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Managing your risk by Michael Kelly

NCACC Risk Management Director Michael Kelly writes a regular column on risk management for CountyLines. With more than 41 years of risk management/ insurance experience, he holds the CPCU - Chartered Property & Casualty Underwriter, ARM-P - Associate in Risk Management for Public Entities, CRM - Certified Risk Manager, ARe - Associate in Reinsurance and CIC - Certified Insurance Counselor Professional Designations. He can be reached at michael.kelly@ncacc.org or (919) 719-1124.  For archives of this column click here.

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Feb 26

Reinsurance: Insurance for the Insurance Companies

Posted on February 26, 2013 at 1:49 PM by Chris Baucom

One of the terms thrown around in the business of risk management is “Reinsurance.” This is a virtual necessity for commercial carriers and for clients the size and makeup of county governments.  Without its existence, it would be exceedingly difficult if not impossible to procure insurance coverage on any large scale.  So what is reinsurance exactly, and how is it important to you as a Risk Manager for your County?

Reinsurance in simple terms is insurance for the insurance companies and comes into play in virtually all county risk management programs.  More specifically, it is a contractual agreement that transfers a portion of an insured loss from policies written by one insurance company to another insurer. This first company is the primary insurer (also known as the “Cedant”) and the carrier that assumes some or all of the potential costs of an insured loss from the primary insurer is the “Reinsurer.”   The principal function of a reinsurance program is to reduce the primary insurer’s exposure to loss by passing part of the risk of loss to a reinsurer or a group of reinsurers.  It is another method to accomplish the systemized spread of risk.

The ability for a primary insurer to transfer a portion of any covered loss to a reinsurer becomes an important component in the annual coverage availability and cost at the county level for their insurance. By moving a portion of the primary insurance company’s exposure of loss to another, it allows a larger spread of assumed risk and essentially introduces additional financial leveraging.  It keeps the primary insurer from assuming too much risk at a single location or for a single insured. 

An example would be insuring coastal properties that the standard insurance carriers generally consider more subject to damage from hurricanes than properties located far inland.  Here, primary insurers rely on their ability to transfer some of their risk to a reinsurer in order to have enough financial capacity to provide coverage for a high concentration of property values that are located in a small, geographical area. Absent the ability to buy reinsurance, such high concentrations of property values in a relatively small area greatly diminishes a carrier’s desire and financial ability to insure an account that could be completely devastated by a single event, such as with a hurricane. 

The reality is there would be little or no insurance market for property located in the first and perhaps second tier of counties in a potential storm zone without reinsurance.  Even with the additional leverage of reinsurance, standard insurance carriers utilize large per building windstorm deductibles ranging from a minimum of 2 – 5% per building location per loss event.

Employing reinsurance allows primary insurers to likely increase the creation of a more balanced, heterogeneous (diversified) portfolio class of risk, as the overall risk is shared among all the reinsurers in varying levels of coverage participation.  This is another way of saying their goal is spreading their storage of eggs (exposures to loss from a single event) among many baskets instead of just one.

With the goal of not getting too far into the weeds, there are two general types of reinsurance contract arrangements.  The first is “Facultative Reinsurance” and the second is “Treaty Reinsurance.”  Facultative reinsurance is typically negotiated and purchased on a case by case basis for each insurance contract that is reinsured. As such the cost for underwriting and administration carries typically a higher rate than the same risk if included under a treaty reinsurance program.  

Treaty reinsurance is a type of “upfront” agreement that obligates the reinsurer to provide reinsurance for any and all agreed classes of business that are written by the primary insurance company.  As long as they meet the scope of type of account in the reinsurance contract, reinsurance is automatically available and is not typically subject to negotiation from the reinsurer.  

Today there are approximately 350 reinsurance carriers in the insurance market globally, and for 2011 the top 10 commercial reinsurance carriers with their size expressed in Millions of Gross Written Premiums were: (see chart at top of page) 1 

 2011 Gross Written Premiums Millions of US Dollars
 Munich Re
 Swiss Re
 Hannover Re
 Berkshire Hathaway / General Re
 Lloyd's of London
 Reinsurance Group of America
 China Reinsurance Group
 Korean Reinsurance Company

It is important to note reinsurance is often placed with more than one reinsurance carrier and shared among a group of reinsurance companies. The reinsurer who sets the premium and coverage detail terms for the reinsurance contract is called the lead reinsurer; the other companies participating in the reinsurance contract are called following reinsurers. This multi-level participation is often expressed as layering with different carriers accepting the risk of loss participation at different levels of attachment responsibility.  

For a much-simplified example, a primary insurer (Standard Insurance Co “A”) might issue a property insurance policy that affords $100,000,000 of coverage for a county.  The lead reinsurer might agree to provide reinsurance coverage for all single property losses that are higher than $1,000,000 up to a total loss of $10,000,000.  Then the first following reinsurer agrees to be responsible for all losses above $10,000,000 up to $35,000,000.  The second following reinsurer then agrees to be responsible for all losses above $35,000,000 picking up the last $65,000,000, for a total of $100,000,000 of property coverage. (see chart below)

$65,000,000 Second Following Reinsurer
$25,000,000 First Following Reinsurer
$9,000,000 Lead Reinsurer
$1,000,000 Standard Insurance Co “A”
$100,000,000 Total Property Coverage Limit

Now given a loss scenario that stems from a fire that totals a county courthouse and its administrative offices at a replacement reconstruction cost value of $14.5 million, Standard Insurance Co “A” will issue the county a check for the total insured amount. Behind the scenes, they will be reimbursed from all reinsurers participating in the loss. As illustrated above, the first $9 million in excess of $1 million will be reimbursed by the lead reinsurer, and the next $4.5 million above that from the first following reinsurer.  The point being that even though there is a total of $14.5 million of insurance applicable to this single building location, Standard Insurance Co “A” only has the first $1 million at true, financial risk.  By using reinsurance, Standard Co “A” can provide much larger limits of coverage than they would be willing to assume themselves for a single loss event.  

The cost for reinsurance decreases as the level at which the responsibility for responding increases. This makes sense in that the chance for participating in a loss is highest at the lower or first level of reinsurance provided by the Lead Reinsurer.  In our example above, the last following reinsurer affording the top $65,000,000 of coverage was not affected or required to respond financially at all, since the total was not large enough to get into their layer of responsibility. 

So why does all of this matter to you as the risk manager for your county? As in most cases, knowledge is power.  Understanding the mechanics behind your insurance coverage, its financial leverage and genetic makeup is never a bad thing.  Through a deeper understanding of how your program is put together, it will enable a clearer picture and greater understanding of what kind of parts are in your Rolex Watch – or Timex, depending on your choice in a carrier. 

1 "Top 50 Reinsurers Revealed"  Insurance Networking News. Retrieved 01/04/2013.