In the following article, we look at the concepts and principles that form the basis of reinsurance, and conclude with a brief review of where the reinsurance industry appears to be headed.

Topics covered:

Introduction

Utmost good faith

Follow the fortunes

Primary company insolvencies

Situations of direct recourse

Arbitration

Types of reinsurance contracts

Pro rata or proportional arrangements

Excess arrangements

Other uses

Underwriting reinsurance

Pricing of a reinsurance treaty

Reinsurance claim handling

Reinsurance accounting

New developments in the reinsurance market

Introduction

There are several reasons an insurer buys reinsurance. However, they usually come down to one or more of the following: surplus relief (in order to write more policies); increased capacity (in order to write higher limits); stabilization of results; catastrophe protection; and reinsurer services. Like ordinary insurance transactions between a customer and an insurer, a reinsurance transaction involves a contract between the insurer—the cedent—and the reinsurer. Broadly, there are two types of contracts. The first type is treaty. With treaty reinsurance, the reinsurer agrees to accept all classes or types of business from the cedent that come within the term of the agreement. For example, the reinsurer agrees to reinsure all homeowners risks above $2,000,000.

The second type of reinsurance is facultative. In facultative reinsurance, a contract must be negotiated with each risk the cedent wishes to reinsure. These are discussed in more detail later in this article.

Regardless of the type of reinsurance utilized, there are some specific principles that are adhered to by both insurer and reinsurer, although the days of a "gentlemen's agreement" between these two entities appear to be fast declining.

Utmost Good Faith

Many of the same principles that apply to misrepresentations and concealment with regard to insurance also apply to reinsurance. Ceding insurers are to convey material facts about a risk to the reinsurer. The words good faith are heard on a daily basis in the insurance industry. Just as the contract between insurer and insured is based upon the good faith of both, so is the contract between insurer and reinsurer. The reinsurer relies on the idea that the information given by the insurer is accurate and truthful. The insurer relies on the reinsurer's promise to come through with a fair and timely payment in case of a covered loss. According to Couch on Insurance (Third Edition) §9:31, "The duty of good faith that runs between the parties to a reinsurance contract is essential to the reinsurance relationship, stemming from the reinsurer's need to rely upon and not duplicate the reinsured's efforts in properly evaluating risks and handling claims, and reducing costs for both parties to the reinsurance contract. Due to these specific needs of the industry, the duty of utmost good faith in this context connotes a higher duty than the ordinary duty of good faith that is inherent in general contract law. Accordingly, it requires that the reinsured must disclose to the reinsurer all material facts which may affect the subject risk. The failure of a reinsured to disclose material facts to the reinsurer will warrant the recission of a reinsurance contract."

The reinsurer's reliance upon the ceding insurer's statements is such that, unlike many other insurance transactions, should the ceding insurer make a misrepresentation—however innocently—the reinsurer has sufficient grounds for voiding or rescinding the policy. As in other insurance, though, the misrepresentation must be material; that is, of the type which, had it been known, would have caused the reinsurer either not to issue the policy or to charge a higher premium.

One case demonstrating this principle is Allendale Mutual Ins. Co. v. Excess Ins. Co. Ltd., 992 F. Supp. 278 (S.D.N.Y. 1998). The ceding insurer failed to inform its reinsurers about an engineering report that made specific recommendations for the insured warehouse; among them fire hoses and sprinklers. The first reinsurance contract contained a "subject to all recommendations" (sub all recs) clause, although subsequent contracts did not.

Following a total fire loss, the reinsurer denied the claim and moved to rescind the contract. The court upheld the reinsurer's position, stating that "under New York law, core of reinsured's duty of utmost good faith is basic obligation to disclose to potential reinsurers all material facts regarding original risk of loss, and failure to do so renders reinsurance agreement voidable or rescindable… [the] doctrine of uberrimae fidae imposes no duty of inquiry upon reinsurer; rather, burden is on reinsured to volunteer all material facts." Even the insurer's argument that the "sub all recs" clause was missing from later contracts did not weigh with the court. The court said that the insurer had been put on notice that the reinsurer considered the recommendations important, and notifying it with each contract was unnecessary.

Follow the Fortunes

Utmost good faith is one key. Another long-time principle in reinsurance is that the reinsurer follows the fortunes of the ceding company. If the primary company suffers a loss, the reinsurer loses as well. As cited in International Surplus Lines Insurance Co., v. Certain Underwriters and Underwriting Syndicates at Lloyd's of London, 868 F. Supp. 917 (S.D. Oh. 1994), the "follow the fortunes" doctrine may be expressed formally in the reinsurance agreement, but, even if it is not formally stated, it nonetheless applies to all reinsurance contracts. Under this doctrine, the reinsurer is required to indemnify the ceding insurer for payments made reasonably within the terms of the original policy, even if not technically covered by it.

This principle applies even if the primary insurer pays a claim not covered by the policy, as long as the decision is reasonable. In International, the court further stated that the standard for reasonable payment is purposely low because, if every decision were subject to court review, the "foundation of the cedent-reinsurer relationship would be forever damaged." The reinsurer is to follow the underwriting and claims settlement decisions of the ceding insurer. This prevents the insurer from having decisions "second-guessed" by the reinsurer, and the reinsurer cannot then raise a defense of a claim's not being covered to prevent payment.

The follow the fortunes clause usually is broader than a typical following form provision in a reinsurance contract, as explained in North River Insurance Co. v. Cigna Reinsurance Co., 52 F. 3d 1194 (3rd Cir. 1995). The following form provision limits the reinsurance to the terms and conditions of the ceded coverage and provides that the reinsurance certificate covers only the kinds of liability covered in the original policy. In this case, the cedent issued an excess policy to an asbestos manufacturer which did not include defense coverage. When the primary policy's limits were exhausted, the manufacturer turned to the excess insurer for indemnity and defense. The excess insurer denied coverage and entered into binding arbitration with the manufacturer. The arbitrator found that the excess insurer was liable; the reinsurer indemnified the cedent for liability but refused defense costs. But the court held that the reinsurer was liable for the costs, holding that the "follow the fortunes" clause "applies generally to all outcomes of coverage disputes, whether in the form of settlements or judgments."

The court also noted, though, that while a follow the fortunes clause prevents reinsurers from second-guessing good-faith settlements, it does not make a reinsurance company liable for risks beyond what is dictated in the reinsurance contract. The distinction between these two principles is explained further in International (discussed earlier) and Unigard Security Insurance Co., Inc., v. North River Insurance Co., 762 F. Supp. 566, 581 (S.D.N.Y. 1991). In analyzing the relevant terms, the court looked at the reinsurance contract between the parties: "[T]he liability of [Unigard] shall follow that of [North River] and, except as otherwise provided in this Certificate, shall be subject in all respects to the terms and conditions of [the contract] except as such may purport to create a direct obligation of [Unigard] to the original insured or anyone other than [North River]." This, explained the court, is the "following form" clause. The "follow the fortunes clause in the contract was: "All claims covered by this reinsurance when settled by [North River] shall be binding on [Unigard], who shall be bound to pay [its] proportion of such settlements…" (This case was upheld in part and overturned in part; see later in this article.)

Indeed, even after what appears to be definitive litigation of the matter, new cases come before the court to determine how far the "follow the fortunes" principle is to be taken. In American Employers' Insurance Company v. Swiss Reinsurance America Corporation, 413 F.3d 129 (1st Cir. 2005), the court said "[u]nder either New York or Massachusetts law, 'follow the fortunes' provisions preclude the reinsurer from challenging a reinsured's decision to settle so long as the settlement is reasonable within the terms of the reinsured's policy, even if not technically covered by it, and so long as the reinsured has acted in good faith." The case was remanded to the district court for determination if the reinsurer was precluded by the "follow the fortunes" provision from challenging the reinsured's decision to settle underlying environmental claims against its insured.

And, in National Union Fire Insurance Co. of Pittsburgh, Pennsylvania v. American Re-Insurance Co., 441 F. Supp.2d 646 (S.D.N.Y. 2006), a chemical company's primary commercial general liability insurer sued its reinsurer, alleging breach of contract. The insurer had paid a claim against its insured for damages arising out of bodily injury sustained by workers in an auto manufacturer because of prolonged exposure to metalworking fluids. But when the insurer sought reimbursement from the reinsurer, the reinsurer claimed it had been misled as to the nature of the chemicals. The court, however, held that the settlement was at least arguably within the scope of coverage, and thus the "follow the fortunes" doctrine compelled payment.

Just as reasonable good-faith settlements are a part of the follow the fortunes doctrine, the reverse is true. A ceding insurer acting with gross negligence or recklessness in settling a claim need not expect the reinsurer to acquiesce and tender payment.

Bad Faith Claims

Despite the emphasis on good faith, the reinsurance industry itself has not been exempt from bad faith litigation. The impact and complexity of the class action asbestos claims that arose in the 1980s caused contention between insurers and reinsurers that resulted in allegations of bad faith. Heretofore, transactions between insurer and reinsurer were almost of the "handshake" variety in that both parties amicably negotiated contracts and resolved disputes between themselves. The asbestos and other environmental pollution cases illustrate a shift in the insurer-reinsurer relationship to a more arms-length transaction than it was previously.

The asbestos litigation entailed tens of thousands of asbestos injury claims that were filed against asbestos producers who were represented by more than 1,000 law firms across the country. By 1985, producers and their insurers had paid an estimated one billion dollars in asbestos injury claims, with roughly half going for costs alone (North River Insurance Co. v. Cigna Reinsurance Co., 52 F.3d 1194 (3rd Cir. 1995).) In 1985, several insurers and asbestos producers entered into the Agreement Concerning Asbestos Related Claims, which is commonly known as the Wellington Agreement.

The Wellington Agreement established a facility for coordinating claims payments on behalf of the asbestos industry. In an effort to reduce litigation and related costs, it set arbitration procedures to adjudicate claims. Parties to the agreement could dictate whether they were including or excluding defense costs in their participation. As noted by the appeals court in Unigard Security Insurance Co., Inc., v. North River Insurance Co., 4 F.3d 1049 (S.D.N.Y. 1993), the proponents of the agreement did not anticipate that all reinsurers would accept it, and it was not expected that reinsurers would be willing to sign blank checks for recoveries based on the agreement in asbestos-related claims. However, it was anticipated that reinsurers would accept its basic principles and agree that payments made by the facility would be viewed as acceptable for reinsurance recoveries subject to the specific terms and conditions of individual reinsurance certificates.

In the lower court's hearing of the Unigard case, the reinsurer had claimed it suffered economic injury because the insurer, North River, had not given timely notice of its signing of the agreement. The U.S. Court of Appeals for the Second Circuit, in its 1993 decision on appeal of Unigard, discussed the question of whether prompt notice was required by the insurance certificate and "the good faith doctrine." The circuit appeals court ruled North River should have notified Unigard upon its signing of the Wellington Agreement. However, the court further stated that the failure was one of simple negligence that did not prejudice Unigard's position and therefore did not constitute bad faith.

The appeals court did, however, overturn the lower court's ruling that Unigard was liable for expenses that North River had been compelled to pay by arbitration. The court ruled that Unigard's liability to North River under the reinsurer certificate was capped by the limit of liability on the certificate.

The Unigard case and others like it seem to have signaled the shift from reliance on a good faith partnership between reinsurer and insurer to one of strict contractual terms.

Primary Company Insolvencies

Primary company insolvencies are another area where courts have stepped into the reinsurance business. Even though the primary company may be insolvent, the reinsurer is still liable for any losses it would have paid anyway. However, courts have ruled that the ordinary reinsurance certificate provides for indemnity of the primary insurer, not direct indemnity to the insured. Because of this, the primary insurer must have issued payment under a policy before ordinary reinsurance reimburses.

The case of Melco System v. Receivers of Trans-America Insurance Co., 105 So. 2d 43 (Ala. 1958) involved a petition by the receivers of insolvent Trans-America that $130,000 be accepted as a single settlement from its reinsurer, Employers Reinsurance Corp., to settle all claims against Employers by Trans-America. The reinsurance agreement—ruled to be an "ordinary" agreement by the court—provided that Employers would indemnify Trans-America for all judgments against Trans-America in excess of $10,000. One of the policyholders, Melco System, contested the petition, saying it had a right to proceed against Employers directly and that the receivers had no right to compromise its claim against the reinsurer.

In ruling on the decision of the lower court, the supreme court of Alabama stated that the trial court had "followed cases which hold that ordinarily a contract of reinsurance is one of indemnity to the reinsured, and that a reinsurer is under no contract obligation to the original insured and does not become liable to him." Continuing this line of reasoning, the court explained that Employers was only responsible, under the contract, to reimburse Trans-America after a claim exceeding $10,000 was paid. As stated in this ruling, "There is no mention, hint, or suggestion that Employers has agreed to do more than indemnify Trans-America, or its receiver, or that this contract is made for anyone's benefit other than Trans-America."

Situations of Direct Recourse

There are, however, instances where a reinsurer may be required to respond directly to a primary insured. One of these involves situations in which the reinsurer agrees to make itself directly liable to the insured. In this case, a cut-through endorsement or clause is attached to the contract, or is included within it. The reinsurer then agrees that in the event of the insolvency of the primary insurer, it will pay losses directly to the insured. Such an endorsement is often sought by mortgage holders when their customer obtains property insurance from an insurer without an acceptable rating from a national rating organization (such as A.M. Best).

Other situations of direct recourse may involve reinsurers that bypassed the primary insurance company to deal directly with the insured, such as in the case of Klockner Stadler Hurter, Ltd., v. Insurance Co. of the State of Pennsylvania, 780 F. Supp. 148 (S.D.N.Y 1991). This case involved two primary policies and one reinsurance policy. One of the reinsured policies contained a clause allowing direct action against the reinsurer. The reinsurer and its manager, though, had dealt directly with the insured, creating a direct relationship in which the primary insurer was not involved. Thus, the court had to determine whether the insured could sue the reinsurer even though no insolvency was involved. Based on insufficient evidence, the case was remanded for trial.

Reinsurance agreements also may permit the reinsurer to associate in the handling and defense of claims covered by the treaty. This type of clause also may dictate that, when the reinsurer participates in claims, it must bear the costs of adjustment and litigation.

Arbitration

An important part of the reinsurance agreement is the arbitration clause. Similar to the arbitration clause in most property/casualty policies, its purpose is to attempt to keep the parties to the contract out of court when contesting the terms, conditions or a loss settlement. But, unlike common arbitration clauses in standard policies, the arbitration clauses often vary greatly since both parties attempt to determine prior to a loss what disputes should be submitted. According to Couch on Insurance (Third Edition) §9:34, "A common clause requires arbitration of all issues in connection with the reinsurance agreement. Such a provision is generally construed broadly."

As with primary insurance, both parties usually are required to choose an arbiter, and the two arbiters choose an umpire; the decision of any two is binding on all parties. The arbiters and umpire are current or retired officers of a reinsurance company. But again, the language of the arbitration clause itself might dictate a different selection.

However, unlike primary policies, the reinsurance arbitration clause is not based on the strict rules of law. Rather, the arbiters are to view the treaty as an honorable engagement. (For example, in Home, discussed later in this section, the wording of the arbitration clause is "The arbitrators shall interpret this Agreement as an honorable engagement and not merely as a legal obligation; they are relieved of all judicial formalities and may abstain from following the strict rules of law…") The procedures followed are based on standard reinsurance industry practices, and the task of the arbiters is to determine the intent of the parties.

When arranging reinsurance, it is important that if many contracts are involved, the arbitration clause of each contract allows for consolidation of arbitration proceedings. See, for example, the case of American Centennial Ins. Co. v. National Casualty, 951 F.2d 107, 108 (6th Cir. 1991), which affirmed the lower court's decision refusing to consolidate numerous arbitration proceedings involving reinsurance companies over the objection of one company, where arbitration clauses in relevant reinsurance agreements were silent as to consolidation. See also the case of Home Ins. Co. v. New England Reinsurance Corp., 1999 WL 681388 (S.D.N.Y. 1999), which involved four reinsurance agreements between the two parties. Two of the treaties contained the same arbitration clause, but two later treaties contained dissimilar clauses. The Home Insurance Company sought to compel New England Re to four separate arbitrations, while New England Re wanted to consolidate them into one, or, at least, to consolidate two and stay the others until the first arbitration process was completed. But the court looked at earlier decisions of the Supreme Court, which had clarified that the purpose of the Federal Arbitration Act was to assure enforcement of privately negotiated arbitration agreements. Thus, the court did not have authority to enforce consolidation unless the parties' mutual consent had been written into the clause, and so the four arbitration proceedings were appropriate.

Types of Reinsurance Contracts

As noted in the Introduction, there are two broad categories of reinsurance: treaty and facultative. In treaty reinsurance, the ceding company agrees in advance to cede certain classes of business or types of insurance to the reinsurer. The reinsurer agrees to accept all risks that fall within the terms of the agreement. For example, an insurer may negotiate treaties to reinsure the portion of all property risks above a certain value, or a pre-set portion of each premises or products liability risk. Individual risks are not underwritten or discussed; the reinsurer relies on the insurer to accept only risks that fall within acceptable underwriting criteria and reinsures all risks that fall within the reinsurance treaty agreement. As soon as the primary insurance is in force, the reinsurance is as well.

On the other hand, facultative reinsurance means that separate reinsurance agreements must be written for each risk or policy that is being reinsured. As an example, an underwriter may want to insure a risk that falls outside her company's standard underwriting criteria and treaties. In order to write the risk, she may arrange facultative reinsurance so she can issue the policy. Market conditions also may dictate that facultative reinsurance be arranged. At times, the cost to reinsure part of a risk through a facultative agreement may be less than the insurer's internal rates and, if the treaty agreement permits some risks not to be included, less expensive than rates under the treaty. However, if the treaty covering the class of business requires that all risks insured be included in the treaty, the underwriter would not be able to replace the treaty reinsurance with facultative in order to write a particular piece of business.

Underwriters may be precluded from accepting risks that they would like to insure if they fall outside the terms of their treaties. Or, terms of a treaty covering a risk may dictate which, if any, additional exclusions must be added to the policy.

At times, types of reinsurance that appear to mix treaty and facultative reinsurance may exist. Terms such as "automatic facultative reinsurance" are used to describe situations in which facultative arrangements are made in advance, but the insurer can decide whether to cede certain risks or not. If the insurer wants to cede them, however, the reinsurer would have to accept them.

In other words, the terms of the treaty, which is negotiated between the insurance company and the reinsurer, dictate which risks can and must be reinsured under it.

Facultative reinsurance agreements may encompass many types of sharing or ceding of risks because each agreement is negotiated separately. Treaty reinsurance usually falls within general categories that describe what portion and type of the risk is ceded. The type of sharing that is used is dictated by the needs of the insurer: surplus relief, increased capacity, stabilization of results, or catastrophe protection.

Pro Rata or Proportional Arrangements

Both treaty and facultative reinsurance agreements can be structured on either a pro rata (or "proportional") basis, or excess ("non-proportional") basis, depending on the mix of business of the ceding company. Excess arrangements are discussed later in this article.

With proportional agreements, as the term implies, the primary insurer and reinsurer share the liability risk proportionately. Treaties are written as a quota share agreement (the primary insurer and reinsurer share in the premium and losses of a policy on a fixed percentage basis), or a surplus share agreement (the primary insurer selects the amount of liability it will retain on any one risk or policy and cedes a percentage of premium and losses to the reinsurer.). In each of these arrangements, a certain portion of every risk covered by the treaty is ceded. The insurer and reinsurer share a portion of all insurance, premium, and losses in the same amount. The insurer is paid a commission in exchange for ceding the risk portion and premium to the reinsurer. Only the way that the insurer's retention is stated varies between quota and surplus share reinsurance.

It is important to keep in mind that insurers are regulated as to the amount of insurance they can write based on the amount of surplus funds they hold. When a policy is written, the insurer must book the premium as a liability until it is earned. As an example, when a $2,500 premium is written, the insurer earns the premium over the life of the policy term. The premium remains unearned—a liability—and is earned as the term elapses. This depletes surplus. But through use of a proportional treaty, the insurer receives commission from the reinsurer at the beginning of the policy term. This can be booked as an asset and adds to the carrier's surplus.

The primary insurer's retention in a quota share treaty is stated as a percentage of the amount insured. The insurer retains the same percentage of insurance, premium, and losses and cedes the rest to the reinsurer—subject to the reinsurance limit. This type of contract tends to provide surplus relief, because the insurer receives commission in exchange for ceding the premium, and large lines capacity, because the insurer is able to write larger risks with it.

The primary insurer's retention in a surplus share treaty is stated as a dollar amount of the amount insured. The insurer retains a dollar amount of all insurance, premium, and losses that fall within the treaty and cedes the rest to the reinsurer. As with quota share arrangements, a commission is paid to the insurer in return for the premium ceded.

Surplus share treaties tend to increase large line capacity because an insurer is retaining only a specific dollar amount of each loss, and can also enhance surplus. This dollar amount remains consistent across all policies that are reinsured regardless of the amount of insurance provided in each. The insurer can write larger risks without threat of incurring more losses than it wants to assume, because the retention amount remains constant. In contrast, the amount retained in a quota share treaty would increase as the amount of insurance increases because the retention is a percentage of the amount insured.

To illustrate the difference, assume that an insurer wants to write a property valued at $1,000,000. In a quota share arrangement with a 25 percent retention, the insured would retain $250,000 of the property risk and cede $750,000 to the reinsurer. If the property were valued at $2,000,000 under the same quota share arrangement, the insurer would retain $500,000 and cede $1,500,000.

In a surplus share treaty, the insurer might choose to retain $250,000 of each property risk insured. The insurer thus would retain $250,000 on both a $1,000,000 property, ceding $750,000, and on a $2,000,000 property, on which it would cede $1,750,000. These examples illustrate how a surplus share reinsurance treaty would have a greater impact on large line capacity than would a quota share arrangement.

Excess Arrangements

The second major structure for either a treaty or a facultative contract arrangement is excess reinsurance. In an excess reinsurance arrangement, only losses are ceded to the reinsurer. The primary insurer retains the amount of insurance and premium. Commission is not normally paid, although exceptions to this generalization may occur.

The three standard types of excess treaties are per risk excess, per occurrence/per loss excess, and aggregate (stop loss) excess.

In per risk/per loss excess, losses above a certain dollar amount are ceded to the reinsurer, who is responsible for all losses from any one exposure above this amount up to the reinsurance limit. The retention applies separately to each subject of insurance. Therefore, if the insurer retains $100,000 of each risk, and fires at two risks that are covered by the treaty occur, the insurer would be responsible for $200,000 in losses—one $100,000 retention for each of the fires. This serves to promote large line capacity, stabilization of losses, and catastrophic protection because, once again, the insured can quantify its exposure by comparing its per risk retention to the number of risks written. It is not responsible for losses above the retention, regardless of the value of the exposures insured.

Since no commission is paid and premiums are lower than in proportional treaties, per risk excess arrangements do not tend to provide surplus relief. However, in addition to promoting large line capacity and catastrophic protection, they also help to stabilize the losses of the insurer. This is because, once again, the insurer's responsibility to pay losses is capped at the retention amount.

Per risk retentions may be set low enough that claim frequency is reinsured. This is termed working layer excess coverage because the reinsurer is participating in a layer in which claims frequently occur. Since reinsurers have different preferences for working layers and excess layers, reinsurance programs may be purchased in several layers, each one being excess of the layer(s) below it. The premium for each succeeding layer becomes less and less, because the further out the layers go, the less chance there is of a payment by the reinsurer. The layers go from "working excess" (where most of the losses are) to "high excess" (where few, if any, losses occur).

Per occurrence or per loss excess treaties are similar to per risk arrangements. However, the retention is stated as an amount incurred per occurrence. An occurrence may be one hurricane, one flood, or one accident that results in workers compensation, auto, and general liability claims. The amount retained by the insurer is applied to the total amount generated by the one occurrence.

The difference between per risk and per occurrence excess treaties can be illustrated through the use of a hurricane, which damages 100 homes in a given area. If the insurer had ceded the losses on a per risk basis with a $50,000 retention, it would be responsible for the $50,000 retention on each of the 100 homes, or $5,000,000. However, on a per occurrence basis, the insurer may have retained $500,000 per occurrence. In the hurricane example, the insurer would have to pay $500,000, and the reinsurer would be responsible for the rest of the losses up to the reinsurance limit.

Because the retention applies per occurrence, this type of excess treaty provides good catastrophe protection.

The third type of excess treaty is known as aggregate excess, sometimes called stop loss or excess of loss ratio. The retention in this type of arrangement is calculated based on all losses over a period of time stated in the treaty. The retention may be stated as a dollar amount, a loss ratio, or some combination of the two.

To illustrate this type of treaty, an insurer may want to cap the total amount of losses for which it is responsible over a certain period of time—perhaps a year. All losses generated by the line reinsured, such as workers compensation, are added together. The reinsurer is required to pay once the aggregate cap is reached. The treaty may dictate that the primary insurer is responsible for a total of $10,000,000 in losses in one year on workers' compensation insurance, regardless of whether the $10,000,000 arises from 100 or 1,000 individual claims or occurrences.

This type of reinsurance is particularly important in stabilizing underwriting results, promoting large line capacity, and providing catastrophe protection because the insurer's responsibility is capped for the entire period of time for each line reinsured.

The following chart provides a quick look at the general provisions of the various types of treaties. Keep in mind that any of these types of reinsurance may be used when negotiating facultative reinsurance on a case by case basis.

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Other Uses

A type of catastrophe coverage for casualty insurance is the clash cover. Clash covers are very inexpensive and cover losses that exceed the retention. However, the retention is equal to the highest limit on any one policy. A clash cover is written to cover all losses from one cause, e.g. a construction site. Clash covers also absorb the additional retentions caused when two or more insureds are involved in the same occurrence. Since workers compensation does not have a policy limit, this type of treaty can be written to include workers compensation policies when payment by the ceding company under the workers compensation policies exceeds the net retention.

A variation of the catastrophe cover is the funded cover. Under one type of funded cover, the ceding company sets aside a certain amount of its own funds each year with a reinsurer. The arrangement is non-cancelable unless both parties agree. Each year the fund builds, until the loss ratio exceeds the pre-arranged number. Then, the ceding company collects payment from the fund. The rate for the funded cover may escalate as payments are made to the ceding company.

There may be tax implications with a funded cover because it is similar to captive insurance. Therefore, it is recommended that tax advice be sought if contemplating this type of arrangement.

Per occurrence and aggregate reinsurance often are used in self-funded programs. A combination of the two types of insurance may be used to cap the self-insured's retention on each occurrence (per occurrence excess) and in the aggregate. For example, a self-insured workers compensation risk may elect to retain $250,000 on each occurrence and reinsure (or insure) the remaining loss incurred in each occurrence. The self-insured then may elect to cap the total retention, which is made up of individual per occurrence retentions of $250,000, at $5,000,000 in any one year through an aggregate arrangement. Thus, there would have to be 20 occurrences of at least $250,000 each before the aggregate insurance is tapped. This type of self-insured plan may be underwritten by primary insurers or by reinsurers.

Reinsurance can also be used by reinsurers themselves. If reinsurers transfer the reinsured risk to another entity, the process is called a "retrocessional agreement." The transferring reinsurer is the "retrocedent," and the reinsurer who accepts the risk is the "retrocessionaire." Sometimes one reinsurer will pay all claims of a reinsured, and then recover the amounts above the agreed-upon share from other reinsurers in a syndicate. This type of arrangement is known as "fronting"' the original reinsurer thus becomes the fronter.

Underwriting Reinsurance

Just like primary insurers, reinsurers have underwriters. However, unlike the primary insurer, there are no set rules, guidelines, or forms. Where the primary company underwriter evaluates on a risk-by-risk basis, the treaty reinsurance underwriter evaluates the insurer as a whole. As noted earlier, facultative reinsurers consider risks on a case-by-case basis.

Because every ceding company is different, each evaluation must necessarily be different from all others. The underwriter examines the ceding company's financial statements, management, and underwriting philosophy. The evaluation includes checking of outside sources, such as A.M. Best, and the company's annual report. Other items considered by the reinsurer are the qualifications of the personnel and the territories where the insurer does business.

An important part of the underwriting process is a visit by the reinsurance underwriter to the insurer applicant. On such a visit the reinsurance underwriter would check the work flow. For example, is the company following its underwriting guide and procedures? If money is required up-front with an application, is it being collected? Is the underwriting file complete, e.g., with a completed application? Is it evident that the primary underwriter has put some thought into this risk?

The class of business written is another concern. Different consideration is given to a company writing primarily homeowners as opposed to one writing medical malpractice. Also considered is how much authority is given to managing general agents.

Generally in an underwriting audit (inspection), the reinsurer examines the following areas:

I.     Selection/Decision Process

A.     Is the data in the underwriting file adequate?

B.     Is this insured eligible for the program?

C.     Are the underwriting guides and manuals being followed?

D.     Are the limits of liability acceptable?

E.     Is the loss data current and properly evaluated?

II.     Classification/Rating/Pricing