Reinsurance: The Invisible Force Impacting Your Insurance Premiums

Insurance is a fundamental aspect of our lives, providing us with financial security and peace of mind. However, have you ever wondered why insurance premiums fluctuate? One answer lies in a complex and lesser-known industry known as reinsurance. In this blog, we will explore what reinsurance is and how it affects your insurance premiums.

What is Reinsurance?

Reinsurance is a process and an industry in which insurance companies transfer a portion of their risk to other insurers, known as reinsurers. It acts as a safety net for insurance companies, helping them manage their exposure to potential losses from large claims or unexpected events. Think of it as the insurance company buying insurance for the insurance that they sold you. 

When an insurance company issues a policy to an individual or a business, it assumes the responsibility of paying claims in the event of covered losses. However, some risks can be too large or financially burdensome for a single insurer to handle on its own. This is where reinsurance comes into play.

Insurance companies purchase reinsurance to mitigate their risk by transferring a portion of it to reinsurers. In exchange for a premium paid by the insurance company, the reinsurance company agrees to share the financial responsibility for claims that exceed certain thresholds or limits. This arrangement allows the primary insurer to reduce its exposure to catastrophic losses and maintain its financial stability.

Types of Reinsurance

There are two primary types of reinsurance: treaty reinsurance and facultative reinsurance. Treaty reinsurance involves an ongoing agreement between the primary insurer and the reinsurer to cover a specific type of risk or a portfolio of policies. On the other hand, facultative reinsurance is more specific and case-by-case. It involves a reinsurer evaluating individual risks presented by the primary insurer on a per-policy basis. Facultative reinsurance is typically used for large or complex risks that fall outside the scope of treaty reinsurance.

The key features of treaty reinsurance include:

1. 1. Automatic Coverage: Once the treaty is in place, all eligible policies falling within its scope are automatically covered by the reinsurer. There is no need for the primary insurer (aka ceding company) to seek approval for each individual policy.
   2. Risk Sharing: The reinsurer assumes a predetermined portion of the risks associated with the covered policies. This risk-sharing arrangement helps the primary insurer reduce its exposure to large losses, maintain financial stability, and comply with regulatory requirements.

   3. Premium Sharing: The primary insurer pays a premium to the reinsurer for assuming the risk. The premium is typically a percentage of the original premium collected by the primary insurer from the policyholders. The specific premium rate is determined based on factors such as the historical loss experience, risk profile, and the financial strength of the primary insurer.

   4. Reinsurance Limits: The reinsurance treaty specifies the maximum liability of the reinsurer for each covered policy or for the portfolio as a whole. This ensures that the primary insurance company retains a certain level of risk and retains the responsibility for claims up to the specified limit.

   5. Long-Term Relationship: Treaty reinsurance agreements often have a multi-year duration, typically ranging over a period of time. This allows for stability and continuity in the reinsurance coverage, enabling the primary insurance company to plan its risk management strategies effectively.

Key features of facultative reinsurance include:

1. 1. Risk Evaluation: Facultative reinsurance involves a thorough assessment of individual risks by the reinsurer. The reinsurer evaluates each policy presented by the primary insurer on a case-by-case basis, considering factors such as the insured's risk profile, policy terms and conditions, and potential loss exposures.

   2. Individual Risk Selection: Facultative reinsurance allows the reinsurer to selectively accept or decline each risk presented by the primary insurance company. Unlike treaty reinsurance, there is no automatic coverage for all policies falling within a specific category. The reinsurer has the discretion to choose which risks to assume based on their own risk appetite and underwriting criteria.

   3. Tailored Coverage: Facultative reinsurance offers flexibility in coverage. The reinsurer can provide customized terms and conditions based on the specific risk being evaluated. This allows for more tailored coverage to address unique or complex risks that may not fit within standard treaty arrangements.

   4. Higher Complexity and Larger Risks: Facultative reinsurance is typically used for risks that are large, complex, or unique in nature. These risks may exceed the limits or criteria set by treaty agreements. Examples of risks that often require facultative reinsurance include major construction projects, high-value properties, or specialized liability coverage.

   5. Pricing and Negotiation: Unlike treaty reinsurance, which often follows pre-agreed premium rates, facultative reinsurance involves pricing and negotiation on a case-by-case basis. The reinsurance company assesses the risk and determines the appropriate premium based on factors such as risk exposure, loss potential, and other relevant considerations.

   6. Limited Duration: Facultative reinsurance is generally for a specific policy or a specific period rather than a long-term agreement. It provides coverage for the duration of the policy or the agreed-upon term. After the term expires, the primary insurer and the reinsurer may need to renegotiate the terms for further coverage.

Impact on Insurance Premiums

Reinsurance is a significant factor in the calculation of insurance premiums. When insurance companies purchase reinsurance, they transfer a portion of the risk to the reinsurance company. By reducing their overall risk exposure, insurance companies are able to lower their premium rates. In the event of a lack of reinsurance coverage or a high frequency of claims, an insurance company may need to increase its premiums to ensure financial stability. A recent example of this is inflation. Current inflation impacted the reinsurance industry and led to an increase in reinsurance coverage costs, resulting in increased premiums passed to policyholders 

When inflation occurs, the cost of goods and services rises, including the expenses associated with claims settlement. This means that insurance companies may face higher claim amounts due to increased costs for repairs, medical treatments, or replacement of assets. To protect themselves from these rising costs and maintain their financial stability, insurance companies may opt to increase their reinsurance coverage. By increasing the amount of risk transferred to reinsurers, insurance companies can mitigate the potential impact of inflation on their claims expenses. Reinsurers have in turn, also had to adjust their rates to account for the increased risk exposure they assume. This interplay between inflation and reinsurance highlights the need for insurance companies to adapt their risk management strategies to changing economic conditions.

Reinsurance Rating Factors

Not only inflations but other global events such as natural disasters, pandemics, or economic downturns can significantly impact the reinsurance industry. For instance, a widespread catastrophe like a hurricane can result in an upsurge in insurance claims, leading reinsurers to increase their rates. Additionally, regional factors such as climate, crime rates, and healthcare costs can also affect reinsurance pricing, ultimately influencing the insurance premiums charged by insurers operating in those areas.

Let's look at some of the other reasons for an increase in insurance rates:

1. Increased Frequency and Severity of Claims: If there is a rise in the frequency or severity of claims within a particular line of business or geographic region, reinsurers may increase their rates to account for the higher potential for losses. This can happen when there are more significant or frequent natural disasters, accidents, or other catastrophic events that lead to a surge in claims.
2. Adverse Underwriting Performance: If an insurance company experiences poor underwriting results, such as high loss ratios or inadequate pricing, it may face challenges in obtaining reinsurance programs at favorable rates. Reinsurers may respond by increasing rates to compensate for the perceived higher risk associated with the ceding company's portfolio.
3. Changes in Regulatory Environment: Regulatory changes, such as stricter capital requirements or new solvency standards, can impact reinsurance rates. Reinsurers may adjust their rates to reflect the additional costs or obligations imposed by regulatory authorities.
4. Economic Conditions: Economic factors, such as interest rates and investment returns, can influence reinsurance rates. In a low-interest-rate environment, reinsurers may seek to offset reduced investment income by increasing premium rates.
5. Loss Experience and Market Conditions: Reinsurers consider the historical loss experience and overall market conditions when determining their rates. If the industry experiences a period of high losses or a lack of available capacity due to market disruptions, reinsurers may respond by increasing rates to reflect the heightened risk environment.
6. Emerging Risks: New or evolving risks, such as cyber liability or climate change-related perils, can impact reinsurance rates. As the understanding of these risks evolves and their potential impact on the insurance industry becomes clearer, reinsurers may adjust their rates to reflect the increased exposure.
7. Capital Adequacy and Risk Appetite: Reinsurers' capital positions and risk appetites can also influence rates. If reinsurers have limited capital resources or a reduced appetite for certain types of risks, they may increase rates to ensure they are adequately compensated for assuming those risks.

Conclusion

Reinsurance is a vital aspect of the insurance industry, despite appearing complicated and distant. Reinsurers play a vital role in the stability of insurance companies by absorbing and distributing risk, ultimately impacting the premiums paid by customers. As a result of rising inflation and more severe catastrophic losses, the necessity for reinsurance has become increasingly crucial. Having a grasp of this fundamental process can aid in making better choices and managing insurance coverage effectively.

Need help navigating a confusing world of insurance jargon? We talk Texan and we talk insurance. If you would like information as it pertains to your individual insurance needs we would appreciate the opportunity to speak with you. Contact our office today to discuss your individual insurance needs.