Despite the reemergence of reinsurance carrying the weight in the much professed return to the hard market, some insurance buyers tell us they missed the chapter on reinsurance in Insurance 101. So we're covering some basics of traditional reinsurance here.

Reinsurance is a tool that enables risk to be spread across a number of financial backers. Companies that buy reinsurance are called ceding companies. Companies that provide reinsurance are called, quite naturally, reinsurers. 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 won't 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 isn't as long as the rates assume, the insurance company 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 company's 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 insurer's underwriting risks when one occurrence triggers coverage under a number of policies—many of which may affect a single primary insurer or reinsurer.

The ceding company retains a portion of the risk it accepts and spreads the rest among its reinsurers. This is done to protect against large accumulations of losses from single catastrophes, such as floods and earthquakes; to protect against unexpected increases in claim frequency; to increase policyholder surplus, which is similar to the net worth of noninsurance-related businesses; to allow an insurer to write larger risks; or to absorb 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, between the insurer, or self-insurer, and the reinsurer, that automatically transfer portions of certain types of risk to the reinsurer. For example, an insurer may cede wind losses over a certain dollar amount to its reinsurer.  During hard-market hairpin turns, corporate insurance buyers often are left without insurance renewal details until the very last minute—or 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 renewals—or even which companies ultimately would write their risks—until the eleventh hour. Often, the reason given was 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 risk to risk. Facultative often is used to gain reinsurance relief for an exposure that is excluded on treaties or to gain a pricing advantage, or to simply cover an excess amount in event of loss that the primary insurer is unwilling or unable to cover.  

For example, property underwriters often place facultative reinsurance on accounts when they aren't comfortable with the amount or type of risk they would be retaining without additional reinsurance. Let's say a carrier provides a minimal amount of flood coverage but an insured needs a higher limit. facultative reinsurance could be purchased the higher limit above the limit that the carrier is able to provide.

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 risk—or both. Treaties may combine both traditional and financial reinsurance.

Traditional reinsurance supports pro rata (proportional) and excess-of-loss treaties. 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 share of all losses that fall under the treaty. Under surplus share, reinsurers take a proportional share of insurance, premium, and losses that are greater than a specified retention amount. For example, the ceding company may not transfer risk to the reinsurer unless the amount of insurance written on a policy is greater than a stated retention threshold, such as $10,000 or $100,000.

Contrary to proportional treaties, excess-of-loss treaties don't 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 don't 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 doesn't 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 treaties—which may be called catastrophe treaties in property insurance and clash cover in casualty insurance—work 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 insurer's loss ratio because, once losses exceed the aggregate retention, future losses are transferred to the reinsurer.

Even those corporate insurance buyers who are experts in the ins and outs of reinsurance often are at the mercy of reinsurance negotiations. Despite the reliance on reinsurance, insured businesses usually aren't able to tap reinsurance proceeds directly when their primary insurer becomes insolvent—unless they've 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, but that is not the norm. A cut-through clause or endorsement is part of the reinsurance contract between the ceding company and the reinsurer but the benefit goes direct to the insured rather than the carrier. The clause or endorsement 'cuts through' the contract and makes provision for insolvency of the carrier. It is used in the event the ceding company's financial rating is insufficient to attract large commercial policyholders and thus the company goes insolvent; in this case the reinsurer will pay any loss covered by the reinsurance contract directly to the insured. A cut-through endorsement is also called an "assumption endorsement", as the reinsurer agrees to assume the loss. 

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