Reinsurance: A Primer for Agents

Insurance for Insurance

The most basic explanation is that reinsurance is insurance for insurance companies. It is a way to spread risk and insure against monumental claims that could drive an insurance company out of business. Reinsurance is available from several sources including dedicated US-based reinsurers (primary companies that also sell reinsurance) and alien reinsurers located in places like London, Europe, and Bermuda. Though they are huge multi-billion-dollar companies, few are household names.

Instead of individual policies, reinsurers sell insurance that cover an insurer's book of business. These business arrangements are know as "treaties." For example, a property insurer may have a portfolio that includes replacement policies on 100 homes valued at $100,000 each, which equals a total exposure of $10 million. This "primary" insurance company can cover the normal volume of claims through adequate rates and surplus. However, if a hurricane were to destroy most or all of those homes, the losses could overwhelm the company and force it into bankruptcy. To protect itself, the insurance company buys reinsurance as a way to ensure solvency in the face of catastrophic losses.

Two Types Available

Reinsurers sell two basic types of reinsurance. Proportional reinsurance, as the name implies, is where a reinsurance company agrees to cover a portion of a primary company's losses in exchange for a portion of the premium. Per my example, if a company wants to reduce its share of the $10 million in total exposure, the company could cede a portion of the premiums they collect to the reinsurer in exchange for the reinsurer paying out a portion of the losses. Another form of reinsurance is excess-of-loss reinsurance which covers losses that are above and beyond a primary company's retention or deductible.

Supply and Demand

There are several key benefits that reinsurers provide primary insurance companies. First, they limit an insurer's liability and provide protection against catastrophic losses. As a result, there is more capacity in the market and that enables companies to sell more policies.

In recent years, the need for the catastrophe protection that reinsurance provides has been the most relevant to Florida policyholders. Six of the 10 most violent hurricanes ever to come ashore in the United States have occurred in the past two years. Hurricane Wilma was the most intense hurricane ever officially recorded. Hurricanes Katrina and Rita, by themselves, generated insured losses totaling close to $50 billion. Nearly half of this cost was borne by reinsurers. Meteorologists agree that we are in the middle of a multi-decade period of heightened hurricane activity and that there are at least 10 more years to go.

Both primary insurance and reinsurance companies are evaluated by rating agencies, which assess their financial health and ability to pay claims. Knowing that there are more storms to come, the rating agencies are demanding that insurers and reinsurers put aside more reserves to cover claims. Companies that fall short of these capitalization requirements can be issued a "downgrade" – a lower financial strength rating that can make it virtually impossible for an insurer to operate. The need for increased capital restricts the ability of insurers to write policies. The only other option is to raise premiums on policyholders.

Unlike primary insurers, whose rates are typically approved by state regulators, reinsurers charge what they feel are adequate rates. This disparity is called "dislocation" and is very much present in Florida. Unable to raise rates sufficiently to pay for reinsurance, some primary insurers have been forced to stop writing new policies or even drop existing policies. Ultimately, the laws of supply and demand prevail.

Reevaluating Modeling Tools

Reinsurers rely on outside consultants who evaluate the risks of primary insurers using sophisticated modeling tools. Katrina and Rita demonstrated to these catastrophe-modeling companies that their previous models had low-balled the potential destruction, and losses were far greater than anticipated. As a result, probable maximum loss estimates have been increased significantly. Reinsurers have no choice but to charge more.

Meanwhile, insurers in other states – especially those along the eastern seaboard – are also seeking more reinsurance to cover their own increased catastrophic exposures. With more insurers chasing fewer reinsurance dollars, prices rise.

Many agents will remember that Florida has been through a property insurance crisis before. It was after Hurricane Andrew that the state broadly expanded coverage that is now provided by Citizens Property Insurance Corporation to insure homeowners who could not find insurance anywhere else. Later, the state also founded the Florida Hurricane Catastrophe Fund (FHCF) to act as a reinsurer for all companies writing residential property exposures. Unfortunately, both of these institutions have been overwhelmed by recent storms. Citizens, originally created to be the market of last resort, is now the largest homeowners' insurer in the state, and, due to huge losses, the FHCF has had to issue bonds.

Truth be told, the picture is not rosy. With the threat of more violent hurricane seasons to come, reinsurance will remain in short supply. As the insurance industry's most visible representatives, agents bear the brunt of the public's anger and skepticism. Unfortunately, policyholders' arguments are not necessarily with insurance companies or their reinsurers, but with Mother Nature.