underwrite reinsurance.

Because of the high expense, an insurer would incur in setting up an underwriting office and

employing specialist underwriters, there are obvious advantages in joining an underwriting agency.

Moreover, by mobilizing the capacity of other members an agency can accept larger amounts and

so provide worthwhile additional capacity to a particular market.

The costs are shared among members of the agency and the underwriting is left to the discretion

of the appointed underwriter and management team. Very often the managers are paid a profit

commission on the results of the business, so that they have an incentive to do prudent

underwriting.

10.2.5 State Reinsurance Companies

Since the 1950's, the governments of many countries, particularly amongst the developing nations,

formed state reinsurance corporations to provide reinsurance facilities for local insurers.

Generally, state reinsurance corporations seek reciprocal exchanges of business for the reinsurance

they cede to international reinsurers. Some have developed international accounts, having

established branch offices or contact offices in one or more of the international reinsurance

markets.

10.3 REINSURANCE BROKERS

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The reinsurance broker requires two markets, one from which to canvass business and one in which

to place its business. Without these two it has no function.

10.3.1 Functions of a Reinsurance Broker

The reinsurance broker has three primary roles, which are the acquisition, placing and servicing of

business.

(i) Acquisition of business

Business may come to a broker either:

by a direct approach from an insurer who usually deals through a broker, probably because it has a large or complicated reinsurance programme to place;

because the broker developed an idea of a new contract or form of reinsurance which it

successfully sold to its client;

through a personal relationship which has led to the placing of a treaty or a facultative reinsurance:

through a long-standing relationship between an insurer and a broker whom the former considers as having a better overall view of international markets and being better placed

to design and place a reinsurance programme than itself; or

because a broker is able to provide expertise and contacts with markets beyond the scope of an ordinary insurer.

(ii) Placing of business by an international broker situated in London

The business, depending upon its quality, geographical location and type, may be placed:

locally: in London by means of a slip; in Paris and other international markets by means

of a telephone call or by means of a letter;

Overseas: usually this requires a series of e-mails or letters to be sent to potential markets on a fairly impersonal basis, the acceptances and declinature being recorded in the broker's

office; or

Personally: in the case of a particularly important contract the broker will travel details in hand, to its various markets both at home and abroad to place the business.

(iii) Servicing

The broker performs the function of the marketing and production departments of a professional

reinsurance company and so requires as many, if not more, staff to keep abreast of its clients'

demands.

Its functions are to:

advise clients of its current accounting position with its reinsurers;

inform its clients' reinsurers of any large losses which might affect the business between them;

collect claims from a variety of markets and reinsurers, and pay them within the due time and without unnecessary delay, funding them if necessary on behalf of reinsurers;

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pay premiums as soon as collected from insurers to the markets in which it has placed the business;

provide inwards business or reciprocal business for risks shown to a particular reinsurer,

either by means of a strict reciprocity, that is, arranging a fixed volume of business in return

for a fixed value of premium received, or by a loose reciprocity, that is, offering a general

broad account of reinsurance business to an insurer.

The servicing element is the most crucial function of a reinsurance broker. If it is unable to provide

the accounting and financial services required by a client and, if necessary, to fund the payment of

premiums on time to reinsurers, the reinsurance broker could not exist.

10.4 LONDON MARKET

The London market comprises most of the components described previously. The market consists

of life, marine and non-marine business.

10.4.1 The Lloyd's Market

Lloyd's is perhaps the closest approach to a perfectly competitive market, with Lloyd's

underwriters acting as both buyers and sellers of reinsurance.

As sellers of reinsurance, Lloyd's underwriters deal only through authorized Lloyd's brokers upon

whom they have to rely heavily for the information required to underwrite the business they are

offered.

Many underwriters travel abroad to meet their overseas clients and to obtain for themselves details

of local conditions relative to the cover required. Such visits are more prevalent to the USA than elsewhere, reflecting the importance of American business to the Lloyd's market. Similar visits to

European markets are also made.

Information obtained by an underwriter is supplementary to the information provided by an

intermediary, and visits are always carried out in the knowledge and with the approval of the broker

concerned.

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10.4.2 The London Company Market

The market:

is the world's 2nd largest commercial insurer and 6th largest reinsurer:

is the only location where all 20 of the world's largest insurers and reinsurers have offices;

employs 40 000 people in London and another 10 000 elsewhere in the UK;

enjoys a huge concentration of underwriting and broking expertise, capital and support services:

boasted Gross Premiums: £24.3bn in 2006 - almost double the total for 1999:

has seen significant consolidation in the past decade, but there have also many new entrants

since 2001;

is the leading provider of insurance and reinsurance to the US, attracting 20% of outwards reinsurance and 50% of US primary insurance placed abroad;

consists mainly of general (non life) insurance and reinsurance - predominantly high exposure risks.

It also includes:

the reinsurance departments of the major direct insurers which accept inwards reinsurance

business;

Insurers that have appointed underwriting agents to write reinsurance business on their behalf;

the contact offices of other reinsurers and insurers that have not obtained formal authorization to write business in the UK, but forward offers received to their head offices

for acceptance.

Most of the offices of insurers writing reinsurance business are to be found within a relatively

small area of the City of London, in and around the Lloyd's building. The insurers have always

been scattered amongst different buildings, and therefore there has been less contact between

individual underwriters than in the Lloyd's market, although underwriters have various specialist

associations to look after their requirements. The situation is changing with the development of

underwriting centres other than Lloyd's as described below.

10.4.3 The International Underwriting Association Of London (IUA)

It is the world's largest representative organization for international and wholesale insurance and reinsurance companies.

It exists to promote and enhance the business environment for international insurance and

reinsurance companies operating in or through London.

The IUA was formed in 1998, through the merger of the London International Insurance and Reinsurance Market Association (L1RMA) and the Institute of London Underwriters

(ILU).

The history of the ILU in the marine, aviation and transport insurance markets dates back to 1884.

L1RMA evolved from insurance associations established in the 1960s and 1970s to support

non-marine insurance business and reinsurance.

There are 39 Ordinary members representing the vast majority of business written by the London company market.

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It provides affiliate membership for London Market organizations in run-off or providing professional services to Ordinary members

10.4.4 The London Underwriting Centre (LUC)

The company market situation changed with the establishment of the LUC housing some one

hundred or so insurance and reinsurance companies in one location.

After a number of earlier initiatives, a decision was taken among a number of reinsurers within the

London market to establish an underwriting centre to regroup the activities of the company market

in a similar way to those of the Institute of London Underwriters for the marine and aviation

insurance.

Situated in 3 Minster Court, the London Underwriting Centre (LUC) is intended to run in parallel

to the underwriting room at Lloyd's of London. It provides a facility for insurers' underwriters to

meet brokers at a single venue, as Lloyds is only open to Lloyds syndicate underwriters. The LUC

specializes in international insurance and reinsurance, and can be visited by up to 4 000 brokers a

day.

10.4.5 Operation

The London market is offered business emanating worldwide, London, however, plays a particular

role in selling reinsurance protection to certain areas of the world, whilst in other areas more

important roles are played by other markets.

London is the principal external reinsurance market for the vast USA insurance account, and on

that portfolio the leading role is played by Lloyd's syndicates. London's role with regarding

European countries varies considerably depending on the country. It is also the principal

reinsurance market for Japan and plays a predominant role in the developing world.

London based brokers play a particular role because they place their accounts not only in the

London market but also with reinsurers across the world.

Reinsurance is placed in London for all classes of insurance business, and cover is provided on

both a proportional and non-proportional basis. However, in comparison with the other markets,

London plays a predominant role in providing both catastrophe and capacity cover, together with

specialist underwriting skills in particular classes.

The greatest attributes of the London market are generally accepted to be their flexibility and

originality of approach to new forms of cover and new risks. Expertise has developed in both the

underwriting and placement of certain types of business, which has led to the recognition of

specialist lead underwriters and placing brokers.

As London was the first competitive market for marine business, expertise built up and eventually

this transformed into standard conditions of insurance from which underwriters vary conditions to

suit clients.

International brokers have extended their role to include the negotiation of risks in order that the

best price and cover can be obtained. Insurers and reinsurers rely on the brokers for certain

administrative functions, such as the collection of premium and issue of policies. A virtual circle

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of interest formed, thus increasing the power of the London market to attract new business. As

risks became larger and more highly valued, the need for reinsurance and retrocession grew, and

with it the administrative role of the broker expanded.

Networking within both the Lloyd's and the insurance market led to the development of

coordinated administrative practices (see the IUA. This means that the cycle of direct, reinsurance

and retrocession claims has shortened considerably.

The impact on the retrocession market is considerable as the length of time retrocessionaires would

expect to retain money before it is needed to be paid as a claim is greatly reduced. This has resulted

in a fundamental move away from profitability for the retrocession market. The overall impact

could be the reduction of retrocession capacity, but considerable savings in administrative costs

for participating members.

10.5 UGANDA REINSURANCE MARKET

Reinsurance market in Uganda comprise of only one company, Uganda reinsurance company

which is currently licensed by The Insurance Regulatory Authority of Uganda (IRA) under the

insurance Act(_Cap 213) law of Uganda. There are also Regional reinsurance companies such as

Africa Re, PTA Re: Tan Re; and Kenyan Re operating in the country. There are international

reinsurance companies such as Swiss Re; Munich Re; Hannover Re’ and Continental Re operating

in the country.

There is one reinsurance Broker, Guardian Re which is licensed in the country. There are also

regional and international reinsurance brokers doing business in Uganda such as First Re OF

Kenya; J.B. Boda of India and AON Re of South Africa.

Reinsurance business in Uganda is regulated under the Insurance Act Cap 213 Laws of Uganda

and the main requirements are:

(ii) Minimum Paid-up Capital is Ushs. 10 billion.

(iii) Insurance Companies have to place at least:

5% of its reinsurance cession with Africa Re

10% of its reinsurance cession with PTA Re

15% of its reinsurance cession with Uganda Re.

(iv) The IRA has powers to modify terms and conditions of a reinsurance contract where it

finds that the terms are unfavourable to the insurer or in the interest of the economy or the

insurance industry or in the public interest.

(v) No insurance agent, director administrator, employee or shareholder of an insurance

broking company is allowed to negotiate or intervene in the placement of reinsurance in

his or her personal capacity.

(vi) A foreign reinsurance company may, with the approval of IRA appoint a reinsurance

broker or Reinsurance Company licensed under the Insurance Act to be is representative

in Uganda for purposes of accepting reinsurance business on its behalf.

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(vii) The shareholding of Uganda Reinsurance Company and any changes to the shareholding

is approved by the IRA.

(viii) Insurance companies are to first place reinsurance business with Uganda RE; Africa Re

and PTA Re or an insurance company licensed under the Insurance Act, to the maximum

extent possible, before placement of the business outside Uganda.

Questions

1. What is the main restriction on reinsurance placed in the Lloyd’s market?

2. Name three players in the reinsurance market.

3. State two restrictions in the Uganda Insurance Market as provided by the Insurance Act.

4. State three factors which insurers take into account when deciding on their reinsurance

programmes.

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SUMMARY

Buyers of reinsurance

Direct Insurers

Lloyd's Syndicates

State Insurers

Captive Insurers

Reinsurers

Reinsurance Pools

Sellers of reinsurance

Professional Reinsurance Companies

Lloyd's Syndicates

Direct Insurers

Underwriting Agencies

State Reinsurance Companies

Reinsurance brokers

Functions of a Reinsurance Broker:

Acquisition of business

Placing of business by an international broker situated in London

Servicing the reinsurers and their clients

References

1. Reinsurance Management by the Insurance Institute of India, Revised Edition 2013.

2. Reinsurance by the Insurance Institute of South Africa.

3. A Non-Life Manual of the Non-Life Branches by the Swiss Reinsurance Company – 1986.

4. The Insurance Act (Cap 213), Laws of Uganda, 2000.

5. The Reinsurance Market by the Chartered Insurance Institute – 1991.

6. Principles of Reinsurance by the Chartered Insurance Institute - 1991.