7.3: Insurance Operations- Reinsurance, Legal and Regulatory Issues, Claims, and Management
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In this section we elaborate on the following:
- How reinsurance works and the protection it provides
- Contract arrangements in reinsurance transactions and methods of coverage
- The benefits of reinsurance
- The general legal aspects of insurance
- The claims adjustment process and the role of the claims adjuster
- The management function
Reinsurance
Reinsurance is an arrangement by which an insurance company transfers all or a portion of its risk under a contract (or contracts) of insurance to another company. The company transferring risk in a reinsurance arrangement is called the ceding insurer. The company taking over the risk in a reinsurance arrangement is the assuming reinsurer. In effect, the insurance company that issued the policies is seeking protection from another insurer, the assuming reinsurer. Typically, the reinsurer assumes responsibility for part of the losses under an insurance contract; however, in some instances, the reinsurer assumes full responsibility for the original insurance contract. As with insurance, reinsurance involves risk transfer, risk distribution, risk diversification across more insurance companies, and coverage against insurance risk. Risk diversification is the spreading of the risk to other insurers to reduce the exposure of the primary insurer, the one that deals with the final consumer.
How Reinsurance Works
Reinsurance may be divided into three types: (1) treaty, (2) facultative, and (3) a combination of these two. Each of these types may be further classified as proportional or nonproportional. The original or primary insurer (the ceding company) may have a treaty with a reinsurer. Under a treaty arrangement, the original insurer is obligated to automatically reinsure any new underlying insurance contract that meets the terms of a prearranged treaty, and the reinsurer is obligated to accept certain responsibilities for the specified insurance. Thus, the reinsurance coverage is provided automatically for many policies. In a facultative arrangement, both the primary insurer and the reinsurer retain full decision-making powers with respect to each insurance contract. As each insurance contract is issued, the primary insurer decides whether or not to seek reinsurance, and the reinsurer retains the flexibility to accept or reject each application for reinsurance on a case-by-case basis. The combination approach may require the primary insurer to offer to reinsure specified contracts (like the treaty approach) while leaving the reinsurer free to decide whether to accept or reject reinsurance on each contract (like the facultative approach). Alternatively, the combination approach can give the option to the primary insurer and automatically require acceptance by the reinsurer on all contracts offered for reinsurance. In any event, a contract between the ceding company and the reinsurer spells out the agreement between the two parties.
When the reinsurance agreement calls for proportional (pro rata) reinsurance, the reinsurer assumes a prespecified percentage of both premiums and losses. Expenses are also shared in accord with this prespecified percentage. Because the ceding company has incurred operating expenses associated with the marketing, evaluation, and delivery of coverage, the reinsurer often pays a fee called a ceding commission to the original insurer. Such a commission may make reinsurance profitable to the ceding company, in addition to offering protection against catastrophe and improved predictability.
Nonproportional reinsurance obligates the reinsurer to pay losses when they exceed a designated threshold. Excess-loss reinsurance, for instance, requires the reinsurer to accept amounts of insurance that exceed the ceding insurer’s retention limit. As an example, a small insurer might reinsure all property insurance above $25,000 per contract. The excess policy could be written per contract or per occurrence. Both proportional and nonproportional reinsurance may be either treaty or facultative. The excess-loss arrangement is depicted in Table 7.9. A proportional agreement is shown in Table 7.10.
In addition to specifying the situations under which a reinsurer has financial responsibility, the reinsurance agreement places a limit on the amount of reinsurance the reinsurer must accept. For example, the SSS Reinsurance Company may limit its liability per contract to four times the ceding insurer’s retention limit, which in this case would yield total coverage of $125,000 ($25,000 retention plus $100,000 in reinsurance on any one property). When the ceding company issues a policy for an amount that exceeds the sum of its retention limit and SSS’s reinsurance limit, it would still need another reinsurer, perhaps TTT Reinsurance Company, to accept a second layer of reinsurance.
| Original Policy Limit of $200,000 Layered as Multiples of Primary Retention | |
|---|---|
| $75,000 | Second reinsurer’s coverage (equal to the remainder of the $200,000 contract) |
| 100,000 | First reinsurer’s limit (four times the retention) |
| 25,000 | Original insurer’s retention |
| Total Exposure | Premium | Expenses | Net Premium* | Loss | |
|---|---|---|---|---|---|
| Reinsurer | 70% | 7,000 | 1,400 | 5,600 | 105,000 |
| Ceding Insurer | 30% | 3,000 | 600 | 2,400 | 45,000 |
| Total | 100 | 10,00 | 2,000 | 8,000 | 150,000 |
| * Net premium = Premium–Expenses | |||||
Assume 30–70 split, premiums of $10,000, expense of $2,000, and a loss of $150,000. Ignore any ceding commission.
Benefits of Reinsurance
A ceding company (the primary insurer) uses reinsurance mainly to protect itself against losses in individual cases beyond a specified sum (i.e., its retention limit), but competition and the demands of its sales force may require issuance of policies of greater amounts. A company that issued policies no larger than its retention would severely limit its opportunities in the market. Many insureds do not want to place their insurance with several companies, preferring to have one policy with one company for each loss exposure. Furthermore, agents find it inconvenient to place multiple policies every time they insure a large risk.
In addition to its concern with individual cases, a primary insurer must protect itself from catastrophic losses of a particular type (such as a windstorm), in a particular area (such as a city or a block in a city), or during a specified period of operations (such as a calendar year). An aggregate reinsurance policy can be purchased for coverage against potentially catastrophic situations faced by the primary insurer. Sometimes they are considered excess policies, as described above, when the excess retention is per occurrence. An example of how an excess-per-occurrence policy works can be seen from the damage caused by Hurricane Andrew in 1992. Insurers who sell property insurance in hurricane-prone areas probably choose to reinsure their exposures not just on a property-by-property basis but also above some chosen level for any specific event. Andrew was considered one event and caused billions of dollars of damage in Florida alone. A Florida insurer may have set limits, perhaps $100 million, for its own exposure to a given hurricane. For its insurance in force above $100 million, the insurer can purchase excess or aggregate reinsurance.
Other benefits of reinsurance can be derived when a company offering a particular line of insurance for the first time wants to protect itself from excessive losses and also take advantage of the reinsurer’s knowledge concerning the proper rates to be charged and underwriting practices to be followed. In other cases, a rapidly expanding company may have to shift some of its liabilities to a reinsurer to avoid impairing its capital. Reinsurance often also increases the amount of insurance the underlying insurer can sell. This is referred to as increasing capacity.
Reinsurance is significant to the buyer of insurance for a number of reasons. First, reinsurance increases the financial stability of insurers by spreading risk. This increases the likelihood that the original insurer will be able to pay its claims. Second, reinsurance facilitates placing large or unusual exposures with one company, thus reducing the time spent seeking insurance and eliminating the need for numerous policies to cover one exposure. This reduces transaction costs for both buyer and seller. Third, reinsurance helps small insurance companies stay in business, thus increasing competition in the industry. Without reinsurance, small companies would find it much more difficult to compete with larger ones.
Individual policyholders, however, rarely know about any reinsurance that may apply to their coverage. Even for those who are aware of the reinsurance, whether it is on a business or an individual contract, most insurance policies prohibit direct access from the original insured to the reinsurer. The prohibition exists because the reinsurance agreement is a separate contract from the primary (original) insurance contract, and thus the original insured is not a party to the reinsurance. Because reinsurance is part of the global insurance industry, globalization is also at center stage.
Legal and Regulatory Issues
In reality, the only tangible product we receive from the insurance company when we transfer the risk and pay the premium is a legal contract in the form of a policy. Thus, the nature of insurance is very legal. The wordings of the contracts are regularly challenged. Consequently, law pervades insurance industry operations. Lawyers help draft insurance contracts, interpret contract provisions when claims are presented, defend the insurer in lawsuits, communicate with legislators and regulators, and help with various other aspects of operating an insurance business.
Claims Adjusting
Claims adjusting is the process of paying insureds after they sustain losses. The claims adjuster is the person who represents the insurer when the policyholder presents a claim for payment. Relatively small property losses, up to $500 or so, may be adjusted by the sales agent. Larger claims will be handled by either a company adjuster, an employee of the insurer who handles claims, or an independent adjuster. The independent adjuster is an employee of an adjusting firm that works for several different insurers and receives a fee for each claim handled.
A claims adjuster’s job includes (1) investigating the circumstances surrounding a loss, (2) determining whether the loss is covered or excluded under the terms of the contract, (3) deciding how much should be paid if the loss is covered, (4) paying valid claims promptly, and (5) resisting invalid claims. The varying situations give the claims adjuster opportunities to use her or his knowledge of insurance contracts, investigative abilities, knowledge of the law, negotiation skills, and tactful communication. Most of the adjuster’s work is done outside the office or at a drive-in automobile claims facility. Satisfactory settlement of claims is the ultimate test of an insurance company’s value to its insureds and to society. Like underwriting, claims adjusting requires substantial knowledge of insurance.
Claim Practices
It is unreasonable to expect an insurer to be overly generous in paying claims or to honor claims that should not be paid at all, but it is advisable to avoid a company that makes a practice of resisting reasonable claims. This may signal financial trouble. Information is available about insurers’ claims practices. Each state’s insurance department compiles complaints data. An insurer that has more than an average level of complaints is best avoided.
Management
As in other organizations, an insurer needs competent managers to plan, organize, direct, control, and lead. The insurance management team functions best when it knows the nature of insurance and the environment in which insurers conduct business. Although some top management people are hired without backgrounds in the insurance business, the typical top management team for an insurer consists of people who learned about the business by working in one or more functional areas of insurance. If you choose an insurance career, you will probably begin in one of the functional areas discussed above.
Key Takeaways
In this section you studied the following:
- Reinsurance acts as insurance for insurance companies, assuming responsibility for part of the losses of a ceding insurer by contract.
- Reinsurance may be treaty, facultative, or a combination arrangement.
- Treaty and facultative reinsurance arrangements may be proportional or nonproportional.
- Benefits of reinsurance include protection against excess losses and catastrophe for the ceding insurer, opening new business opportunities through increased capacity, financial stability from spreading risk, greater efficiencies for agents by allowing large risks to be placed with a single company, and increased competition by helping smaller companies remain in business.
- The nature of insurance is very legal, requiring lawyers to draft and interpret policies.
- Claims adjustment and management demand specialists with a great deal of knowledge about the insurance industry.
Discussion Questions
- Distinguish among the different types of reinsurance and give an example of each.
- What are the advantages of reinsuring?
- Explain the differences between company adjusters and independent adjusters. Given the choice, who would you prefer to deal with in managing your claim? Why?