1. Capacity 2. Catastrophe 3. Stability 4. Reinsurance methods 5. Reinsurance and underwriting 6.
Liability for premium 7. Agent for reinsured 8. Non-payment of premium 9. Intermediary clause 10. Set off 11. The reinsurance contract 12.
Characteristics of reinsurance risk 13. Reinsurance regulation 14. The Reinsurance Market: The Impact of the September 11 th Terrorism Catastrophe Reinsurance is the insurance of insurance. It is an agreement whereby an insurance company transfers part of its risks to another organization. Looking at insurance more closely, we can see that its serves three different purposes. It provides capacity, protects against catastrophe loses and furnishes stability.
Capacity By capacity it is meant the ability of a company to provide insurance. Through reinsurance, companies obtain additional capacity and are able to write more coverage than they could if they had to retain all of the risk themselves. All insurers, even mammoth ones have limited resources and must set maximums of the amounts of coverage that they will retain. A moderate-sized life insurer might set its maximum retention on the life of any person at $50000. Without reinsurance it would have to decline all submissions for policies larger than that amount. This would force it to turn down a lot of good business and would also make it difficult for the company to recruit and retain good agents.
Catastrophe In considering their need for reinsurance, insurers must also protect against catastrophes in which many policies could be involved. A fire insurance company might be able to handle up to $100000 on anyone property, but it must consider the possibility that a single hurricane, tornado, brush fire or riot could destroy many of its insured properties. Some kinds of reinsurance are specifically designed to protect insurers against such catastrophes. Stability A slightly different purpose of reinsurance is to provide stability in year-to-year underwriting results. Insurance companies like to avoid large fluctuations in their profits (or losses) just as other organizations do. In this respect reinsurance serves a purpose similar to that of insurance itself, avoiding large unexpected losses and making aggregate loss ratios more predictable.
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Through reinsurance major losses are spread among any insurers and reinsurers around the world, a process that enables individual companies to enjoy relatively stable year-to-year loss experience in spite of airline’s crashes hurricane, hotel fires and other calamities. The following figure shows how such a risk might be shared by four parties through the process of insurance, reinsurers and retrocession. In this case, part of the original risk was retained by the policyholder, perhaps by means of a deductible. Very large risks often are spread among even more companies than the number shown here.
Insurance insurance reinsurance retrocession Policyholder Insurance Reinsurance Reinsurance company company company Figure 1: Insurance, reinsurance and retrocession Reinsurance methods Either of two methods can be used to arrange reinsurance contracts. The first, called facultative reinsurance is used to reinsure a specific policy that the ceding company is issuing. The policy might provide a form of coverage amounts of protection that the company does not normally handle. Therefore it would not be covered by the company’s usual reinsurance program.
To arrange facultative reinsurance an underwriter would phone or write a reinsurer and negotiate terms of coverage for reinsuring the particular policy. The other method of arranging for reinsurance is by treaty. Reinsurance treaty is a standing contract between insurance company and the reinsurer. Under the terms of the treaty the insurance company automatically cedes and the reinsurer automatically reinsures stated portions of certain types of risks.
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For the kinds and amounts of insurance that a company normally writes the treaty method is more efficient and economical than facultative reinsurance, as it avoids having to reinsure each policy separately. There are several types of reinsurance treaties, but all can be classified as either pro-rata treaties or excess-of-loss treaties. Under a pro-rata treaty, the insurance, the premium, and the losses all are shared ‘Ill a proportional basis. In one example, the original insurer retains one-third of the insurance and cedes two-thirds. The reinsurer receives two-thirds of the premium and pays two-thirds of each loss.
An excess-or-loss treaty, on the other hand, provides that the reinsurer will pay the amount by which any covered loss exceeds the ceding companies retention. Reinsurance and underwriting A person who knows about reinsurance might wonder why underwriters have to decline poor risks. Why not assume that the company’s reinsurance treaties will take care of large losses and, if they wouldn’t, why not buy facultative reinsurance that would? Any company whose underwriters adopted this attitude would soon be in big trouble. It would be in a position like that of an agent who dumped poor risks unsuspecting insurers. If this as insurers expect their agents to do a certain amount of underwriting and not to conceal, unfavorable information, reinsures expect each insurance company to underwrite the risks it submits for reinsurance.
If this practice is not followed, it soon will become apparent (as the reinsurer losses mount) and the company will find itself having difficulty locating reinsurers that are willing to take its business. Thus, although reinsurance is essential to underwriting, it must not be misused; it does not relieve underwriters of the need to engage in careful risk selection. Liability for premium The most important difference between the contracts of insurance and reinsurance Is that the liability of a broker for payments of the premiums to the reinsurer under the reinsurance treaty has not yet been established by a statute of a common law, and the broker is not liable in the absence of prior agreement. There is no reason why the broker should be liable; the parties of the agreement are both professionals operating in a specialized market and are subject to solvency controls, thereby reducing the apparent risk of default by the parties. In practice brokers do not usually render themselves liable to pay reinsurance premiums, subject of course Lloyd’d custom that a Lloyd’s broker is personally liable to the Lloyd’s underwriter, that s 53 of the marine insurance act 1906 applies to facultative marine reinsurance and that the broker may foolishly incur liability by sending out accounts stating his liability, or as a principle under the terms of the reinsurance contract.
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Some of these aspects appeared in Grand Union Insurance Company Limited v Evans- Lom be Ashton & Company Limited (unreported June 1989) where the court of appeal heard the reinsurance brokers’ argument during an appeal from a summary judgment against them to the effect that their undisputed liability for premium under s 53 for marine facultative reinsurance was displaced by the universal practice in the reinsurance marker known as “net accounting.” The court allowed the brokers’ appeal to enable them to go to trial in order to establish the existence of alleged universal practice. A decision on this point is still awaited. Agent for reinsured The broker acts as agent for the reinsured. Thus, any premium paid by the reinsured to the broker does not constitute a discharge of the reinsured’s debt until passed on to the reinsurer. There are often several brokers in the reinsurance chain, and a broker passing on money to an other should insure that he is authorized by the reinsured to do so. The broker is liable to account for it as an agent holding money had and received to the use of the reinsured.
The insolvency of a broker will mean that the reinsured must prove as an unsecured creditor in the liquidation, either for unpaid premium or as a debtor for claims received from the reinsurer. Non-payment of premium Payment of premiums in treaty reinsurance is unlikely to be a condition precedent, although non-payment could eventually constitute a breach and entitling the reinsurer to treat the contract as terminated. Payment by the reinsured to the broker in cash or by setting of premiums due to the reinsurer against claims due from the broker are irrelevant to the reinsurer. He does not necessarily obtain payment from the broker personally as in marine and Lloyd’s insurance, but may look to the reinsured for payment. Similarly the reinsurer can not set off premium alleged to be owed from the broker against claims because the broker is not the creditor of the reinsurer for claim’s moneys, which are owed direct to the reinsured.
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Intermediary clause The term “intermediary” is found throughout the insurance world particularly in reinsurance. However the concept of intermediary was frowned upon by Me gaw J in anglo-african merchants Ltd. V Bayley. Thus, although the general rule is that the broker act for the insured or reinsured, nevertheless parties can agree that payment to the broker constitutes good payment to the other party. The parties can therefore set off sums due to them of the contract of reinsurance, but not on others without wider agreement to do so, since the connection will not be close enough to constitute mutuality, there being no mutuality of liability in the first place. The usual insurance position remains in force in respect of the entitlement of the broker to act in his personal capacity: he can not sue for premiums or claims since he owes and is owed neither.
This debts exist solely between the reinsurer and the reinsured. The reinsured can of course sue the broker where the broker has received claims moneys from the reinsurer but has failed to pass them on. Set off A broker in strict analysis should not need to set off. He is not liable for premium and therefore need only act as a pure agent, without personal liability, subject to the proviso that he may be liable for premium in marine and Lloyd’s facultative contracts of reinsurance. In reality, however, he funds claims.
His entitlement to sue personally or otherwise recover has been consider above, from which it will be seen that his chances of success are slim, unless he receives assistance from the reinsured. He is also at risk in respect of any central system of multilateral netting off without the reinsured’s consent since again there is no mutuality. The broker is obliged to receive payment in cash and can not set off claims against premium without reinsured’s consent. The broker may attempt to establish a marker usage for netting off but it would probably go no further than the premiums and claims in one account between the reinsured and the reinsurer. Reinsured would be unlikely to accept netting off between unrelated contracts. The broker would, however, point out that the reinsured is a professional who is fully cognizant of the accounting position and therefore that he has consented to the customer.
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The Reinsurance Contract Based on its business needs, an insurer negotiates with a reinsurer, directly or through a broker, to determine the terms, conditions and costs of a reinsurance contract. Under a reinsurance contract, an insurer is indemnified for losses occurring on its insurance policies and covered by the reinsurance contract. There are no standard reinsurance contracts although two basic types, treaty and facultative, are used and adapted to meet individual insurers’ requirements. Underwriting treaty reinsurance differs greatly from that of facultative reinsurance. Reinsurance treaties automatically cover all risks written by the insured that fall within their terms unless they specifically exclude exposures. While treaty reinsurance does not require review of individual risks by the reinsurer, it demands a careful review of the underwriting philosophy, practice and historical experience of the ceding insurer, as well as a thoughtful evaluation of the company’s attitude toward claims management and engineering control and management’s general background, expertise and planned objectives.
Facultative reinsurance contracts cover individual underlying policies and are written on an individual basis. Stated simply, facultative reinsurance covers a specific risk. Both facultative and treaty contracts may be written on a proportional or an excess of loss basis, or a combination of both. A facultative agreement covers a specific risk of the ceding insurer. A reinsurer and ceding insurer agree on facultative terms and conditions in each individual contract.
In contrast, a reinsurance treaty is a broad agreement covering some portion of a particular class or classes of business (e. g. , an insurer’s entire workers’ compensation or property book of business).
Historically, treaties remain in force for long periods of time and are renewed on a fairly automatic basis unless either party wishes to negotiate a change in terms. Facultative reinsurance agreements often cover catastrophic or unusual risk exposures.
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Prior to the 1950’s, U. S. insurers made relatively little use of facultative reinsurance and Lloyd’s of London was virtually the sole source of facultative coverages. U. S. reinsurers began to compete with Lloyd’s for facultative business ins the 1950’s and today facultative reinsurance plays a major role in the U.
S. reinsurance market. Facultative reinsurance requires substantial personnel and technical resources for underwriting individual risks. Often, facultative business presents significant potential for loss, thus a reinsurer must have the necessary staff knowledge to underwrite each exposure accurately.
Facultative reinsurance contracts are also used to supplement treaty arrangements when treaties contain specific exclusions, such as exposures involving long haul trucking or munitions manufacturing. Insurers may fill coverage voids created by reinsurance treaty exclusions by negotiating a separate facultative reinsurance contract for a particular policy or group of policies. Certain classes of risks anticipated to develop significant losses may adversely affect an insurer’s treaty experience. Although not excluded from a treaty, these risks may be placed facultative ly. For example, a primary insurer that may not ordinarily provide commercial automobile coverage might agree, as a service to its insured, to write such a policy as an accommodation.
The company may then seek facultative reinsurance to protect its loss experience under treaty agreements. The reinsurer providing an insurer’s treaty coverage may not necessarily provide its facultative reinsurance. Reinsurers also purchase their own reinsurance protection, called retrocessions, in the same forms and for the same reasons as ceding insurers. By protecting reinsurers from catastrophic losses, as well as an accumulation of smaller losses, retrocessions stabilize reinsurer results, thus serving the same risk-spreading objectives as the initial reinsurance transaction. Reinsurance relationships range from the simple to the complex. An insurer may enter into a single reinsurance treaty to cover certain loss exposures or may purchase numerous treaties until the desired level of reinsurance protection is achieved.
This process, known as layering, uses two or more reinsurance agreements to obtain desired level of coverage. At the time a claim comes due, the reinsurers respond in a predetermined sequence, as necessary, to cover the loss. Layering of reinsurance coverage is no different in principle than the layering of excess and umbrella coverage by a policyholder, or the purchase of specific risk coverage through a rider on an insurance policy. It is simply a means of securing the type and amount of insurance or reinsurance protection desired by a purchaser. Certain fundamental principles underlie all reinsurance contracts, regardless of how simple or complex the reinsurance transaction.
First, the only parties to a reinsurance contract are a reinsured company and its reinsurer. All contractual rights and obligations run only between these two companies. Second, the proceeds collectible under the reinsurance contract are an asset of the ceding company. Finally, as a contract of indemnification, the reinsurance is payable only after the reinsured company has paid losses due under its own insurance or reinsurance agreements, unless there is an insolvency clause, which allows the receiver of an insolvent insurer to collect on reinsurance contracts. Characteristics of reinsurance risks Reinsurance is a transaction in which one insurer agrees, for a premium, to indemnify another insurer against all or part of the loss that insurer may sustain under its policy or policies of insurance. The company purchasing reinsurance is known as the ceding insurer; the company selling reinsurance is known as the assuming insurer, or, more simply, the reinsurer.
Described as the “insurance of insurance companies,” reinsurance provides reimbursement to the ceding insurer for losses covered by the reinsurance agreement. It enhances the fundamental objective of insurance: to spread the risk so that no single entity finds itself saddled with a financial burden beyond its ability to pay. Although to many, reinsurance is a relatively unknown aspect of the insurance industry, its roots can be traced as far back as the late 14 th century. From that time forward, reinsurance evolved into the business as it operates today. While the early focus of reinsurance was in the marine and fire insurance lines, it has expanded during the last century to encompass virtually every aspect of the modern insurance market.
Reinsurance can be purchased from three distinct sources: domestic reinsurance companies, reinsurance affiliates of primary U. S. insurance companies and alien reinsurers that are located outside the U. S. and are not licensed here. The ceding insurer may purchase reinsurance directly from a reinsurer or through a broker or reinsurance intermediary.
The two main types of reinsurance agreements are proportional and excess of loss. A reinsurance contract written on a proportional basis simply prorates all premium, losses and expenses between the insurer and the reinsurer on a pre-arranged basis. The proportional approach is used extensively in property reinsurance. Excess of loss contracts require the primary insurer to keep all losses up to a predetermined retention and the reinsurer to reimburse the company for any losses above that retention, up to the limits of the reinsurance contract. In simplest terms, a retention is analogous to the deductible a policyholder may have on a personal insurance policy, such as an automobile or homeowner’s policy.
Insurers purchase reinsurance for essentially four reasons: (1) to limit liability on specific risks; (2) to stabilize loss experience; (3) to protect against catastrophes; and (4) to increase capacity. Depending on the ceding company’s goals, different types of reinsurance contracts are available to bring about the desired result. Limiting Liability: By providing a mechanism in which companies limit loss exposure to levels commensurate with net assets, reinsurance allows insurance companies to offer coverage limits considerably higher than they could otherwise provide. This function of reinsurance is crucial because it allows all companies, large and small, to offer coverage limits to meet their policyholders’ needs. In this manner, reinsurance provides an avenue for small-to-medium size companies to compete with industry giants. In calculating an appropriate level of reinsurance, a company takes into account the amount of its available surplus and determines its retention based on the amount of loss it can absorb financially.
Surplus, sometimes referred to as policyholders’s surplus, is the amount by which the assets of an insurer exceed its liabilities. A company’s retention may range from a few thousand dollars to one million dollars or more. The loss exposure above the retention, up to the policy limits of the reinsurance contract, is indemnified by the reinsurer. Reinsurance helps to stabilize loss experience on individual risks, as well as on accumulated losses under many policies occurring during a specified period. Stabilization: Insurers often seek to reduce the wide swings in profit and loss margins inherent to the insurance business. These fluctuations result, in part, from the unique nature of insurance, which involves pricing a product whose actual cost will not be known until sometime in the future.
Through reinsurance, insurers can reduce these fluctuations in loss experience, thus stabilizing the company’s overall operating results. Catastrophe Protection: Reinsurance provides protection against catastrophic loss in much the same way it helps stabilize an insurer’s loss experience. Insurers use reinsurance to protect against catastrophes in two ways. The first is to protect against catastrophic loss resulting from a single event, such as the total fire loss of a large manufacturing plant. However, insurers also seek reinsurance to protect against the aggregation of many smaller claims which could result from a single event affecting many policyholders simultaneously, such as an earthquake or a major hurricane. Financially, the insurer is able to pay losses individually, but when the losses are aggregated, the total may be more than the insurer wishes to retain.
Through the careful use of reinsurance, the disruptive effects catastrophes have on an insurer’s loss experience can be reduced dramatically. The decisions a company makes when purchasing catastrophe coverage (e. g. , size of retention and coverage limits) are unique to each individual company and vary widely depending on the type and size of the company purchasing the reinsurance and the risk to be reinsured. Increased Capacity: Capacity measures the dollar amount of risk an insurer can assume based on its surplus and the nature of the business written. When an insurance company issues a policy, the expenses associated with issuing that policy — taxes, agent commissions, administrative expenses — are charged immediately against the company’s income, resulting in a decrease in surplus, while the premium collected must be set aside in an unearned premium reserve to be recognized as income over a period of time.
While this accounting procedure allows for strong solvency regulation, it ultimately leads to decreased capacity because the more business an insurance company writes, the more expenses that must be paid from surplus, thus reducing the company’s ability to write additional business. Companies experiencing rapid expansion are particularly susceptible to the timing problem between expenses (which must be debited immediately) and income (which must be credited over time) generated by new business. By reinsuring a portion of the business it writes, an insurance company reduces the problem of decreased surplus. Through reinsurance, the company shares a portion of its underwriting expenses with its reinsurer and reduces the drain on surplus. Reinsurance also permits the ceding company to expand capacity by permitting the ceding company to take credit for reinsurance on the annual accounting statement it files with state regulators. Credit for reinsurance can be described as follows: If the reinsurer satisfies certain regulatory requirements intended to assure the security of the reinsurance arrangement, the ceding company may count as an asset reinsurance payments owed to it on claims it has paid, thus expanding its surplus.
The ceding company can also reduce liabilities and loss reserves attributable to the business ceded to the reinsurer. In addition, the ceding company often receives a ceding commission from the reinsurer as reimbursement for expenses, such as agent commissions and overhead, associated with acquiring the business being reinsured. The ceding commission is added directly to the ceding company’s surplus, thus increasing it further. Another type of reinsurance transaction which may affect surplus is known as loss portfolio transfer. In such an arrangement, one insurer cedes to another insurer its reserves for incurred but unpaid losses and loss adjustment expenses. Typically, these reserves are associated with a particular class or line of business, such as medical malpractices.
The ceding insurer transfers cash to the assuming insurer equal to the assuming insurer’s estimate of the present value of these liabilities, plus an amount the reinsurer may require to carry the additional risks involved in the transfer. In addition, reinsurers often provide insurers with a variety of other services. Some reinsurers provide guidance to insurers in underwriting, claims reserving and handling, investments and even general management. These services are particularly important to smaller companies or companies interested in entering new lines of insurance.
In any discussion of reinsurance, limitations of the business must be considered along with the advantages. First and foremost, reinsurance does not change the inherent nature of a risk being insured. Thus, it does not make a bad risk insurable or an exposure more predictable or desirable. While it may limit an insurance company’s exposure to a risk, the total risk exposure is not altered through the use of reinsurance.
Reinsurance regulation Reinsurance regulation focuses on ensuring the solvency of reinsurance companies. The driving force behind regulation of reinsurers’s olvency, as opposed to regulation of the reinsurance contract, is to safeguard reinsurance collectibility. Reinsurance purchased at the best terms and the lowest price means nothing if the reinsurance company is no longer in business when the claim payment for indemnification comes due. Therefore, state insurance regulators focus on reinsurance solvency to ensure that reinsurance companies are able to meet their claims obligations. A second reason for regulating reinsurers’s olvency is to maintain flexibility in the reinsurance business. Regulation focusing primarily on the reinsurer itself, rather than on the reinsurance contract, allows primary insurance companies to purchase reinsurance to suit their particular business needs.
However, when overriding public policy concerns require regulatory involvement, nearly all states have adopted regulations affecting reinsurance contracts. An example of this type of regulatory involvement is the requirement of a standard clause, called the insolvency clause, which allows the receiver of an insolvent insurer to collect on reinsurance contracts, but these are the exception. There are several reasons why there is special treatment of the reinsurance contract. Reinsurance contracts are entered into by two or more insurance companies — the reinsurer (s) and the insurer (s).
Recognizing that there are always some exceptions to the rule, the two companies are generally expected to be knowledgeable about the insurance business. Therefore, the oversight necessary in primary insurance to protect consumer interests is not essential in the reinsurance business.
In addition, reinsurance contracts must be shaped to the ceding insurer’s unique requirements. No two contracts are alike — all have marked variations in retention levels, coverages and exclusions. An insurance company’s needs for reinsurance depend on its book of business and financial and underwriting strategies. The reinsurance contract, and hence reinsurance premiums, must be individually tailored and determined by the parties.
It is important however, to recognize the existence of indirect regulation of reinsurance contracts and rates. Indirect regulation refers to restrictions on insurance rates that in turn affect reinsurance rates. Generally, if the amount paid in premium to the insurer is limited, the amount paid to a reinsurer may also be within that limitation. Reinsurance laws do not require insurers to purchase reinsurance from a U.
S. company. With few exceptions, an insurer can purchase reinsurance from a reinsurer located anywhere in the world. The U. S. insurance and reinsurance marketplace needs the additional capacity provided by reinsurers located around the world.
However, state insurance departments are unable to assess the strength of companies located in other countries and cannot measure the extent of regulation under which these alien reinsurers operate. To ensure the collectibility of reinsurance purchased overseas, state insurance departments impose regulatory restrictions on U. S. insurers that frequently require security arrangements between the ceding insurer and reinsurer. Since recoverable reinsurance is usually a substantial asset, insurers attempt to satisfy the state credit for reinsurance laws.
Virtually every state enforces some type of credit for reinsurance law, regulation or internal departmental standard. Ideally, the state should impose adequate uniform standards. The objective of any credit for reinsurance law, to balance capacity and security, can be met through a variety of alternatives. First, credit should be allowed if the reinsurer is licensed or accredited in the same state where the primary insurer does business. A license is the best means for an insurance department to ensure the solvency of a reinsurer. However, some companies have chosen to become accredited rather than licensed.
The process of accreditation usually requires a company to submit data to the state insurance department comparable to that of a company seeking licensure. Second, credit is usually allowed if the reinsurer is domiciled and licensed in a state which employs substantially similar credit for reinsurance standards to those imposed by the primary insurer’s state of domicile. Most U. S.
reinsurers satisfy one of these tests and primary insurers doing business with these companies will usually receive favorable treatment of assets and liabilities on their annual statement. However, the primary insurer is not required to purchase reinsurance from a reinsurer licensed in the U. S. If a company chooses to buy from an alien reinsurer, the reinsurer must usually satisfy one of two requirements for the ceding company to receive credit for reinsurance. First, credit is allowed if the alien reinsurer establishes a substantial U. S.
trust fund which must satisfy various state requirements on reporting, solvency and collectibility. Second, credit should be allowed if the alien reinsurer establishes security in the U. S. , such as a clean irrevocable and unconditional letter of credit issued by an acceptable bank. These alternatives provide state insurance departments with a means to assess the ability of a reinsurer, domestic or alien, to meet its obligations.
They also allow U. S. reinsurers access to the international reinsurance marketplace needed for greater capacity and stability. It is important to note that nearly all insurers may write reinsurance. State insurance laws usually allow an insurer to offer reinsurance in the same lines it writes on a direct basis. In most states, an insurer who wishes to get into the reinsurance market need not satisfy an additional financial requirements.
Taken together, the direct and indirect regulation of reinsurance contracts is significant, if not the same as required of the primary insurance industry. This does not place the policyholders at risk if all other solvency and contract oversight is in place. The goal of reinsurance regulation, beginning with credit for reinsurance laws, is to provide reasonable assurance that reinsurance recoverable’s will be paid when they become due. This is accomplished in two ways: by direct solvency regulation of the reinsurer or by providing sufficient collateral to meet the reinsurer’s obligations. This goal encourages ceding insurers to do business with reinsurers, domestic or alien, that are well funded, solvent, responsible and will be there to pay when insurance claims come due. The Reinsurance Market: The Impact of the September 11 th Terrorism Catastrophe The US insurance market is the largest in the world.
The open US market affords a perfect opportunity for investors around the globe to provide insurance capacity that supports the US economy. The unprecedented size and scope of the September 11 th insured loss has sent a tidal wave through those global insurance markets. Calm will not be easily restored. The losses also appear to have served as a catalyst that will drive market forces responding to a series of macro environmental factors. The most critical and the most beneficial action that can be taken is for the US Congress to create a terrorism insurance safety net to provide necessary coverage and assure financial support for those insurers continuing to risk their capital in insuring this risk. The Reinsurance Association of America has prepared this short fact sheet, in question and answer format, to help respond to commonly asked questions about the status of the reinsurance industry and the future outlook with respect to terrorism insurance and reinsurance.
1. How large are the expected insured losses from the September 11 th events? The September 11 th terrorist attacks have caused the largest insured losses ever recorded. Estimates vary, but the range of expected losses is between $35 and $75 billion. For comparison purposes it is useful to note that the previous largest worldwide insured loss was from Florida’s 1992 Hurricane Andrew, 2 now estimated to have caused $20 billion in insured losses. California’s Northridge Earthquake in 1994 is now estimated to have caused $16 billion in insured losses.
Although no one will know the ultimate insured loss from the September 11 th events for several years, if the losses reach $60 billion then the attacks will have caused insured losses three times greater than any previous event. Analysts and reinsurance executives have forecast that 60 to 80 percent of these losses will lie with the reinsurance industry. 2. Will these unprecedented losses bankrupt insurers? Economists and rating agencies have stated that the insurance industry remains strong and will be able to weather the financial storm. The basic message is good: the insurers had a strong capital base and can pay for these unprecedented losses. Commentators expect some insolvencies; in fact at least one Japanese insurer has now declared itself bankrupt as a result of aviation losses stemming from the terrorist attacks.
3 Standard and Poor’s 4 has noted, though, that if losses exceed the $70 billion threshold then additional reinsurer insolvencies should be expected. The firm notes that if this happens it will send ripples through the insurance markets likely leading to additional insurance insolvencies. As always, consumers should check rating agency evaluations of the financial strength of insurance companies. Rating agencies are regularly providing updated reports on insurers’ financial health as insurers continue to update loss estimates. 3. Are these losses evenly distributed through the insurance markets? The losses fall largely on the commercial lines insurance market.
The losses cover nearly every line of business, but largely fall in nine commercial lines segments. The biggest insured losses are in business interruption, commercial property, liability, and worker’s compensation. To put the estimated $35 to $70 billion in losses in context, one has to look at the capital base that supports this business. The US property and casualty insurance industry reported at yearend 2000 a surplus of nearly $317 billion.
6 [Note: Surplus declined at yearend 2001 to $289 billion. The commercial lines segment of the market has access to roughly $130 billion of this amount. The US reinsurance companies have surplus equivalent to roughly $25 billion. The global reinsurance capital base has been estimated between $100 and $200 billion.
10 The higher estimates overstate the capital base because of the inclusion of insurers that primarily write direct insurance business. To put the reinsurance losses into perspective we need to review some standard industry loss ratio measurements. The impact of the September 11 th losses are now reflected in the RAA’s Quarterly Reinsurance Underwriting Report for 2001. The US reinsurance industry’s combined ratio for the year 2001 was 141%.
Year 2001 produced the worst ever combined ratio for the US reinsurance business. The combined ratio means that without taking into account investment income, reinsurers as a whole paid out $1. 41 for every $1 in premium that was earned. It was a terrible year and it comes on the heels of substantial underwriting losses in 1999 and 2000. In fact according to the RAA data, US reinsurers’ aggregate surplus has declined now for two out of the last three years (1999 and 2001).
How are these losses distributed between commercial insurers and reinsurers? The losses disproportionately fall on the reinsurance market. Observers estimate that 60 to 80 percent of the ultimate losses will lie with reinsurers. Taking $50 billion as a round number then, between $30 billion and $40 billion of those losses would lie with the reinsurance industry. As noted above, it is difficult to find a definitive measure of global reinsurance industry surplus, but after reviewing Morgan Stanley, A. M. Best, Standard and Poor’s information and then consulting with reinsurance executives, the RAA believes it is fair to estimate that about $125 billion in surplus supports the global reinsurance industry.
11 If the reinsurers’s hare of the estimated $50 billion in losses is 60 percent ($30 billion) then 24 percent of the worldwide reinsurance industry’s surplus was lost due to these catastrophic events. If the reinsurers’s hare is 80 percent ($40 billion) then an amount equal to nearly 32 percent of the global reinsurance industry’s surplus was lost due to the September 11 th tragedy. 12 It is extraordinary that the global reinsurance industry could suffer a loss of 24 to 32 percent of its surplus from a single event. Of course, individual reinsurance companies will lose a far greater share of their surplus since the loss will not be evenly distributed among reinsurance companies. These losses will have a material effect on the industry in providing commercial lines coverage in the coming year.
5. Are reinsurers committed to the marketplace and seeking a resolution of the marketplace dislocations with regard to terrorism coverage? If so, what are they doing to show that commitment? Reinsurers have been working hard to bring about a resolution to the problems caused by the September 11 th attacks. They recognize the need for federal legislation to provide a financial “backstop” that will allow the insurance market to cover terrorism risk. Infinite risk simply cannot be written on a finite capital base. Reinsurers have aggressively worked this issue with the US Congress and the Bush Administration and taken a leadership role, through the RAA, early on in the process. But the key in avoiding market dislocation is Congress passing legislation that provides for a terrorism insurance program that will work-that restores confidence to the market and protects against insurer insolvency in the event of more catastrophic losses due to terrorism.
Meanwhile, reinsurers are working with their clients, many of them wanting to provide whatever financial assistance they can, until Congress acts. 6. ISO has worked with US regulators on terrorism exclusion language for inclusion in primary commercial policies. If regulators approve those exclusions for commercial lines, will reinsurers follow the same exclusion language in their reinsurance contracts? If not, why not? There is no ISO for reinsurance contracts because reinsurance contracts are not subject to regulation. Reinsurers cannot enter into a joint effort to discuss contract terms or exclusions as the antitrust laws of the United States and the several states do not permit discussions of that nature. Reinsurance companies will take whatever action with respect to coverage and pricing as they believe appropriate on an individual basis.
Some reinsurers may include broad exclusions in their contracts with respect to terrorism because they believe that without doing so they will expose their company’s capital to risk that they cannot withstand. One of the largest US reinsurers has informed regulators that it has lost more than 40 percent of its year-end surplus due to losses arising from this single event. It would be self-destructive for a reinsurer to act to expose the company, or its shareholders, to financial ruin. 7. Since reinsurance is a global market, what share of the reinsurance market is provided by US versus non-US companies? According to the RAA’s just published Alien Reinsurance in the US Market, US reinsurers have about 54 percent of the US reinsurance market with 46 percent held by the non-US reinsurers.
The share of the market held by the non-US reinsurers has been gradually increasing in the last five years. The US is an open market for reinsurance with few barriers to entry, as attested by the market share statistics. Based on reported losses to date, it appears that the non-US reinsurers will assume a larger share of the losses than these statistics would otherwise predict. 8. Is it true, as some have suggested, that insurance and reinsurance companies are opportunistically increasing rates and will profit from the tragic events? According to the Insurance Information Institute (III) commercial lines insurance and reinsurance rates were increasing (by 10 to 30 percent) prior to the events of September 11 th. The industry was coming out of a sustained period of price competition which had substantially lowered prices during that time.
Due to the unprofitable environment, commercial lines prices had begun to increase in 2000 setting the trend for additional increases in 2001. 15 The terrorist attacks (because of the huge losses to the commercial lines and a material loss to the capital base) will likely cause additional price increases. The price increases are necessary for the industry to return to profitability and replenish its capital base. Insurance company executives have noted that price increases are attributable to several factors: 1. Unprofitable commercial lines business, pre-September 11 th; 2.
Necessity to write business on a profitable basis as required by investors / owners ; 3. Necessity to build additional capital to support future business; 4. Expected reduction in investment income due to the 2001 stock “bear market.” The III reports it expects across-the-board commercial lines price increases of 30 percent, about half attributable to the market environment prior to September 11 th and about half due to the aftermath of the terrorists attacks. 16 Insurance broker Willis has projected expected average price increases of between 30 and 60 percent, with much higher increases in certain segments.
Morgan Stanley notes that insurance prices will increase in 2002 due to a convergence of a number of macro-economic issues: bad results from a prolonged soft market, current “bear” stock market, US economy now in recession, other large catastrophe losses in 2001 – Tropical Storm Allison and hailstorms, numerous aviation losses and the Enron bankruptcy. 9. How profitable are insurance companies compared to other business groups? Insurance companies rarely meet investment return on equity targets of the Fortune 500. Historically insurance companies have under-performed compared to the Fortune 500 and their financial industry peers in the banking and securities business. 18 The III study shows that the peak performance of the US property and casualty insurance business was 18 percent return on equity in 1987.
By contrast the lowest return for the US property and casualty business during the study period was 4 percent in 1992. Industry performance has generally been between 5 percent and 10 percent contrasted to other financial services and Fortune 500 peers, which range between 10 percent and 20 percent return on equity. In 2000 the industry earned a 6 percent rate of return. Just completed analysis for calendar year 2001 documents a negative 2. 7% rate of return. The worst performance on record.
The reinsurance business generally exhibits volatility greater than the insurance business. For the last 20 years US reinsurance companies have not reported a single year of profitable underwriting. 20 Profits earned were the result of substantial investment income. For 1999 US reinsurers reported a combined ratio of 114 percent; for 2000 a combined ratio of 113 percent and as noted above for 2001 — 141 percent combined ratio. 10. Will consumers face multiple years of large insurance price increases? Insurance is a cyclical business, where supply and demand are not always in equilibrium.
When profits are expected substantial inflows of capital are attracted to the markets. This is happening now. According to various reports an estimated $23 billion in has now been raised to support insurance and reinsurance markets. 21 There are few if any barriers to entry in the insurance business, thus it is easy for opportunistic capital to flow into the market. Historical evidence shows that these inflows of capital ensure that profits are kept down as the additional capital allows supply to more than meet demand. Morgan Stanley notes that the insurance price increases are necessary but that, over time, price increases will moderate, supply and demand will get back into equilibrium and then prices will likely fall once again.
22 A. M. Best notes that, with the new inflow of capital into the business, increased competition will begin moderating price increases by year-end 2002 and the beginning of 2003.