In yesterday’s note, a great deal of time was spent discussing the loss reserves that an insurance or reinsurance company is required to record on its books. The one thing that these reserves have in common is that the losses for which these reserves are booked have occurred. This approach works for most of the business that a company may write. The premiums charged anticipate that the losses, if any, will occur during the term of the policy.

There is a portion of the premium in most property lines of business that is charged for catastrophe protection, “catastrophe premium”. Catastrophes by definition are unusual events and may occur only once every 10, 50, 250 or more years. The models that are used to help price the catastrophe premium factor these and more frequencies of occurrence into their results. Don’t worry, this will not be a discussion of catastrophe modelling. While catastrophe pricing takes a long view of these events, US accounting and tax rules do not. If there isn’t a catastrophe during the reporting period, the catastrophe premium is considered to be profit.

The New York Insurance Department has issued Proposed Regulation 189, http://www.ins.state.ny.us/r_prop/pdf/rp189txt.pdf that addresses at least part of this concern. This proposed regulation requires insurance companies writing NY natural catastrophe exposed business to create a mandatory contingent reserve which will be used to pay catastrophe losses. I am not going to discuss the pros and cons of this particular proposal. I do want to say that this is a step in the right direction. We need more states to step up and changes in the tax code to recognize that, when a catastrophe does not occur during a particular year, the catastrophe premium is not pure profit.

Most of the risks for which insurance provides protection occur with some frequency, if not for the individual insured, at least for the group of similar insureds. Building fires, car crashes, slips and falls are all examples of the high frequency losses to which insurance and reinsurance respond. The news reports these events every day. Insurance and reinsurance companies are required by law and common sense to put aside reserves to pay for all the losses that they know about and those that they don’t know about.

In the United States, companies are only permitted to establish reserves for losses after they occur. Losses fall into two categories. The first category is for those losses that are reported to the company. A claims person will assemble the information and, based on this information, will establish a reserve. This reserve is an estimate and like all estimates sometimes it is too low and sometimes it is too high. If the claims person is good, the highs and the lows will balance out.

The second category of losses is for those that have occurred but haven’t been reported to the insurance company. It is not that the insured is keeping the loss a secret, although that has been known to happen when it is close to a renewal and the rate might go up, but the insured may not know about the loss. Depending on the type of loss, the reporting of the loss may be fairly quick or years down the road.

For example, if there were a building fire on New Year’s Eve, it would be unlikely that the owner would be able to report the loss before yearend but the owner would be reporting the fire fairly quickly thereafter. On the other hand, if someone had tripped and fell outside the building on the same evening and thought that all they had was a bruised knee, they may not report anything. If a year or two later, it turns out that there was something more significant, it might be reported at that time. We’ll forget about the problems with proof or any potential statute of limitations questions in this example.

A company’s actuary will use its own information and industry information to establish the reserves. Just as when they were establishing rates, the more information that they have, the better the result will be. These type of reserves are called Incurred But Not Reported or IBNR.

The reason for this long winded discussion about reserves will be more apparent in the next blog.

When an insurance company or a reinsurance company is trying to determine how much it should charge for its product, it is basically trying to predict the future. It bases its prediction on past information and applies this information to certain models. If a company has a great deal of information for the type of risks for which it is trying to predict the future, its models will do a better job than if there is a paucity of information. For most companies that have been writing a particular line of business for some time, they will use a mix of their own data and industry data.

First and foremost, a model is a model is a model. It is not real. Perhaps, using a trip where you have to drive four or five hundred miles away and you have to arrive by a particular time would be a good example. You know where you are starting out and where you want to end your trip. You consult maps or online mapping services and a trip is laid out that includes the duration. What we have done here is to try and predict the future in terms of the route and the length of time for the trip.

Now, most times, everything goes smoothly but we all have had the inevitable “road is closed take this detour” type of trip. It is not the map maker’s fault. When the maps were drawn, the road wasn’t closed. So, what do we do? If we are experienced drivers, we give ourselves a margin of error in the time estimate. If the trip were five miles to the train station, we would most likely give ourselves an extra five or ten minutes. The further we have to go the more time we would give ourselves. If our four hundred mile trip was supposed to take nine hours, we add another one to two hours to the trip. However, if we absolutely had to be there, we might even plan on arriving the night before.

When we have a great deal of information,i.e. the local trip to the train station, we don’t have to give ourselves a large margin of error. However, as in the example above, the less information that we have, the greater a margin of error we give ourselves. My poor attempt with this analogy is that, when we are pricing an excess reinsurance product, the more losses that the reinsurer’s actuary has (like the trip to the train station) the less margin of error that will be used.

We are fortunate that there are not usually too many large losses. This condition is a good news/bad news situation. When there is a small amount of information (like the road conditions 400 miles away), we build into our model a greater margin of error.

We should note that when the reinsurer is pricing the agreement, it is doing so with old information. The newest data will be more than 1 year old when the term of the agreement begins. The end of the agreement will frequently be fifteen months after the reinsurer develops its rate.

Going back to my trip planning analogy, it is like planning your trip with road conditions that are a year old and the trip won’t be finished for another year. How frequently do you think that you’ll get it right without the “are we there yet?”

When a reinsurer is considering whether it should agree to participate in a proportional reinsurance agreement, it is basically relying on the ceding company’s pricing of its own insurance policies. If the reinsurer believes that the pricing is inadequate, it usually will not wish to be a party to the agreement. When it comes to an excess agreement, the reinsurer sets its own rate. The reinsurance rate is applied to the premiums that the ceding company is charging. If the ceding company charges amounts for its policies that are different from what had originally discussed with the reinsurer, then it will obviously change the amount that the reinsurer receives. For purposes of our discussion, we will assume that the ceding company does not change the amount it charges for its policies during the term or the reinsurance agreement.

So, what does inflation have to do with pricing an excess of loss reinsurance agreement? Let’s look at five losses from 2004. To make it simple, we will assume that all these losses were all settled in 2004 as well. The losses were $90,000, $100,000, $110,000, $120,000 and $130,000. If the company’s retention were $100,000, it would have been responsible for $490,000 of the losses and recovered $60,000 from its reinsurer.

If a reinsurer was trying to determine how much it should charge the ceding company with the same retention as in 2004, it would want to know how much it would cost if those same losses were to occur in 2009. Let’s assume that over the last five years the cost to settle those types of losses increased by 20%. The individual losses would now be $108,000, $120,000, $132,000, $144,000 and $156,000. The ceding company’s share of the losses would have increased by 2% to $500,000 while the reinsurer’s share would have increased by 167% to $160,000.

So a frequent bone of contention between the ceding company and the reinsurer is what is the proper rate of inflation to be applied to existing losses. Please note that a ceding company’s own losses are only some of what goes into pricing a program. The reinsurer would not price a program based on only five losses. The reinsurer would also use industry statistics. Tomorrow, there will be the last bit discussion of pricing.

The other type of reinsurance is where the ceding company retains the responsibility for all the losses below a fixed dollar amount and the reinsurers have the responsibility for losses that are in excess of this level up to some higher agreed amount. The fixed amount that is the responsibility of the ceding company is called its retention. This type of reinsurance is called excess reinsurance. It is fairly easy to administer. The reinsurers develop a rate that is applied to all the premiums for the business that the treaty covers. In return, the reinsurers will pay for the portion of the losses that exceed the ceding company’s retention up to the limit of the treaty. The way in which excess reinsurance applies to losses is similar to an individual’s homeowners policy. A homeowner policy has a deductible and any losses below the deductible are the responsibility of the individual and the amount of the loss that is in excess of the this deductible up to the policy limits is the responsibility of the insurance company.

As is frequently the case when something seems very easy and straightforward, there always seems to be a “but” that needs to be injected somewhere. The “but” here comes in developing the rate. I won’t spend any time in today’s post talking about developing rates. I just ask you to think about the law of large numbers and inflation and how they might apply to this type of agreement.

The other principle type of proportional reinsurance is called a surplus treaty. It can be best thought of as a variable quota share, see the previous post. The company that is being reinsured is called the ceding company. Remember, in a quota share treaty, the ceding company, usually a insurance company, agrees to give the reinsurers a fixed percentage of its premiums, less a commission, for part or all of its business in return for the reinsurers paying the same fixed percentage of the losses from that business. The percentage of premiums remains the same regardless of whether the risk being covered is a $50,000 cabin in the woods or a $600,000 home in suburbia.

An insurance company may feel that it can absorb smaller losses without too much of an impact on its balance sheet or P&L. It might also want a larger share of the premiums from smaller risks and a smaller share of losses from the larger risks. The surplus treaty is a way to achieve all these objectives.

With a surplus treaty, the ceding company keeps all the premiums and losses for risks that are valued at less than some fixed amount. This part of the concept is fairly easy to understand. It is the next part that sometimes throws a curve for people. When the risk is greater than this fixed amount, then all premiums and losses are shared in proportion that this fixed amount has to the total value of the risk.

I hope a couple of examples will clarify the sharing. We will examine three different risks, the $60,000 cabin, a $200,000 starter home and the $600,000 home. The fixed amount that we will use is $100,000. Since the cabin’s value is less than $100,000, the ceding company keeps all the premiums that it receives for insuring the cabin and pays all of the loss that it may have from that cabin.

The starter home is valued at twice the fixed amount, $200,000 vs. $100,000. Thus, the insurer’s share of the premiums and losses is 50%. It will give or cede 50% of the premiums and will recover 50% of all the losses associated with this house and not just those that are greater than the fixed amount of $100,000. In the last example, the insurer’s share is 1/6th of the premiums and losses and the reinsurers’ share is 5/6th , $600,000 vs. $100,000.

As with many things in this world, reinsurance has many variations. Fundamentally, there are just two types of reinsurance, proportional or excess. The way in which reinsurance is bought is either for a broad range risks which is called treaty reinsurance or for an individual risk which is called facultative reinsurance. Many insurance companies will buy both treaty and facultative reinsurance and sometimes it will be on the same risk. We will leave explanations of the variations for another day. For now, let’s just explore proportional reinsurance.

An insurance company may not want to keep all of a line of business on its own books. For example, it may have introduced a new product and it is writing a lot of business. The premium income is great but it might put some strains on its capital. At this point the company has three choices. First, it can stop writing new business. Most companies wouldn’t want to put the breaks on a hot new product. Second, they could try to raise new capital. This option is not always available and the additional capital stays around even if the product does not. The third choice is a quota share reinsurance treaty which can be cancelled if the product dies down or capital increases without any penalty.

The most basic type of proportional or pro rata reinsurance is called quota share reinsurance. It is also the easiest to understand. In return for accepting a fixed percentage of premiums for this line of business, the reinsurer agrees to pay for the same fixed percentage of losses. The premiums that the insurance company sends to the reinsurer are called ceded premiums. The insurance company has certain expenses associated with this business such as agents commissions, taxes or internal expenses. The reinsurer will compensate the insurer for these expenses by giving a commission on the ceded premiums that it receives. It is called a ceding commission.

For all of you who are reinsurance experts, check back in a week. We are first going to have a little Reinsurance 101.

Why would an insurance company buy reinsurance? The short answer is that an insurance company would buy reinsurance for many of the same reasons that an individual or business would buy insurance. One reason would be that in the event that there is a single large loss or series of losses, the size of these losses is greater than the company is comfortable showing on its books. A easy example would a natural catastrophe.

An insurance company writing property business on the eastern or southern coasts of the United States has to be concerned about the impact of a tropical storm or hurricane not only on its operating results but potentially even on its solvency. These storms can result in damage to many structures producing large losses. In order to protect itself from the full financial impact of these losses, the insurance company will buy reinsurance that will reimburse them once an accumulation of these losses exceeds a certain fixed amount. This type of reinsurance is called catastrophe reinsurance. The amount of catastrophe reinsurance that an insurance company will buy depends on the size of the company, i.e. capital, the amount of property insured in the area that is catastrophe prone and the company’s risk appetite.

For those of us who have been in the reinsurance business for some time, most of what is written about reinsurance by the mainstream press makes us cringe. To be fair, we usually do a very poor job of explaining ourselves to the general public. If it weren’t for catastrophes, any reporting or discussion of reinsurance would hardly ever occur. Reinsurers are then viewed as a faceless sinkhole into which money flows never to return. This blog will look to put a face on our industry by providing a common understanding of reinsurance and commentary on the issues most impacting our business. For reinsurers, insurers, legislators, reporters and all those interested in reinsurance welcome.

If you have any comments, questions or suggestions, please drop me a line