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Chapter 9 Reinsurance market 9/19

C7 Reinsurance of captives
A captive insurer may operate as either a direct insurer or a reinsurer:
• As a direct writing captive issuing policies to its insureds, the captive purchases reinsurance in the
commercial reinsurance market. Retentions will typically be high and aimed at low frequency and high
severity losses.
• As a reinsurance captive, the captive will issue policies to commercial (or fronting) insurers licensed
and admitted in the location of the original risks. In this way, the fronting companies transfer the
entire risk to the captive reinsurer.
In the USA, such fronting arrangements enable captives to comply with laws, imposed by many states for
automobile liability and workers compensation insurance, that require insureds to provide evidence of
coverage written by an admitted insurer. They may also enable insureds to satisfy contractual
requirements from business contracts – for example, leases or service contracts – for cover from insurers
with certain minimum financial ratings.

Insurers have access to claims handling and risk control services, and to excess risk transfer capacity in
a cost effective manner. In return, they receive a percentage of the gross written premium and are careful
to require collateral to secure the captive’s obligation. For example, a letter of credit, a trust agreement
funded by the captive’s assets and/or the retention of original premium.

D Market cycles
Non-life insurance typically goes through unpredictable price or, more appropriately, underwriting cycles
that extend over several years, leading to what are termed ‘hard’ and ‘soft’ markets by those working in
those markets.
In economic terms, we could say that the underwriting cycle for both insurance and reinsurance reflects
the law of supply and demand. Supply for both is plentiful in profitable times but scarce when an
abnormally large loss, and more particularly, a series of large losses, has affected the worldwide
insurance and reinsurance markets. Reference copy for CII Face to Face Training
In practical terms, the cycle is characterised by peaks and troughs that reflect the rise and fall of
Cycle is characterised
(re)insurance prices. It alternates between periods of soft market conditions, when premium rates are by peaks and troughs
stable or falling and (re)insurance is readily available, and periods of hard market conditions, when
rates rise, coverage becomes difficult to find, and (re)insurers’ profits increase.
Reinsurance is particularly susceptible to market cycles, since terms for both proportional treaties and
excess of loss contracts are agreed in advance of the actual treaty or contract period. Whatever losses
affect a reinsurance agreement during its currency, the agreed terms at inception are rarely amended for
that particular period.
Consider this…
Contrast this situation to that of an insurance company which is able to increase or reduce its pricing for new and
renewal business at any time it pleases. It will most probably have sophisticated computer systems to implement
rating adjustments with immediate effect.

You should be aware that some forms of reinsurance experience greater volatility in the cycle than
others. Price swings tend to be more pronounced in non-proportional reinsurance whereas in
proportional reinsurance rates do not fluctuate quite so widely because this business is more closely Chapter
linked to the less volatile direct business.
In addition to the timing of reinsurance price changes, there are other important factors that influence a 9
reinsurer’s ability to manage its affairs, as we will see later. The buyer’s need for reinsurance will also be
assessed by the reinsurer that is approached for cover. At the same time, the security of the reinsurer
and market conditions will play an important part in the buyer’s decision whether to purchase, what to
purchase and how much to purchase. That decision will also be affected by considerations of timing.
When market capacity is freely available, investment yields are high and results are moderate to good,
there is a greater likelihood that buyers can capitalise on ‘soft’ market conditions by buying more
reinsurance and at better terms.