3.3 Reinsurance, Capital, and Solvency

Even a well-priced book can be too large, too peaked on the Gulf Coast, or too concentrated in one product for the surplus the company actually has. Reinsurance, capital, and solvency are how insurers keep the promises that make the rest of the business possible. Assignment 2's title — how insurers succeed — is incomplete if you stop at combined ratio. Success means still being able to pay claims after the year nobody modeled perfectly.

Why Primary Insurers Buy Reinsurance

Reinsurance is insurance for insurers. The ceding insurer (the cedent, the primary company) transfers some premium and some potential loss to a reinsurer. The transferred piece is the cession. What the cedent keeps is the retention (or net retention).

Companies buy reinsurance for several business reasons, and AINS expects you to match the reason to the structure:

1. Capacity. Surplus and net-retention rules limit how much limit a company can issue on one risk or how much premium it can write. Reinsurance lets it offer a $20 million property line while keeping $2 million net.
2. Catastrophe protection. A hurricane, wildfire siege, or tornado outbreak can hit thousands of policies at once. Catastrophe covers keep one event from consuming surplus.
3. Surplus relief. Especially with pro rata covers and a ceding commission, reinsurance can reduce net unearned-premium leverage and support more writings relative to surplus.
4. Stability. Ceding a share of every loss, or covering the spike above a retention, smooths the loss ratio that agents and rating agencies watch.
5. Withdrawal from a line. If management exits trucking or coastal property, a treaty or loss-portfolio transfer can move runoff off the net account so the company can redeploy capital.

Reinsurance is not a substitute for underwriting. A 40% quota share of a poorly priced book is a smaller poorly priced book plus counterparty risk — the chance the reinsurer is slow, disputed, or unable to pay.

Treaty vs Facultative

Treaty reinsurance covers a defined class of business automatically — for example, all homeowners written in named states, subject to limits and exclusions in the treaty. The cedent must cede, and the reinsurer must accept, those qualifying risks. Treaties are efficient for a going book.

Facultative reinsurance is risk-by-risk. Either party may decline. It is used for jumbo or unusual risks, treaty exclusions, or accounts that need extra capacity. An $80 million warehouse that blows through the property treaty's per-risk limit is a facultative placement, not something the treaty silently absorbs. Facultative underwriting looks a lot like primary underwriting on that one account: the reinsurer wants the same loss history, COPE data, and occupancy facts the cedent used.

Pro Rata vs Excess of Loss

Pro rata (proportional) reinsurance shares premium and losses in the same percentage, after a ceding commission that reimburses the cedent for acquisition costs.

• Quota share: a fixed percentage of every subject risk. A 40% quota share means the reinsurer takes 40% of premium (and pays a ceding commission) and 40% of losses, including LAE if the treaty says so.
• Surplus share: the cedent keeps a line (a dollar retention per risk, say $500,000). The reinsurer takes the surplus above that line, up to a stated number of lines. A $2 million building, $500,000 line, and three lines of surplus equals $500,000 retained and $1.5 million ceded. Smaller risks that fit inside the line are not ceded.

Excess of loss (nonproportional) reinsurance pays only when a loss exceeds a retention. The reinsurer does not take a matching percentage of original premium; it charges a reinsurance premium (often a rate on subject premium) for that layer.

• Per-risk excess (working cover): one insured or one risk, such as $4 million excess of $1 million each risk.
• Per-occurrence or catastrophe excess: one event accumulating across many policies, such as $50 million excess of $10 million each occurrence.
• Aggregate excess (stop-loss): protection when total losses for a period exceed a ratio or dollar amount.

Quota-share numbers

Subject premium $10 million, 30% quota share, 25% ceding commission.

• Reinsurer's share of premium = 0.30 × $10 million = $3.0 million
• Ceding commission = 0.25 × $3.0 million = $750,000 back to the cedent
• Net premium to the reinsurer = $3.0 million − $0.75 million = $2.25 million
• A later $400,000 subject loss: reinsurer pays 30% = $120,000; cedent retains $280,000

If the same $400,000 loss had been under a $250,000 per-risk excess treaty instead, the reinsurer would pay $150,000 (the amount above $250,000), and original premium would not have been split 30/70. Different product, different math. A catastrophe treaty would not even see an isolated $400,000 warehouse fire unless that fire was part of a named occurrence that also pierced the cat retention.

Capital, Surplus, and Solvency

Policyholders' surplus (capital and surplus) is the cushion: in simplified statutory language, admitted assets minus liabilities. Unearned premium and loss reserves are liabilities. Surplus is what remains to absorb pricing mistakes, catastrophes, and reserve development.

Solvency is the ability to pay claims as they become due. It is not the same thing as this year's combined ratio. A company can post a 107 combined ratio after a hurricane and remain solvent if surplus, collectible reinsurance recoverables, and cash are adequate. A company can show a 92 combined ratio and still be in trouble if surplus is thin, reserves are optimistic, or reinsurance counterparties fail.

Picture a Gulf Coast homeowners writer after a major storm. Gross losses are $400 million. A catastrophe treaty attaching at $50 million and covering $300 million excess of $50 million, plus a quota share on the net, is the difference between an ugly year and a surplus event that forces the company to stop writing. That is how reinsurance and capital turn into customer outcomes: the claims still get paid, producers still have a market, and the company is still there next season.

State regulators watch surplus through tools such as risk-based capital (RBC) and financial ratios; those mechanisms belong with the later regulation chapter. The Assignment 2 point is managerial: insurers succeed by holding enough surplus for the net risk they keep, buying reinsurance for the risk they should not keep, and staying solvent so producers can keep placing trust in them.

Rating agencies publish financial-strength ratings that estimate claim-paying ability. A.M. Best is the agency producers and risk managers most often cite for U.S. insurers. Other firms (for example S&P, Moody's, and Fitch) also rate insurers. AINS does not require you to memorize a particular company's current letter grade as if it were a statute. Ratings change. What you must know is that buyers use those ratings as one input, that Best distinguishes stronger (often described as Secure) from weaker (Vulnerable) categories, and that a letter is not a substitute for understanding surplus, reserve adequacy, and reinsurance.

Put this chapter together. Insurers succeed when the type of company matches its capital model, when combined-ratio and investment results earn the cost of bearing risk, and when reinsurance and surplus keep the enterprise solvent through the years the loss ratio looks ugly. That is the operating system behind every policy you will study in AINS 102 and AINS 103.

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