Page 22 - M97TB9_2018-19_[low-res]_F2F_Neat2

1/4 M97/February 2018 Reinsurance
1
Chapter

We can see from figure 1.2 that reinsurance is only one of a number of ways in which an insurance
company could consider dealing with a risk. However, reinsurance is a vital tool in an insurer’s handling
of risk as it provides a greater degree of financial control over the risks that the company has
underwritten. It should be appreciated, however, that some insurers are more ‘risk averse’ than others,
and so will be more inclined to reinsure, whereas others may buy less reinsurance or perhaps none
at all.
We have established that insurance is a mechanism that allows the impact of loss to be spread.
Insurance allows the
impact of loss to be Reinsurance serves the same purpose but at a macro level – it is the means by which insurers can
spread spread their losses by transfer of risk to reinsurers. Insurers may not want a concentration of liability for
one type of business, class of risk, geographical area or other classification. By effecting reinsurance as
part of a risk management strategy, the potential impact of future loss is spread.

A2 Increases capacity

An insurance company’s capacity is its ability to provide a limit of cover in the policy it issues to its
insured. The insurance company is making a promise to pay when an insured event happens, so it will
aim to have a gross capacity, before the application of any reinsurance, which is large enough for it to
write most of the business it seeks or is offered. Its net capacity is the amount it retains for itself after it
has laid off (or passed on) part of its liability to a reinsurer. In addition to the capacity it can offer on a
single risk, the insurance company also has to consider the extent to which it takes on aggregations of
liability from writing many risks which are all exposed to the same potential loss.

Using reinsurance enables an insurance company to offer a greater gross capacity than it considers
Reinsurance enables
an insurance prudent to retain for its net account by paying a reinsurer to take on the difference. In determining its
company to offer a capacity, the insurance company has to calculate how much of its capital it is prepared to put at risk.
greater gross
capacity
In certain classes of business, reinsurance provides a method of increasing an insurance company’s
capacity to compete against other insurance companies in a market where an ability to accept large risks
is vital, for example, marine, aviation or space risks. The size and capacity of an insurance company
attracts clients or brokers to place business with it if that insurance company can cover the entire risk.
This reduces the administrative burden of having to place the risk with more than one insurance Reference copy for CII Face to Face Training
company, thus representing a significant economy of scale benefit. It is also easier to track the
performance of and security offered by just one insurer.
An insurance company might be limited in its overall capacity to accept business by Solvency II (see
PRA decides the
underwriting capacity chapter 9, section B) and its regulator’s determination of how much it can underwrite on the basis of its
of a company based available assets. Government regulation of the limitation of capacity applies to the overall amount of
on its solvency
margin premium income written as well as underwriting limits. In the UK, the Prudential Regulation Authority
(PRA) decides the underwriting capacity of a company based on its solvency margin (assets over
liabilities).
In other countries, such as the USA, the advent of regulations concerning risk-based capital has assisted
in growing the use of reinsurance. Risk-based capital is a method developed by regulators to measure
the minimum amount of capital that an insurance company needs to support its overall business
operations. It is used to set capital requirements considering the size and degree of risk taken by the
insurer. By committing to reinsurance, an insurance company reduces its capital requirements.

Question 1.2
Why would an insured, or a broker acting on behalf of an insured, prefer to use an insurer that can accommodate the
whole of a risk offered?

If one insurance company does not have enough gross capacity to accept a risk from an insured, the
insured may have to co-insure the risk with one or more other insurance companies. This is a means of
increasing the capacity of a market to underwrite risks, with each insurance company being limited to
the amount it underwrites on the original policy. Each co-insurer would have a contractual relationship
with the insured. This system is used particularly for covering large industrial risks. The following
example contrasts the different ways that reinsurance and co-insurance work.