Reinsurance is insurance that is purchased by an insurance company (insurer also sometimes called a "cedant" or "cedent") from another insurance company (reinsurer) as a means of risk management. The reinsurer and the insurer enter into a reinsurance agreement which details the conditions upon which the reinsurerwould pay the insurer's losses (in terms of excess of loss or proportional to loss). The reinsurer is paid a reinsurance premium by the insurer, and the insurer issues insurance policies to its own policyholders. The main reason for insurers to buy reinsurance is to transfer risk from the insurer to the reinsurer, but reinsurance has various other functions as explained below.
For example, assume an insurer sells one thousand policies, each with a $1 million policy limit. Theoretically, the insurer could lose $1 million on each policy – totaling up to $1 billion. It may be better to pass some risk to a reinsurance company (reinsurer) as this will reduce the insurer's exposure to risk.
There are two basic methods of reinsurance:
- Facultative Reinsurance In facultative reinsurance, the ceding company cedes and the reinsurer assumes all or part of the risk assumed by a particular specified insurance policy. Facultative reinsurance is negotiated separately for each insurance contract that is reinsured. Facultative reinsurance normally is purchased by ceding companies for individual risks not covered by their reinsurance treaties, for amounts in excess of the monetary limits of their reinsurance treaties and for unusual risks. Underwriting expenses and, in particular, personnel costs, are higher relative to premiums written on facultative business because each risk is individually underwritten and administered. The ability to separately evaluate each risk reinsured, however, increases the probability that the underwriter can price the contract to more accurately reflect the risks involved.
- Treaty Reinsurance is a method of reinsurance in which the insurer and the reinsurer formulate and execute a reinsurance contract. The reinsurer then covers all the insurance policies coming within the scope of that contract. The reinsurance contract may oblige the reinsurer to accept reinsurance of all contracts within the scope (known as "obligatory" reinsurance), or it may require the insurer to give the reinsurer the option to reinsure each such contract (known as "facultative-obligatory" or "fac oblig" reinsurance).
There are two basic methods of treaty reinsurance:
- Quota Share Treaty Reinsurance, and
- Excess of Loss Treaty Reinsurance.
- In the past 30 years there has been a major shift from Quota Share to Excess of Loss in the property and casualty fields.
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