Insurance is a process where one (the insured) pays a monetary amount (premium) to another entity (insurance company) in exchange for protection from an uncertain event (the risk). It is a contract of indemnity between two entities, whereby the insurance company agrees to reinstate the insured or its business to the level it upheld when the damage/loss occurred. (A person will not be able to get life insurance coverage for an amount of $1 million if his financial worth is $50,000.)
The terms of agreement between the insurance company and the insured (the policy) define several clauses that identify:
· The original insured and beneficiary in case the event occurs. (For example you would be the original insured and would name your spouse as the beneficiary of a life policy).
· The risk being insured against (For example damage to yourself, damage to your motor vehicle)
· The inclusions of what the insurance company will pay for. (For example in case of a motor vehicle insurance, this cover could include bodily injury to yourself or others, the physical damage caused to your vehicle, car rental while the car is being fixed, etc.)
· The exclusions from the cover, if any. (For example, the policy could exclude drivers under 21 years old).
· The monetary deductible, a percentage franchise, or a co-payment, if any. (An amount that the insured will co-pay in case the policy is activated and for each event or occurrence)
· The sum at risk (This is the maximum amount that the insurance company will be liable for in case of damage. It could be a sum insured or a limit pre-agreed on). In some rare cases, policies could have unlimited liability by law, such as Motor Third Party Insurance (Bodily Injury claims).
· The period of coverage/policy
· The geographical location being covered.
· Others terms and conditions.
Many other terms and conditions are usually associated with a policy depending on the “Line of Business” involved, or the “Branch of Insurance”. The type of insurance sought defines the main type of expertise needed in analyzing and underwriting the policy. The insurance can be purchased for personal use (Personal lines) or for commercial reasons (Commercial lines). The main branches of insurance include Motor, Medical, Fire, Engineering, Personal Accident, Liabilities, Aviation, Life, Cargo(Inland and Marine), Marine Hull, Non-Marine Energy, and Marine Energy. Branches of insurance could also be pooled under an umbrella insurance that would combine all covers needed for a certain business.
Each branch of insurance contains specific coverage against damage and these are sometimes divided into sub-limits. This limit identifies the liability of an insurance company should an event occur by the defined stated cause; thus it places a limitation on the amount of compensation for a given coverage. For instance, a fire policy could cover the building and contents of a certain venue for an amount of USD1,000,000. On the other hand, it could be stipulated in the fire policy that if the damage of fire is caused by lighting, then the limit of coverage would be USD100,000. This same contract could cover other lines of business, such as business interruption in case of a fire; which essentially means that the business owner will be compensated for the salaries and costs that the business will need to upkeep while getting the fire damage fixed.
The total premium paid by the insured for a certain policy is based on the summation of the rate per cover/sub-limit multiplied by the sum at risk. Many insurance companies might also charge fees or taxes.
Above diagram illustrates a typical process for the issuance of an insurance policy
The rate charged by insurance companies for a given branch and sub-limit is based on many factors. The most elastic of which is competition among insurance companies. Some of the factors include:
· Governmental policies and laws.
· The insurance company’s historical experience in a given branch.
· The experience with a specific client and overall performance in other branches.
· The overall market conditions.
· The geographical area being covered.
· The competitiveness of the market conditions.
Many insurance companies rely on actuarial services to define the rates and expected losses by using probability models, historical performance, and expected events. But at the end of the day, as long as the branch of insurance is profitable for the company, the real driving force is dictated by the competition and governmental regulations.
The government could play a positive role in the industry by implementing regulations that would insure fair profits for the insurance companies and adequate protection for the insured. For example, in a society where everyone is trying to obtain a license for an insurance company which will provide an unhealthy environment for the insured (as driving the price down to a level where you will see insurance companies going bankrupt or shutting down leading to unpaid claims) the government should be strict on the requirement of licenses. The governments and regulatory bodies have many tools that can be put in place to properly monitor and control this social sector.
The concept of insurance is admirable; it is a way of spreading the risk from an individual and or company to a group against probable events. The theory is that individuals and companies pay premium to cover an event that no one company and or individual by themselves can afford to lose without jeopardizing their operational risk. Another bases for this theory is the event will only effect a small portion of the group. So basically the insurance company collects the premium from this group, invest it as wisely as possible (low risk investments such as government bonds), and in the event of someone in the group experiences a covered incident, the company uses part of the premium collected to cover the losses incurred. In theory, this is great; in practice this is not always the case. For sure healthy markets should always adapt to achieve such a model. This can be achieved by adapting the rates, increasing and diversification of their portfolio, as well as adapting there reserves to name a few.
One of the main tools that almost if not all insurance companies have reduce the financial impact the losses of the many will have on its portfolio is to transfer the risk through reinsurance.
Similar to what an insurance company provides to the insured, reinsurance companies provide protection to insurance companies (the cedant) against events that might disrupt proper operations of the insurance company towards the insured. Basically reinsurance companies insure insurance companies. The term cedant is commonly used due to the fact that the insurance company cede part of the risk to another entity (in most cases a reinsurance company).
Risk transfer can take place on per policy basis (facultative) or as a transfer of a bulk of policies through one contract (treaty). The process involves a negotiation phase between the insurance company and reinsurance companies.
In facultative transfer, the reinsurance company receives full information on the risk being insured with details of the rates and commissioning structure. Negotiations on the terms (for example commissions, covers, and rates) could take place with a final accepted share by the reinsurance company. Under this form of placement, the reinsurance company would receive all the details and incidents that arise from this policy (for example outstanding claims). Any changes to the policy (Endorsements) need to be promptly informed to the reinsurer and some require approval by the reinsurance companies on the risk. Endorsements are amendments to the original policy. For example, extending the policy, cancellation of the policy, modifying the sum insured, or as simple as modifying the original insured are all done through endorsement.
On the other hand treaty reinsurance is a process where insurance companies sign an agreement (treaty) with reinsurance companies which protects the insurance company portfolio from fluctuating incidents as well as provide higher solvency for the insurance company. This protection allow insurance companies to underwrite for amounts much greater than there capital and reserves. A treaty is usually divided among several reinsurance companies with a leading reinsurer that customarily has the biggest share (leader). Terms of the agreement are negotiated between the insurance company and the leader (if one exists). All other reinsurance companies that participate in the treaty would follow the leader’s terms.
Treaties between an insurance and reinsurance company are divided into two main types:
· Proportional treaties
· Non-proportional treaties or Excess Of Loss (XOL) treaties
Proportional treaties are sub divided into:
· Quota share (QS) treaties
· Surplus treaties
· FacOblig treaties
In proportional treaties, the reinsurance company goes into a limited partnership with the insurance company (the cedant). For an agreed upon share of the premium the reinsurance company agrees to pay part of the cedant’s claims when they arise.
Quota share (QS) treaties are treaties that rely on 3 main parameters; Maximum Liability (known as Line Limit), cedant share (a percentage identifying the retained share by the insurance company), and Reinsured Share (this is usually 100%-cedant’s share). The cedant share is termed Retention while the rest is simply the reinsured Share. The calculation of premium and liability for each entity is fairly straight forward:
Retention Ratio = cedant share/100
Ceded Ratio =1 - Retention Ratio
The above ratios are used to account for premiums and claims given that the policy’s liability is less than or equal to the Line Limit. If the policy’s liability is greater than the line limit then the premium applied to this treaty would be pro-rated based on the line limit and policy liability as follows:
QS Treaty Ratio = (line limit/policy liability)
Unprotected Ratio = 1 – QS Treaty Ratio
Retention Ratio = QS Treaty Ratio x cedant share/100
Ceded Ratio = QS Treaty Ratio – Retention Ratio
The QS treaty ratio above is used to calculate the premium and claims incurred for the policy. The unprotected portion of the policy can either be retained by the insurer, applied to another treaty (for example 1st surplus), or placed through a facultative agreement.
QS treaties are typically termed as “following the cedant’s fortune”. Theoretically, if the cedant makes money at the end of the year, the reinsurance company also makes money. In reality thou it is typical for an insurance company to make money while a reinsurance company losses money due to loading/commission and low retentions.
Surplus treaties are also a form of proportional treaties but are defined and accounted for differently. Surplus treaties are described by the number of line limits, with a starting and ending line number. In surplus treaties, the maximum liability is based on the number of line limits. The line limit is the cedant’s retention.
An insurance company could have several surplus treaties covering a different range of liabilities. The 1st surplus of n lines would cover policies with liabilities greater than the line limit and up to a maximum liability of (n+1) x LineLimit; a 2nd surplus treaty might have n2 lines and therefore would cover policies with liabilities greater than (n+1) x LineLimit up to a maximum liability of (n+n2+1) x LineLimit and so on.
Determination of the portion of the premium ceded to a specific surplus treaty is based on the policy’s liability prorated to the various treaties available. Let’s look at the following examples below:
Example 1: An insurance company has the following fire treaties:
QS treaty; Cedant share 25%, Line Limit USD1,000,000.
1st surplus; 5 lines è Policies with Liability >USD1,000,000 are ceded here
2nd surplus; 10 lines è Policies with Liability >USD6,000,000 are ceded here
a) If a fire policy with a total sum insured (=total liability) of USD900,000 and a premium of USD1,000 is charged calculate the ratios, the premium for each treaty, and the cedant’s final share.
Since the sum insured is less than the line limit the full premium will be ceded to the QS treaty. The cedant’s premium income would be (25/100) * 1000 = USD250. The reinsurer will be credited the rest = 1000 – 250 or 1000 * (75/100) è USD750.
b) If a claim was generated on the policy and costed USD200,000 how would that effect each party?
Since the premium was proportionally divided 25% - 75%, the same ratio is used for the claim’s division. Note that the insurance company is legally liable for the full amount towards the original insured. Therefore the insurance company would pay the full claim and recover the 75% of the claim from the reinsurer. At the end the cedant’s cost would be USD200,000 – (USD200,000) x (75/100) = USD50,000.
The reinsurer would be liable for USD200,000 x 75/100 = USD150,000.
Example 2: Assume the same treaty structure as example 1, with a fire policy and a total sum insured (total liability) of USD4,000,000 generating a premium of USD4,000 lets calculate the ratios:
· Since the sum insured is USD4,000, 000 this will be ceded to the QS and 1st surplus treaties as follows:
QS Treaty Ratio = (LineLimit/PolicyLiability) = 1000000 / 4000000 = .25 è 25% of premiums and claims
1st Surplus Ratio = (PolicyLiability – (Starting line number x LineLimit) / PolicyLiability = (USD4,000,000 – 1 x USD1,000,000)/USD4,000,000 = .75 è 75%
· The cedant’s participation would be:
(cedant’s share x QS Treaty Ratio) = .25 x .25 =0.0625 è 6.25% of the total premiums and claims
Premium income = USD4,000 x .0625 = USD250
· The reinsurer of the QS treaty participation would be:
(Reinsured share x QS Treaty Ratio) = .75 x .25 = 0.1875 è 18.75% of total premiums and claims.
QS reinsurance premium = USD4,000 x .1875 = USD750
· The 1st Surplus treaty premium is ceded as follows:
1st surplus ratio x policy premium = .75 x 4000 = USD3,000.
Claims would be recovered using the same ratios of premium distribution.
Since the policy’s liability can be totally covered by the 1st surplus treaty, no premium is ceded to the 2nd surplus treaty.
Example 3: Assume the same treaty structure as example 1, if a fire policy and a total sum insured (=total liability) of USD20,000,000 generating a premium of USD18,000 lets calculate the ratios:
Since the sum insured is USD20,000, 000 this will be ceded to the QS and 1st surplus treaties and 2nd surplus and will have a surplus of unprotected liability as follows:
Maximum liability = QS line Limit + (1st surplus + 2nd surplus number of lines) x line limit
= USD1,000,000 +(5+10) x USD1,000,000 =USD16,000,000
Unprotected Liability =USD20,000,000 – USD16,000,000 = USD4,000,000
Since the policy is over the treaty program limit, the insurance company could either retain the difference arrange for facultative placement.
The ratios would then be as follows:
QS Treaty Ratio = (LineLimit/PolicyLiability) = 1000000 / 20000000 = .05 è 5% of premium and claims
1st Surplus Ratio = (number of lines x LineLimit) / PolicyLiability
= (5 x 1,000,000)/20,000,000= .25 è 25%
2nd Surplus Ratio = (number of lines x LineLimit) / PolicyLiability
= (10 x 1,000,000)/20,000,000= .5 è 50%
And lastly, the un-ceded portion would be:
Un-ceded Ratio = (un-ceded Liability/PolicyLiability)
=4,000,000/20,000,000 = .2 è 20%
The cedant’s participation would be:
(cedant’s share x QS Treaty Ratio) = .25 x .05 =0.0125 è 1.25% of the total premium and claims
Premium income = USD18,000 x .0125 = USD225
The reinsurer of the QS treaty participation would be .05 x .75 =0.0375 è 3.75% of total premium and claims.
QS reinsurance premium = USD18,000 x .1875 = USD675
1st Surplus treaty premium = 1st surplus ratio x policy premium = .25 x 18000 = USD4,500.
2nd Surplus treaty premium = 2nd surplus ratio x policy premium = . 5 x 18000 = USD9,000.
In the event the cedant selects to retain the un-ceded liability, then the cedant would collect an added premium of 20% as calculated above but would also be liable for an additional 20% of the claims. Usually, an insurance company will seek facultative placement for such policies.
Claims would be recovered using the same ratios of premium distribution.
The above examples are a simplified look at the interaction between a cedant and a reinsurance company. In practice, several other conditions exist. To name a few, a commission is given to the insurance company to cover the administrative cost involved in issuing the policies, these cost also include whatever direct brokerage is shared in the market to obtain the business. Generally, depending on Government regulation and to give the insurance company some liquidity to pay its future claims, an agreement could also allow the insurance company to block a certain amount of the premium for an agreed amount interest rate for a pre-agreed upon period of time (Premium Reserve Retained) and/or this agreement can also stipulate that all claims that occurred but are not yet paid are also retained (Loss Reserve Retained) by the insurance company. These are few of the conditions that a treaty could stipulate and which would impact the financial revenues that do arise from these proportional agreements. Treaty wording contain the various parameters and conditions that define the covers under a given branch as well as the accounting terms agreed upon between the parties.
Unlike proportional treaties where a reinsurer is always liable for any amount of claim that might arise from a given risk up to the limit of participation, reinsurers involved in non-proportional treaties or excess of loss (XOL) treaties would only be liable when a loss is over a certain amount (known as excess point or priority) and up to a given limit (layer limit). For example, it is common terminology to use 2,000,000 dollars in excess of 500,000 dollars to describe an XOL treaty. This implies that the treaty is triggered when a loss exceeds 500,000 dollars and the total liability of the reinsurer does not exceed 2,000,000 dollars. The insurance company would be liable for the first 500,000 dollars. In essence any losses less than $500,000 would be the sole responsibility of the insurance company. If a loss of $2,750,000 was experienced, the insurance company would initially be liable for the priority of $500,000; the reinsurance company would be liable for $2,000,000 in excess of the $500,000. This leaves the balance of $250,000. If the insurance company has bought another layer of protection then the balance would trigger that layer of XOL otherwise the insurance company would be liable for the balance of $250,000. An insurance company could have several layers of XOL treaties each protecting a range of liability.
XOL treaties have a onetime use. Once triggered, they need to be reinstated. Within the treaty agreement, the conditions of reinstatements are defined. The number of reinstatements permitted and the cost of such reinstatements are usually defined.
The cost of XOL treaties vary based on several elements. Factors like market conditions, specific insurance company statistics, and geographical area are some of the variables that effect pricing.
There are many types of XOL treaties to protect that protect the insurance company based on different events and purposes. For example, some XOL treaties protect per risk, while others protect per event. The XOL protection evolves and is constantly being refined by reinsurance companies as well as brokers to better meet customer needs.
The dynamics of the insurance market extends beyond the scope of an article or even a book. The above presented a brief overview of the interaction between an original insured, insurance company and a reinsurance company.
The dynamics is more complex. Almost always an insurance company would usually have several reinsurers for the same treaty each having a small share. Reinsurance companies themselves also have treaties with other reinsurance companies known as retrocession. The process is similar to that of an insurance company but the dynamics is somewhat different. Co-insurance is also a common practice between insurance companies when the risk is large (usually involves governmental risks).
Other players or layers also exist within the industry; insurance brokers, reinsurance brokers, and service provider (for example surveyors, third party administrators, claim surveyors). Those added players could provide added value for the industry without being involved in any part of the risk.
In the upcoming articles, we will try to shed some light on the interconnections between the various parties, internal operations of such parties, the informational exchange between the parties involved, and the technologies that can be used to stream line information within an organization as well as the connected entities.
For example, [B1]If an insurance company has high liability of accumulated fire policies in a given area, the insurance company might raise its rates for any additional policies in that area while lowering its rates of fire policies in other areas.