From the start, reinsurance — often referred to as "insurance for insurance companies" — has been a vital part of the insurance industry.
It broadens capacity and allows for more and varied risks to be covered. It can be funded traditionally but there are also alternate ways to ensure that funds for claims are available.
Reinsurance is critical to the insurance industry, as the reinsurers carry significant amounts of risk that regular carriers can't handle. It allows carriers to assume more risk knowing that there's layer above their policies to handle such things as catastrophes. That sounds straightforward enough, but in actuality it is a little more nuanced.
In light of the recent natural catastrophes, including wildfires, typhoons, hurricanes and flooding, here is a quick look at the way reinsurance may be funded.
It started with Edward Lloyd
Insurance professionals generally know that the industry began in Edward Lloyd's coffeehouse in England around 1688. However, during the American Revolution, American insurers were cut off from Lloyd's and were forced to form more local insurance companies. Although some may have reinsured themselves, others likely accepted coverage only for losses they could retain.
Fire insurance also was instrumental in the development of reinsurance. In the early 1800s most fire companies reinsured on a coinsurance basis by submitting risks facultatively to other carriers, who happened to be the competition. Therefore, the use of foreign companies was favored to avoid disclosing information to competitors. Trying to only write the risks a carrier could handle was limiting, and carriers didn't want to give business to the competition.
A number of great fires highlighted the need for more insurance capacity. While the Great Fire of London in 1666 spurred the growth of insurance, the 1842 fire in Hamburg that left 20,000 homeless and destroyed one-quarter of the city led to the creation of Cologne Re, the first reinsurance company. Swiss Re was established for a similar reason when the Glarus Fire of 1861 burned two-thirds of the town. Some buildings were insured, but premiums had been calculated based on undervaluation of the property, and the insurer was unable to cover all the losses.
In the United States, the Great Chicago Fire of 1871 and the Great Boston Fire of 1872 had similar effects on the insurance industry.
The ability to increase capacity is one of the great functions of reinsurance. For every policy issued by a carrier, associated expenses are charged against the carrier's income, which decreases surplus, therefore reducing capacity. With reinsurance in place, the carrier can write more policies as the potential for catastrophic losses is passed on to the reinsurance companies.
Here are five additional ways that reinsurance can be funded today:
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1. Catastrophe bonds
Catastrophe bonds are often used to fund reinsurance. These bonds are specialized securities that increase the carriers' ability to provide coverage by transferring the risk to the bond investors. The reinsurer isn't taking chances; the bond investors are.
These bonds are issued through a special purpose reinsurance vehicle (SPRV), which is set up specifically for this purpose, usually offshore, where taxes and regulations are easier to manage. Having high interest rates makes the bonds attractive, although if an event occurs the interest and principal can be lost, depending on the structure of the bond. Cat bonds generally provide multi-year coverage, usually for three years.
Cat bonds took a while to become adopted, however. At first there was insufficient interest from investors, and at times the hurricane season would have started before the transactions could be completed. Eventually, the bonds became a successful way to fund reinsurance.
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2. Loss warranty contract
Another way of financing reinsurance other than premiums is the industry loss warranty contract. (ILW). The ILW is triggered by an industry loss, not a loss by a single carrier.
Hurricane Matthew, for instance, caused at least $6 billion in damage. If the ILW was set at $4 billion of loss, then the reinsurance is triggered and the reinsurer will pay an amount towards the buyer's losses.
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3. Sidecar
The sidecar in insurance parlance does not refer to the passenger compartment on a motorcycle or to the cocktail, which was invented around the end of World War I and named for the motorcycle attachment.
Another method of funding reinsurance is the sidecar. This is a small deal designed to allow a reinsurer to move potential losses to another reinsurer or group of investors. A sidecar is very specific: A specific peril, in a specific geographic area during a specific time is moved, for example, the threat of hurricanes in the Bahamas during September.
Investors in sidecars share in the profit or loss along with the reinsurer. Sidecars are similar to treaties in that regard, in which the reinsurer and primary insurer share the losses.
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4. Alternate transactions
There are some transactions that aren't exactly reinsurance but may nonetheless be labeled as such. For example, a solvent insurer may reinsure the policies of an insolvent insurer as part of the liquidation process. Basically, the new reinsurer takes over the insolvent reinsurer's outstanding claims and pays them off.
In another case, an insurer could transfer its portfolio and assets to another solvent insurer in order to abandon a particular line of insurance or as the consolidation or merger of two insurers. A carrier may have determined that writing in North Carolina isn't profitable, so it arranges to transfer its insureds to another carrier willing to assume the risks and provide coverage.
Such transactions are not actually reinsurance; with true reinsurance, the insurer and the reinsurer both have an obligation to the insured. With the transfers described previously, one insurer is removing itself from the equation, and the reinsurer is taking over its position. Such transactions are better named "assumption agreements" or "substitution agreements."
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5. Hedge funds
Hedge funds have been buyers of cat bonds because they pay high yields until a disaster hits. When there is a long stretch without significant hurricanes or other disasters, it can be quite profitable. Some fund managers are setting up their own reinsurance companies to earn a share of premiums, then they invest the income in high-yield strategies until the next disaster strikes. What helps their returns is that disasters that hit reinsurance are random and not tied to global financial markets.
These new reinsurers invest in higher-risk assets, and believe that betting on securities falling in price and being able to leverage their bets with borrowed cash gives them an advantage over traditional reinsurers. Traditional reinsurers tend to invest in low-yielding, fixed-income assets, which is typical of insurance companies to handle funds conservatively.
These hedge funds have their skeptics. Although natural disasters are not tied to the financial industry, there is the possibility of double events such as a market crash with a hurricane. For example, Sept. 11 2001, caused a market crash that wiped out financial portfolios while insurers were also called upon to pay significant claims.
Hedge funds established in Bermuda aren't as highly regulated, making it easier for funding to be negatively affected when a disaster occurs, possibly leaving insureds without coverage.
At the moment the jury is still out on the viability of this funding mechanism. So far, the new reinsurers are small, covering only a limited portion of the overall property and casualty market. Time will tell if these reinsurers stay in the market and grow, or whether they will withdraw when the business no longer looks worthwhile.
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