Reinsurance and other forms of risk transfer: background
From both an economic and a legal point of view reinsurance is little different from direct insurance. It is the insurance of insurance companies and shares with primary insurance the legal and economic basis outline in GIM1010 onwards. There is, though, a lot of associated jargon which is identified here in bold. In simple terms, reinsurance companies are wholesalers to the primary or direct retailer insurance company.
The transferring insurer is known as the cedant or reinsured and the insurer accepting the risk as the reinsurer or ceding insurer. If a reinsurer in turn transfers or shares risks the transaction is retrocession, to retrocede meaning to reinsure further a reinsured insurance risk. The accepting reinsurer is the retrocessionnaire. In general, a company that acts as a reinsurer in a particular transaction may also act as direct insurer in other transactions, but some companies only carry on reinsurance business. Such a company is known as a pure reinsurer.
The fundamental aim of insurance, to spread the risk using the law of large numbers (see GIM1140) so that no single entity finds itself with a liability beyond its capacity, is enhanced by the ability to reinsure. Reinsurers may also bring additional skills and potential diversification benefits.
Reinsurance as a method of reducing risk is traceable back at least to the fourteenth century. The purposes may be summarised as
- limiting liability on specific risks, allowing the direct insurer to take on a larger risk or a greater range of risks
- stabilising a business prone to large swings in loss experience
- protecting against catastrophic losses
- increasing the direct insurer’s capacity, without the need for further capital.
The international market today is dominated by Germany and Switzerland. In 2008 the five largest reinsurers were Munich Re, Swiss Re, Berkshire Hathaway/General Re, Hannover Re and Lloyd’s. The Lloyd’s market remains a major reinsurer, particularly of more esoteric risks, and underwrites a substantial share of overseas business. Lloyd’s attracts a lot of business to the London market as a whole, but the total premium income of Lloyd’s syndicates is only equivalent to that of one of the major corporate insurers. Munich Re is about three times the size of Lloyd’s, by reference to reinsurance premiums.
In line with general insurance theory, the insured must have an insurable interest. There is normally no privity of contract. This means that the insured, not having entered into any contractual relationship with the reinsurer, has no rights against the reinsurer in the event of the default of the direct insurer. This can cause difficulties when the direct insurer is insolvent. Some commentators on the insurance industry have advocated the development of co-insurance, where the direct risk is shared among a number of insurers, and the creation of market mechanisms to facilitate this. In a number of specialist areas, for example nuclear risks, the writing of policies by a pool of insurers has been common practice for many years, both in the UK and elsewhere. Lloyd’s operates as a subscription market, so that risks are typically spread among its members.
For regulatory return purposes facultative reinsurance is not treated as a separate accounting class, although treaty reinsurance is. These terms are explained at GIM8020. In some other countries reinsurance has been regarded as a separate type of business entirely, particularly in those countries which have historically employed detailed supervision of policy terms and premium rates. On the footing that insurers are big enough to look after themselves reinsurers were subject to little or no regulation at all in some Member States of the Community, and pure reinsurers were formerly not subject to EC insurance legislation. However, Directive 2005/68/EC was adopted by the Council of the EU on 17 October 2005 and came into force on 10 December 2005. Member States were given until 10 December 2007 to implement the Directive into their own legislation. A series of statutory instruments came into force on 19 December 2007, notably The Reinsurance Directive Regulations SI2007/3253. These apply only to pure reinsurers, including captives. Key provisions are authorisation and financial supervision by the Home State (as with direct insurers), mutual recognition across Member States (including EEA), abolition of collateral requirements (sometimes required if there is inadequate supervision) and harmonised minimum standards.
Although some insurers write only direct business, many write both direct business and reinsurance. The proportion of reinsurance to direct business is a crucial factor when examining the level of claims provisions, because reinsurance claims tend to be reported later, thus increasing the proportion of IBNR (incurred but not reported) claims. In addition the tail is generally much longer for reinsurance business, particularly in the case of non-proportional reinsurance, which makes the calculation of provisions more uncertain.