Insurance is all about risk management
and limiting loss. So how do insurance
companies limit the risk within their own businesses? The answer is reinsurance —
insurance for insurance companies.
“Policyholders transfer their financial
risk to their insurance company,” says Tom
Hudock, risk manager with Westfield Insurance. “The company retains some of
that risk and transfers, or cedes, the remainder to other insurance companies
called reinsurers. Reinsurance is primarily
insurance for an insurance company. Large
self-insured businesses can also purchase
reinsurance to reduce their risk.”
Smart Business discussed with Hudock
the purpose and the impact of reinsurance
in the insurance industry.
Why do insurance companies purchase rein-surance?
When an insurance company issues a policy, it promises to pay for future claims that
may occur. In order to deliver on these
promises, an insurer must remain financially sound. Reinsurance preserves policy-holders’ surplus (retained earnings).
There are three main reasons why insurance companies purchase reinsurance:
capacity, stability and catastrophe protection.
- Periodically, an insurer will purchase
reinsurance on a single large risk, e.g. a $50
million building. This is called facultative
reinsurance. It provides the insurer with
the capacity to insure a risk that might otherwise be declined. - Treaty reinsurance is another type of
reinsurance that insurance companies buy
to stabilize their underwriting results for
their portfolio of risks. Loss experience
varies from year to year, and reinsurance
helps smooth earnings. - Insurance companies are exposed to
very large losses from catastrophes, like
hurricanes and earthquakes, which could
result in bankruptcy. To protect its policy-holders’ surplus, an insurer will purchase
catastrophe reinsurance that limits its loss from a single event to a predetermined
amount.
How does reinsurance work?
The insurance company provides the
reinsurer with loss exposure data, claims
experience and the amount of risk that the
insurer wishes to retain. The reinsurer then
determines the reinsurance premium. A
portion of the premium that is collected
from the policyholder is ceded to the rein-surer in payment for the risk assumed by
the reinsurer.
For example, the insurer may retain the
first $1 million of loss and the reinsurer(s)
may agree to pay the next $4 million. If a
policyholder were to incur a $5 million
loss, the insurer would pay its policyholder
$5 million, and then be reimbursed $4 million by the reinsurer.
How does reinsurance affect business insurance policyholders?
Depending upon the size, location and
type of risk to be insured, a business may
have difficulty finding affordable insurance
due to the availability and/or the cost of
reinsurance. Smaller insurance companies
depend more on reinsurance than the large national insurance companies. In some
cases, even the largest insurer may not be
willing to offer insurance due to the lack of
reinsurance.
For example, a business occupying the
Sears Tower in Chicago may not be able to
buy terrorism insurance because reinsurance for a terrorist event is not available.
How is reinsurance related to industry
cycles?
The reinsurance industry also goes
through hard and soft markets. In the two
years following the World Trade Center
attacks in 2001, total losses — including
from hurricanes and other long-tail liabilities — exceeded $50 billion, and capital
losses from the global fall in equity values
exceeded $180 billion. This created a hard
market for reinsurance in which demand
for reinsurance exceeded supply, causing
premiums to rise. This contributed to the
hardening of the primary insurance market.
Due to the increase in reinsurance rates,
and because 2006 was a very profitable
year for reinsurers due to a mild hurricane
season, there are signs that the reinsurance
market may be softening. This will ease
pressure on primary insurers’ pricing.
What else should businesses know about
reinsurance and industry cycles?
Most reinsurers write business worldwide, while most U.S. insurers only write
business in the United States. The U.S.
insurance and reinsurance cycles are
linked together but do not move perfectly
in sync. Softness in reinsurance pricing
contributes to the depth and length of the
soft market for primary insurers. Usually,
the market does not begin to harden until
reinsurer pricing rises.
TOM HUDOCK, CPCU, ARM, ARe, risk manager, can be reached
at (330) 887-0654 or [email protected]. In business
for more than 159 years, Westfield Insurance provides commercial and personal insurance services to customers in 17 states.
Represented by leading independent insurance agencies, the
product we offer is peace of mind and our promise of protection
is supported by a commitment to service excellence. For more
information, visit www.westfieldinsurance.com.