Various types of reinsurance are designed to cover one or all of the general categories of risk: underwriting risk, investment risk or timing risk.

Underwriting risk is the chance that covered losses will occur and trigger insurance coverage.

Investment risk is the chance that the direct insurer wont achieve the rate of return expected when developing rates.

Timing risk is the possibility that claims will be paid sooner than expected, so the time in which premiums are invested is shorter than anticipated. If the investment horizon isnt as long as the rates assume, the insurer may not receive sufficient income to cover its underwriting risk.

One of the main purposes of reinsurance is to reduce potentially dramatic fluctuations in the ceding companys loss ratio.

Peaks and valleys occur because of catastrophes, variations in expected frequency of losses, unusually large individual losses, and, as we discovered in September 2001, the overlap of an insurers underwriting risks when one occurrence triggers coverage under a number of policies written by a single primary insurer or reinsurer.

The ceding company retains a portion of the risk it accepts and spreads the rest among its reinsurers. In addition to smoothing out loss ratios, the ceding company can choose to do this for any number of reasons.

For example, insurers may cede risks to protect against large accumulations of losses from single catastrophes such as floods and earthquakes, to protect against unexpected increases in claim frequency, or to increase policyholder surplus, which is similar to the net worth of non-insurance businesses.

Reinsurance can also allow an insurer to write larger risks or to pass off existing liabilities (claims that already happened) when an insurer wants to exit a line of business.

Much of reinsurance is arranged through contracts, or treaties, that automatically transfer portions of designated types of risk to the reinsurer.

During hard-market hairpin turns, corporate insurance buyers often are left without insurance renewal details until the very last minuteor even are forced to enter into coverage extensions while their insurers treaties are finalized.

This was seen in 2002, when many buyers complained bitterly about not knowing the details of their renewalsor even which companies ultimately would write their risksuntil the eleventh hour. Often, the reason given was the delay caused by treaty negotiations.

An alternative to treaties is facultative reinsurance, in which backstops are placed on individual risks. With facultative reinsurance, each cession is individually negotiated, so the terms and pricing differ from situation to situation.

A key feature of facultative reinsurance, which distinguishes it from treaty reinsurance, is that the reinsurer has the “faculty” or option to accept or reject each individual risk presented to it, and the primary insurer has the option to cede or not to cede each risk. (There are also treaties, known as facultative treaties, which spell out when and how such options apply to defined classes of individual risks.)

Facultative often is used to gain reinsurance relief for an exposure that is excluded on treaties or to gain a pricing advantage.

For example, property underwriters often place facultative reinsurance on accounts when they arent comfortable with the amount or type of risk they would be retaining without additional reinsurance. A classic example in which facultative reinsurance might be used is for insurance on a bridge or similar structure, which has a higher value than an insurer might be willing to accept under a single policy and which is excluded on the insurers reinsurance treaties because it is a bridge.

In addition to the differences between treaty and facultative reinsurance, there are several categories of treaties.

Traditional treaties deal almost exclusively with underwriting risk. Financial reinsurance addresses investment or timing riskor both. Treaties may combine both traditional and financial reinsurance.

The traditional reinsurance treaty category sports pro rata (proportional) and excess-of-loss treaties among the different types. Under pro rata treaties, the ceding company and the reinsurer share the amount of insurance, premium and covered losses in equal proportions. So if the reinsurer takes 35 percent of the insurance, it gets 35 percent of the premium and pays 35 percent of losses that fall under the treaty.

The reinsurer relies on the expertise of the ceding company to underwrite risks and manage the business. In exchange, the reinsurer usually pays a ceding commission to the primary insurer, which helps bolster surplus.

The two main types of pro rata treaties are quota share and surplus share. Under quota share, the reinsurer pays its sharea stated percentageof all losses that fall under the treaty, and receives the same percentage of the premium paid to the ceding company. Under surplus share, reinsurers take a proportional share of insurance, premium and losses that are greater than a specified retention amount.

The key difference between the two types of pro rata treaties is that under quota share, the reinsurer assumes a specified percentage of each risk that is covered by the treaty. Under a surplus share treaty, the reinsurer assumes only its proportion of insurance, premium and losses on policies that exceed the dollar retention amount, which means that the percentage ceded can vary depending on the size of the risk or amount of insurance being provided.

For example, under a surplus share agreement, the ceding company may not transfer risk to the reinsurer unless the amount of insurance written on a policy is greater than the stated retention threshold, such as $100,000. If the risk being insured has a $50,000 value and there is a $100,000 treaty retention, the ceding company retains the entire premium and all the losses for the risk. If instead, a risk being insured has a $400,000 value subject to a $100,000 treaty retention, the reinsurer would accept 75 percent of the premiums and losses for the risk.

Contrary to proportional treaties, excess-of-loss treaties dont come into play until the amount of loss exceeds the specified retention. Because of this, the premium calculation for excess-of-loss treaties is more complicated than that in proportional arrangements.

In addition, reinsurers usually dont pay ceding commission on excess-of-loss treaties. Typically there are three types of excess-of-loss treaties: per risk excess, per occurrence excess and aggregate excess.

As indicated by their titles, per risk excess treaties protect the ceding company against the adverse effect of individual large losses. The reinsurer doesnt pay until the individual claim surpasses the retention, and then it only pays the excess amount of loss over that retention. There also is a treaty limit, which caps the upward limit of reinsurer payments.

Per occurrence excess treatieswhich may be called catastrophe treaties in property insurance and clash cover in casualty insurancework in much the same way, except that both the retention and treaty limit apply to all losses that arise from a single event.

For example, all losses arising from a catastrophic hurricane or flood are added together to erode the retention and the treaty limit.

Aggregate excess treaties often are called stop loss treaties. They are triggered when aggregate losses (the total of all individual losses incurred or paid by the ceding company during a specified period of time) exceed the retention. The retention may be a dollar amount or a loss ratio.

Aggregate excess treaties are the most effective in stabilizing a primary insurers loss ratio because, once losses exceed the aggregate retention, future losses are transferred to the reinsurer.

Even those corporate insurance buyers who are experts on the ins and outs of reinsurance often are at the mercy of reinsurance negotiations. Despite the reliance on reinsurance, insured businesses usually arent able to tap reinsurance proceeds directly when their primary insurer becomes insolventunless theyve purchased an alternative risk transfer program in which they directly have negotiated their reinsurance.

Sometimes reinsurers provide direct rights to insureds through cut-through endorsements, although this is not the norm. An agreement recently announced by The Kemper Insurance Companies, in which a unit of Berkshire-Hathaway is providing a cut-through, is one example.

Absent such cut-through arrangements, the corporate insurance buyer is left in the same position as the weather punditable to talk all he wants, but unable to directly control his insurance destiny.

Diana Reitz is the editor of the National Underwriter Company publication “The Tools & Techniques of Risk Management & Insurance” as well as the “Risk Funding” & “Self-Insurance” Bulletins, both available at www.nationalunderwriter.com/nucatalog.

Reproduced from National Underwriter Edition, February 3, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.