As we know from the reinsurance article, reinsurance is a practice where insurance companies agree to transfer some risks to reinsurance companies to reduce their risks. This process is also known as “insurance for insurance companies”.
You could ask “Why to reinsure at all?”. In essence, insurers decide by themselves which risks are to be reinsured. Moreover, reinsurance helps to recover from big claims, provide a delighted customer service and help companies enter new areas of their business.
Let’s master the definition on practice. Visualize you own an insurance company, which agrees to insure 5 Ferrari “LaFerrari Aperta” cars, at a cost of $2.200.000 each. Doubtless, there is a risk that the cars get damaged. And if all of them are, you need to resolve the claim and potentially you will go bankrupt.
To avoid such and many other kinds of problems, insurance companies decide to hand over some of their risks to reinsurers. The reinsurer, in its turn, agrees to take the risk in exchange for a share of the insurance premium.
There are three types of reinsurance agreements, you can learn by continuing the reading.
Reinsurance can be:
- Obligatory reinsurance: on a wide range of risks
- Facultative reinsurance: on an event-basis
- Fronting: on an individual-level risk basis
Obligatory reinsurance provides legal relationship between the insurer and the reinsurer, which is mandatory in its nature. This reinsurance contract is a legal document that defines the relationship, rights, and responsibilities of the parties.
When choosing an obligatory reinsurance for each class of insurance, the company considers the number of contracts for that class of insurance, the average amount of risks assumed, the loss ratios, the possibility of self-retention, the homogeneity of the risks, the international reinsurance experience and much more.
As an insurance company you will often sign obligatory reinsurance treaties. Obligatory reinsurance process is quite simple!
Before coming to an agreement for obligatory reinsurance, you and the reinsurer make sure that your interests align.
An obligatory reinsurance agreement is an automatic treaty. It imposes the reinsurer to accept all policies you send. When you agree with your customers on a set of risks you automatically send these policies to the reinsurer. You should not wait until their approval; you are just notifying them.
The good news about the obligatory reinsurance is that it supports a long-term relationship between the two parties.
Moreover, it’s time-consuming to agree on terms for small risks individually. Hence, the obligatory insurance increases the efficiency of work.
Well, the concern is that the automatic acceptance does not give the reinsurer the chance to be picky. And because of this, the reinsurer might suddenly be taking a greater risk. The reinsurer might be becoming liable to cover more losses than it originally bargained for.
Facultative reinsurance is non-mandatory in its nature while accepting and transferring the risk. That means, according to the facultative reinsurance type, the insurer (reinsured) can transfer the risks accepted by the reinsurance.
Moreover, the insurer has no obligation to the reinsurer to transfer this or that risk to reinsurance, which can be offered in whole or in part. In turn, the reinsurer has no obligation to the insurer to accept the risks offered. They may reject the reinsurance offer altogether, accept it partially or even offer their terms under which the risk can be accepted for reinsurance.
Facultative reinsurance represents a one-time transactional deal between the insurer and reinsurer. Such types of reinsurance treaties allow the reinsurance company to review every risk they are taking. The more wisely the reinsurer agrees on risks, the greater the chance of recording high profits.
Imagine a customer wants you, as an insurer, to insure a building costing $3.500.000 and you agree on it. Naturally you will get frightened because if this building is on fire, your business is crashed. You don’t want to have endless nights contemplating on this issue. You just sign a facultative reinsurance agreement and enjoy running the business.
For sure, facultative reinsurance contracts are more expensive than that of obligatory reinsurance. This can be explained by the fact that obligatory reinsurance covers a huge number of policies in one agreement. Because of the economies of scale, a single contract for the obligatory reinsurance costs much lower than that of the facultative one.
Although facultative reinsurance is costly, it allows the company to reinsure specific risks it may otherwise not be able to take.
Fronting is most typically perceived as when a ceding company (insurer) underwrites a policy and transfers the entire risk to a reinsurer. The company that underwrites the initial policy is the fronting company and receives a small portion of the premium, despite ceding the entirety of the risk to the reinsurer. Fronting companies usually charge a fee for this service, generally between 5 to 10 percent of the premium being written.
This mechanism is more suitable for international corporations with branches spread all over the world. The large corporation refers to their insurance company (which in most of the cases is an insurance giant), the company then refers to the “domestic” insurer asking to underwrite a policy. This is the case for “Coca-Cola HBCA CJSC”, “HSBC Armenia”, “Geoteam CJSC” and many more of the international organizations. Suppose you, as the owner of an insurance company, get a mail from a reinsurer, who asks you to underwrite a policy they want. Reinsurer states that they will cover all the risks associated with the policy and will maintain complete control over the claims process.
Your company is to be called the fronting company. You receive a percentage of the premium for underwriting the risk, despite transferring all the risks associated with the policy.
Let’s sum up: your insurance company is not liable for the claims in these types of agreements.