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The essence and the meaning of reinsurance.
Reinsurance is a system of economic relations in the process of which the underwriter, undertaking insurance against risks, passes part of their liability on (taking into account his financial possibilities) to other underwriters under agreed conditions in order to create a portfolio of insurance contracts, to provide financial stability and profitability of insurance activities.
An underwriter who undertook the insurance against the risk and passed it on to another underwriter for reinsurance is called reinsurer or cedent. An underwriter who undertook the risk for reinsurance is called cessioner. Having undertaken the risk for reinsurance cessioner can pass it on partially to the third underwriter.
The correct determination of reinsurance amount is of great importance for each insurance company. In this connection the so-called deduction of cedent which means the economically grounded level of amount is a determining factor. An insurance company leaves on its liability definite sum of insurance risks within these limits and passes on to reinsurance sums exceeding this level.
A comparatively optimal variant of limit of deduction can be determined on the data basis within 5 – 10 years if there is the definite soundness of insurance portfolio.
Factors being the basis for the definition of limits of deduction are the following:
- The average nonprofitability on insured risks of types of insurance on which the limits of deduction are established. At that not only the quantity and frequency of insurance cases but also the maximum probable loss are taken into account.
- Premiums volume. The more the volume of premiums being insignificantly deviated from the total number of risks, the higher the limit of deduction can be.
- Average yield or activities’ profitability according to the type of insurance. The more profitable the activities are, the higher the limit of deduction is established.
- The territorial distribution of insured objects. The more the insured objects are in one zone, the lower the limit of deduction is established.
- The rate of expenses while carrying on business. If expenses are too high the insurance company tries to establish the limits of deduction on such a level so that part of these expenditures are to be passed on to underwriters.
Types of reinsurance contracts
There is an active and a passive reinsurance. The purpose of active reinsurance is the passing the risk on, the purpose of passive reinsurance is in its acceptance. But in practice both active and passive reinsurances are carried on simultaneously by one and the same insurance company which performs three functions: of the underwriter, cedent and cessioner. Active and passive reinsurance must be balanced within the given period of time.
The reinsurance contracts are divided into contracts of facultative, obligatory, and facultative-obligatory reinsurance according to the form of mutual liabilities.
The idea of facultative method of reinsurance is that both the cedent and cessioner are given the possibility to evaluate risks which may be passed on to reinsurance. The contract of facultative reinsurance is an individual deal concerning, in general, only one risk. It grants the full freedom to the contracting parties: the cedent has the right to offer some kind of risk and the cessioner has the right to accept or decline the cedent’s offer and to propose counter terms and conditions of the contract. The matter is considered and solved on each risk separately. Passing the risk on to the reinsurance, the cedent has the right to deduct the commission fee.
The contract of obligatory reinsurance forces the cedent to pass on a part of risks accepted for insurance. On the other side the contract of obligatory reinsurance forces the cessioner to accept the risks offered for reinsurance. Reinsurance payments under the contract of obligatory reinsurance are always defined in percentage of the sum of insurance payments being received by the underwriter while concluding the initial contract of insurance.
Obligatory reinsurance covers all or the considerable part of insurance portfolio of an underwriter. The servicing of such contract is cheaper for both parties as compared to the contract of facultative reinsurance.
Facultative-obligatory reinsurance gives the cedent the freedom for decision making. He may choose which risks and in what rate are to be passed on to the cessioner. The cessioner, in his turn, should accept the given risks on terms agreed on beforehand. Such a contract may be unprofitable and unsafe for the cessioner. That is why they are concluded only with cedents being fully confident on the basis of many years’ cooperation.
The contract of proportional reinsurance stipulates, that the cessioner’s share in any given risk is defined according to previously agreed correlation of cedent’s participation. A cessioner’s participation in payments and reimbursement of damage is defined on the same correlation as his participation in risks payments. Proportional reinsurance includes such kinds of contracts as quota, excedent ones.
Under the contract of quota reinsurance a cedent undertakes to pass on to a cessioner a share in all risks of a given kind, and cessioner undertakes to accept these shares. As a rule, the share of participation in insurance is a certain percentage of insurance sum. Contracts of quota reinsurance are easy to be served mainly for a cedent. A cedent transfers to a cessioner a proportional part of received insurance payments, leaving on his account agreed commission for risk’s passing on. The commission is usually higher than that under other kinds of reinsurance contracts as quota reinsurance contracts provide higher insurance payments to the cessioner.
In spite of some advantages, quote reinsurance has some disadvantages. It really reduces cedent’s risk on all contracts passed on to reinsurance, but doesn’t involve enough levelling of insurance portfolio. The main fault of quota contract is also the necessity of reinsurance of small risks, which are not dangerous. Under other circumstances the transferring company could keep these risks under its control, retaining high premiums.
The agreement of excedental reinsurance can lead to complete levelling of that part of insurance portfolio, which remains as a cedents’s participation in risks payments. The maximum of cedent’s participation is called an excedent.
The exceeding of insurance sums over stipulated level of a cedent’s participation in risk’s payments is passed on to one or several cessioners. This exceeding of insurance sums is called excedent’s property.
The servicing of excedent reinsurance contracts is quite laborious for a cedent. It is caused by the necessity of individual consideration of any insurance agreement, whose risks are passed on to reinsurance. In spite of it, excedent reinsurance agreements are quite common, because in this way a cedent can level his insurance portfolio, keep all small risks, as to smaller sum of insurance payments it is transferred to the cessioner.
Disproportional reinsurance is characterised by the lack of upper limit of underwriter’s liability. We should distinguish reinsurance of excedent of loss and excedent of non-profitability.
Reinsurance of excedent of loss is used when underwriter doesn’t want to level separate risks of this kind, but to reach the financial balance of insurance activities in general, which can be violated by causing big damage on some risks from insurance portfolio.
The agreements of this type of reinsurance are usually concluded in the obligatory form. Reinsurance on the basis of excedent of loss is, as a rule, formed in the form of an agreement, according to which reinsurance is in force only when the final sum of loss on insured risk as a result of insurance case is higher than the sum agreed upon in the contract.
The personal participation of a cedent in payment the damages is called a priority, but the upper level of cessioner’s liability for the consequences of insurance case is called a limit of reinsurance payment.
The servicing of reinsurance contracts is simple and profitable for a cedent. On the whole professional cessioners willingly conclude contracts of reinsurance of cedent loss, because this type of contracts allows them to earn high profit. This type of contracts is widely used in civil responsibility insurance, transport insurance, fire insurance, i.e. in the cases when the loss of disastrous origin is possible.
The excedent of non-profitability is an agreement of reinsurance, under which the cessioner protects general results of a case under definite kind of insurance provided the non-profitability exceeds the percentage stipulated in the contract.
While concluding the contract the cessioner undertakes to level the cedent the exceeding of non-profitability over established limit which can make up, for example, 105% from insurance payments, collected by the cesioner. In this case it means that the loss up to 105% will be covered by the cessioner at the expense of this own funds, while the loss over 105% will be covered according to the terms and conditions of the concluded contract.