1. METHODS OF REINSURANCE
G. Mwamba

2. Types of Reinsurance
Distinctions between proportional and non- proportional methods of reinsurance
Reinsurance premiums
Retrocession

3. Introduction
The main types of reinsurance can be divided into two main areas:
a) Facultative – the individual reinsurance of large or hazardous single risks.
b) Treaty – a contract that automatically accepts a large number of similar risks.
These types can be further divided into two basic methods:
Proportional
Non – proportional
These types are subdivided again into various forms as shown below.

4. Reinsurance
Facultative Treaty
Proportional Non-proportional Proportional Non-proportional
Quota Share Excess of Loss Quota share Surplus Excess of Loss Stop Loss

5. Facultative Reinsurance
Facultative reinsurance is the name given to the type of reinsurance whereby both the insurer (cedant) and the reinsurer have the ‘ faculty’ or option to cede and accept, respectively, the business in question.
Facultative reinsurance usually applies to risks in isolation, named and detailed individually.
The term ‘facultative’ is used to define something that is optional and, according to the dictionary, applicable to an act that is not necessary but that can be freely carried out.
The terms, therefore, describe the very essence of facultative reinsurance: the insurer’s freedom to decide whether or not to cede a transaction and to choose which reinsurer is to be offered the risk. By the same philosophy, the reinsurer has the power to accept or refuse the transaction offered.

6. First of all, the direct insurer has to submit a precisely defined offer to the reinsurer, containing all information on the risk offered. Then after examining the offer, the reinsurer decides whether to accept (a share) the risk or reject it.
Facultative reinsurance is the oldest form of reinsurance.

7. Features of Facultative insurance
The original insurer is not obliged to offer the risk on and the reinsurer is not obliged to accept.
Facultative means optional; both parties have a choice as to whether to enter into the contract or not.
Each risk is considered individually, with the original insurer determining whether they wish to place it as reinsurance and the reinsurer determining whether they want to accept the risk.
Each risk is a separate reinsurance contract and this is important to note considering treaty reinsurance later.
Although most of the risks today are ceded to reinsurance in from of treaty reinsurance, there is still an important use of facultative reinsurance particularly where the risks have to be considered individually on their own merit because of their size or their nature.

8. USES OF FACULTATIVE REINSURANCE
The development of facultative business in recent years is linked to the increasing size of risks in technical and also financial terms, together with enormous concentration of values in small areas.
It is precisely these features, together with a few other less important ones that determine the use of facultative reinsurance: everything that cannot be ceded to treaties, mainly due to size, but also due to its nature.

9. USES OF FACULTATIVE REINSURANCE
Those cases in which certain risks are placed facultatively are listed below:
Where the insurer requires capacity beyond its so called automatic underwriting capacity (the total of the limit of the insurer’s own retention plus its treaty limits). An insurer would not want to turn away a good risk because it was too large, so it may attempt to obtain facultative reinsurance to cover the excess capacity.
Where the risk is excluded from the insurer’s treaty reinsurance. Treaty reinsurance generally have a list of exclusions of business that they do not wish to cover. These might be hazardous risks, or areas of business they had particularly bad experience of in the past.

10. 3. Where the insurer does not want to cede the risk to its reinsurance treaty or where a particular risk, although covered under the treaty reinsurance, might lead to losses that could affect the rating (the amount the reinsurer would charge as premium) for the entire portfolio (all the risks that could be ceded to reinsurance).
4. Where the original risk is hazardous.
Certain risks are hazardous and especially in local markets, the insurer may not have the experience of the potential of these risks. A reinsurer would have a more global perspective and experience from other markets which help in rating and consideration of the risk.
5. Where there are unique commercial, financial or strategic reasons. These considerations vary between insurers and geographical locations but there might be pressure on insurers to accept business either for commercial or political reasons that it might otherwise not have considered due to nature or size. The entire local market might support a large or complicated risk as it is in the national interest, e.g a dam.

11. Advantages and disadvantages of facultative reinsurance
Risks are considered individually. Reinsurers can negotiate a suitable premium for the actual risk concerned rather than having to consider it as part of an overall portfolio of risks.
Facultative reinsurance increases the insurer’s competitive edge within its chosen markets.
There is a freedom to offer any risk(by the insurer) which may be accepted or declined (by the reinsurer). The individual examination of the risk with the option to accept or decline allows the reinsurer to select a portfolio of risks which corresponds to their underwriting policy.
An insurer’s treaty reinsurance could be protected by facultative reinsurance of particular risks to ensure a better overall result and lower premiums in the long term.

12. Advantages and disadvantages of facultative reinsurance
An insurer might benefit from the specific knowledge of facultative reinsurer with regard to the nature and potential of the risk.
There is an opportunity for both parties to develop a successful and professional relationship.

13. Disadvantages
As risks are considered individually, the cedant cannot be certain of the placement of the facultative reinsurance and this could affect their ability to underwrite the underlying risk.
The administration involved is labour intensive and expensive and any delay in issuing a policy can create problems with both agents and clients.
The insurer has to disclose full information regarding its underwriitng of the risk. This could be a problem if the reinsurer is also seen as a competitor in that field.

14. Disadvantages
There is the possibility of the reinsurer exercising a certain amount of influence over the insurer’s underwriting by asking them to improve the risk offered or influencing unduly their assessment of the premium on the original risk.
The insurer may lose control over the handling of the risk. E.g it may not be allowed to agree policy amendments without the prior agreement of the reinsurer. Reinsurers may control the handling of any claims by use of a claims co-operation or claims control clause.

15. TREATY REINSURANCE
Instead of having to place all the risks individually with the reinsurer and having the possibility that each separate one could be accepted or rejected, the solution was to develop an obligatory contract where the insurer is bound to cede a fixed amount of its business and the reinsurer is obliged to accept.
The treaty is the contract that outlines under what terms and what share of risk is to be placed with a reinsurer. E.g, a motor insurer insures 100,000 drivers. If it were to reinsure these on a facultatitve basis, that would mean producing 100,000 reinsurance contracts each of which would have to be agreed with the reinsurer. Instead, just one reinsurance treaty is organised. By agreeing to this contract, the insurer has to cede a certain amount of each premium received and the reinsurer is automatically on cover either for a certain percentage of each loss that occurs. This is known as a proportional treaty arrangement.
Alternatively, in a non-proportional treaty, the reinsurer agrees to pay once the loss exceeds a certain monetary amount.

16. Advantages and disadvantages of Treaties
The reinsured has automatic reinsurance cover.
The reinsured receives a contribution towards costs (ceding commission) for proportional treaties.
The reinsured can receive an additional contribution if the business is profitable(profit commission) for proportional treaties.
Administration is quicker and easier than facultative reinsurance, particularly for proportional treaties.
Accounting procedures can be simplified by use of quarterly accounting.
As treaties generally deal with large numbers of homogeneous risks, computer technology can be used for data storage and analytical techniques.

17. Disadvantages
There is no freedom since both parties are tied into the contract. Therefore faith has to be placed in the underwriting ability of the original insurer as the treaty cannot be cancelled prior to the end of the period.
Too much premium can be ‘lost’ to reinsurers on small good risks which an insurer would otherwise retain net for their own account.

18. DISTINCTIONS BETWEEN PROPORTIONAL AND NON PROPORTIONAL METHODS OF REINSURANCE
Both treaty and facultative reinsurance can be divided between proportional and non proportional reinsurance.
Proportional reinsurance is where an insurer cedes a proportion of each risk. The reinsure accepts that share in the risk, a commensurate share of premium and pays the same proportion of the claims.
E.g if the reinsurer accepts a 20% under what is termed a quota share of the insurer’s motor account, it would take 20% of the premium and pay 20% of the claims.

19. DISTINCTIONS BETWEEN PROPORTIONAL AND NON PROPORTIONAL METHODS OF REINSURANCE
Non-proportional reinsurance is based on the size of the loss and not the reinsurer’s share in the risk.
Non-proportional reinsurance is usually referred to as excess of loss as the loss has to exceed a certain retention or deductible(usually a monetary amount) before a claim can be made against the reinsurance.
E.g, if the insurer’s motor account was protected by a reinsurance of K 100,000 excess of K 50,000, the reinsurer would indemnify the insurance company for a loss once a loss exceeded K 50,000 but only upto the maximum indemnity of K 100,000 available under the contract for that loss. Any loss in excess of K 150,000 would be the original insurer’s responsibility.

20. PROPORTIONAL AND NON-PROPORTIONAL REINSURANCE: DIFFERENCES
The original risk, premium, claims and acquisition costs are shared between the insurer and reinsurer in the agreed proportion.
The treaty ‘follows the fortunes’ of the original policy.
Proportional reinsurance involves a partnership with the insurance company.
It is sometimes difficult to administer, as each individual policy, and its size and extent of coverage, needs to be considered, and reinsured to the treaty if necessary.
Large incomes are generated but profit margins are often small.

21. Non-proportional reinsurance
The retention of the reinsured is a monetary barrier before the reinsurers become involved.
The insurer/reinsurer relationship tends to be shorter term.
The excess of loss premium is calculated for the treaty as a whole, not as a proportion of each policy written.
Non-proportional reinsurance is easy to administer, as individual policies do not have to be considered individually.
The incomes may be small (relative to liability accepted) but the profit margins can be large.

22. Reinsurance premiums
The reinsurance premium is the price of cover charged by the reinsurer in consideration for offering to underwrite the risk. In all contracts of reinsurance, the premium is a reflection of the original insurer’s risk, and the basis for calculation of reinsurance premium varies according to the type of reinsurance contract.
There are a number of different definitions of the reinsurer’s premium income on which the reinsurance premium is based.
Gross premium – gross written premiums equal the premiums received for one year.
Written premium – premium income in respect of proportional reinsurance written (new or renewed) during an annual period regardless of the proportions earned.
Gross written premium (GWP) – the gross written premium describes the total premium on insurance underwritten by an insurer during a period before deduction of any outwards reinsurance premium deductions for retrocession cover.

23. 4. Net written premium – written premiums net of outwards reinsurance premium deductions for retrocession/reinsurance cover.
5. Gross net written premium (GNWP) – gross written premium net of policy cancellations and outwards reinsurance premiums but gross of commissions and expense.
6. Gross net written premium income (GNWPI) – gross written premium less only returned premiums and less premiums paid for reinsurance that inure to the benefit of the cover in question. Its purpose is to create a base to which the reinsurance rate is applied. It is the same as GNEPI except premiums are written instead of earned.

24. 7. Earned premium – written premium is premium registered on books of an insurer or reinsurer at the time a policy is issued and paid for. Premium for a future exposure period is said to be unearned premium.
8. Gross earned premium – gross premium less any part of the premium being paid in advance for later insurance years.
9. Gross net earned premium (GNEP) – gross earned premium less any policy cancellations and outwards reinsurance premiums but inclusive of commissions and expenses.

25. 10. Gross net earned premium income (GNEPI) – This represents the earned premiums of the original, reinsuring company for the lines of business covered net, meaning after cancellations, refunds and premiums paid for any reinsurance protecting the cover being rated, but gross, meaning before deducting the premium for the cover being rated.

26. THE END