How do property and casualty insurers manage risk? The role of reinsurance
By tempering financial losses, the insurance industry lends resilience to the economy and helps homeowners and businesses recover from natural disasters and other catastrophes. In order to do this, however, the insurance industry must itself be resilient.
In 2005, U.S. property and casualty (P&C) insurance companies paid out a record
Hurricane Katrina, one of the most destructive storms in U.S. history, caused more than
Insurance and reinsurance
Most Americans have some form of insurance, whether it is car insurance, homeowners insurance, or an extended warranty for an iPhone. In each case, the policyholder pays a premium and the insurer agrees to pay for damages specified in the insurance policy that occur during the life of the contract. Insurers make money when the returns they earn by investing premiums plus the premiums themselves exceed their payments to policyholders.
However, insurers do not know the true cost of an individual policy until after the contract has expired and any losses are known. For example, in a given year, one insured driver may have no accidents, while another causes a five-car pileup that leads to millions of dollars in damages. In order to control the risk of their overall portfolio of insured drivers, insurers rely on the law of large numbers. It is difficult to predict if an individual driver will have an accident in a given year and even more difficult to predict the insured losses due to that accident. However, if a company insures 100,000 drivers, it can estimate the approximate fraction of drivers who will have an accident and predict the total losses within a tight range. By insuring many drivers, the insurance company can better predict average losses per policyholder and set premium prices appropriately. A similar logic applies to other types of insurance as well. However, the law of large numbers does not make it easier to manage some risks, particularly those associated with extreme events that are geographically concentrated, such as Hurricane Katrina. In order to cope with this type of risk, insurers often use reinsurance.
Reinsurance is insurance for insurers. Just as a policyholder pays a premium and in exchange the insurance company pays for losses associated with that policy, in a reinsurance transaction the primary insurer pays a premium to a reinsurer, and in return the reinsurer covers the losses associated with the reinsurance policy. When a primary insurer uses reinsurance, it retains its obligation to pay valid policyholder claims, and policyholders continue to interact with the primary insurer, not the reinsurer. If the reinsurer defaults on its obligation to the primary insurer, the primary insurer still must pay policyholder claims.
In a typical reinsurance contract, the primary insurer pays the reinsurer a share of the premium it receives and the reinsurer agrees to pay the primary insurer for all or part of a loss that the primary insurer experiences on the block of business that has been reinsured. Some reinsurers, such as
Other reinsurers, such as
Managing risk with reinsurance
One of the main reasons primary insurers use reinsurance is to manage risks associated with a concentration of policies in a specific geographic region or business line. A concentrated insurance portfolio can lead to volatile earnings. For example, a company that specializes in fire insurance in
P&C insurers also use reinsurance to increase their capacity to sell insurance.4 Most insurers have a limit on the maximum amount of risk they are willing to accept from a single policy, known as a retention limit. An insurer with a potential client seeking a commercial liability insurance policy that would cover up to
Reinsurance can also increase the capital of the primary insurer. Reinsurance provides capital relief to the primary insurer by removing some insurance risk, which allows the primary insurer to reduce its required reserves. Reserves are liabilities that represent the expected losses from the company's insurance portfolio. To offset reserves, insurers must hold liquid assets such as U.S. Treasury securities or highly rated corporate bonds that they can sell to cover losses in the event of a claim. A primary insurer must hold higher reserves when it is exposed to greater insurance risks. A primary insurer can increase capital through reinsurance because it reduces its insurance risks and, hence, can hold fewer reserves, but it still has some of the assets backing the pre-reinsurance level of reserves.
The flexible nature of reinsurance allows insurance companies to write contracts that fit their specific needs. Reinsurance can be used to help a primary insurer manage risk, increase underwriting capacity, or increase capital. While a variety of reinsurance contract structures exist, they tend to fall into two general categories: proportional reinsurance and nonproportional reinsurance.
Proportional reinsurance
Proportional reinsurance can be thought of as a partnership between the primary insurer and the reinsurer in which risks, premiums, and losses from a given group of policies are shared proportionally. Under a proportional agreement, if the
Nonproportional reinsurance
Nonproportional reinsurance contracts are typically written to protect the primary insurer from a large-loss event.5 In a nonproportional agreement, the reinsurer covers losses that exceed some threshold. These policies usually specify the maximum amount of losses that the reinsurer will cover as well.
Consider, for example, a block of
P&C reinsurance market6
Reinsurance is a crucial part of the P&C insurance industry. In 2013, U.S.-based P&C insurers wrote
In 2013, the top 20% of P&C insurers by assets ceded 13% of their premiums through reinsurance contracts, while the bottom 80% of firms ceded over 22% of premiums. Larger insurers tend to be less likely to use reinsurance because they are more diversified, both geographically and across business lines.
Consider
The use of reinsurance also varies greatly across business lines. Auto insurance (4.3%) is the least reinsured product line, while aircraft insurance (39.5%) is the most reinsured (see figure 1). There are three main reasons why auto insurance requires less reinsurance. First, car accidents are typically uncorrelated events. When a driver insured by Insurance Company A gets into an accident, the likelihood that other Insurance Company A drivers will have accidents does not change. Second, the average car accident claim is relatively inexpensive, even in cases where there are injuries. In 2010, only 2% of payouts exceeded
In contrast, commercial airline crashes are very rare and, hence, more difficult to predict. In addition, when they do occur, insurance payouts can be very large. So far in 2014, there have been seven commercial airline crashes and tens of millions of flights without incident. For the insurance industry, the most expensive of those disasters will likely be Malaysian Airlines Flight 17.
Payouts to the families of plane crash victims are usually capped at
A loss in the range of
The reinsurance industry itself is dominated by large firms. In 2013, the ten largest U.S.-based reinsurers by premiums assumed accounted for
When a primary insurer uses reinsurance, the primary insurer is exposed to counterparty risk, which is the risk that the reinsurer (the counterparty) will not be able to honor its obligations. Because larger, more diversified reinsurers are likely to be able to cope better with outsized claims, nonproportional reinsurance is more concentrated than proportional reinsurance. In 2013, the top ten U.S.based reinsurers by premiums assumed accounted for 76% of the total
Conclusion
Reinsurance plays a critical riskmanagement role in the property and casualty insurance industry. Reinsurance allows P&C insurers to manage risks associated with concentrated exposures to business lines and geographies. Without reinsurance, insurance premiums would likely be higher, less insurance would be offered, and some insurance for infrequent events that cause large, concentrated losses, such as natural catastrophes, might not even exist.
1 See www.iii.org/issue-update/ catastrophes-insurance-issues and www.acegroup.com/bm-en/ assets/3q2010newsletterrevised.pdf.
2 www.nhc.noaa.gov/pdf/TCR-AL122005_ Katrina.pdf.
3 Data from SNL Financial and author's calculations.
4 Underwriting a policy means the insurer guarantees to pay the policyholder in the event that loss or damage occurs.
5
6 Data from SNL Financial and author's calculations. Note, premiums ceded include only unaffiliated reinsurance transactions. Premiums assumed only include premiums assumed from nonaffiliates.
7 See www.nytimes.com/2012/08/25/yourmoney/auto-insurance/how-to-know-ifyou-have-enough-auto-insurance. html?pagewanted=all&_r=0.
8 See www.washingtonpost.com/blogs/ wonkblog/wp/2014/07/19/ to tal-liabili ty-in-m h 17-crash-could-climbto-l-billion/.
9 Data from
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