2.7 The Purpose of Reinsurance

Learning outcome 4 requires candidates to explain the purpose of reinsurance. Reinsurance has appeared in passing in earlier sections — as the answer to partly insurable catastrophe risk in Section 1.5 and as an internal function of an insurer in Section 2.4. This section pulls it together.

What Reinsurance Is

Reinsurance is insurance for insurers. An insurer that has accepted a risk from its policyholder transfers part of that risk to another insurer. The contract is between the two insurers; the original policyholder is not a party to it.

The vocabulary is fixed and examinable:

Why Insurers Buy It — The Five Purposes

1. Capacity. An insurer's ability to accept risk is limited by its capital. Reinsurance lets it accept a risk far larger than it could retain — a £400 million power station, a fleet of aircraft — because it keeps only a manageable slice and cedes the rest. Without reinsurance the largest risks in the economy would be uninsurable or would have to be split among dozens of direct insurers.

2. Stability of results. Claims experience is lumpy. A single large loss, or an unusually bad year, can turn a profit into a loss and destabilise reserves, pricing and shareholder confidence. Reinsurance smooths results from year to year by shaving the peaks off the loss distribution, which in turn allows steadier premium rates for policyholders.

3. Catastrophe protection. A windstorm, flood or earthquake produces an accumulation — many separate policies damaged by a single event. Pooling does not help, because the exposures are correlated: the whole pool is hit at once. Catastrophe reinsurance is the mechanism that spreads that accumulation across the global market, and it is the direct answer to the "not catastrophic to the pool" insurability feature in Section 1.5.

4. Financing and solvency relief. Ceding business reduces the capital an insurer has to hold against it, freeing capital for growth. Proportional reinsurance also produces a ceding commission paid by the reinsurer toward the cedant's acquisition costs, which helps a growing insurer fund new business strain. Under the UK's Solvency UK regime, recognised reinsurance reduces the Solvency Capital Requirement (Section 10.3).

5. Expertise. A reinsurer sees the same class of business across many cedants and many territories. An insurer entering a new class or territory can buy not just capacity but the reinsurer's underwriting guidance, rating data and claims experience.

Facultative and Treaty

The first way to classify reinsurance is by how the business is placed.

• Facultative reinsurance covers one individual risk, negotiated case by case. The cedant offers the risk and the reinsurer may accept or decline it — each side retains the faculty to choose. Used for unusually large or unusual risks that fall outside a treaty, or that exceed treaty limits. Slow and administratively expensive, but precise.
• Treaty reinsurance covers a whole class or portfolio of business under a standing agreement. Every risk falling within the treaty's scope is automatically ceded and automatically accepted — the reinsurer cannot pick individual risks. Efficient, gives the cedant certainty of cover before it writes a risk, and is how the great majority of reinsurance is placed.

Proportional and Non-Proportional

The second way to classify reinsurance is by how premiums and losses are shared.

Proportional

Premium and losses are shared in the same agreed proportion, from the first pound of loss.

• Quota share — a fixed percentage of every risk in the class. A 40% quota share means the reinsurer takes 40% of every premium and pays 40% of every loss. Simple, but the cedant gives away part of even the small risks it could easily have kept.
• Surplus — the cedant sets a retention (a "line") per risk and cedes only the surplus above it, expressed in multiples of that line. This lets the cedant keep small risks in full and cede only the large ones, so it is more selective than quota share but more complex to administer.

Non-proportional

The reinsurer pays only when a loss exceeds a stated amount, and the premium is not proportional to the cedant's premium.

• Excess of loss — the reinsurer pays the layer of any loss above the cedant's retention, up to a limit. A "£4 million excess of £1 million" layer responds to the portion of a loss between £1 million and £5 million. Layers can be stacked, and the cover may operate per risk or per event (catastrophe excess of loss).
• Stop loss — protects the cedant's annual aggregate result, responding when the class's total loss ratio for the year exceeds an agreed percentage. It protects against a bad year rather than a bad loss.

The Point That Is Always Tested: No Privity

The original policyholder has no contract with the reinsurer. Reinsurance is a separate contract between two insurers, and the doctrine of privity of contract means the insured cannot sue the reinsurer or claim against the reinsurance in any way.

The consequences follow directly:

• The direct insurer remains solely liable to its policyholder for the full amount of a valid claim, and must pay it whether or not the reinsurer pays the cedant.
• If the reinsurer becomes insolvent, that is the cedant's problem, not the policyholder's — which is precisely why reinsurer credit risk is itself a prudential concern for the PRA.
• The policyholder generally has no right even to know how, or whether, the risk has been reinsured.

Reinsurance therefore changes nothing about the policyholder's contract. It changes everything about how much risk an insurer can afford to accept in the first place.