Reinsurance

Reinsurance is a contract under which one insurance company transfers part of the risk it has assumed under the policies it issued to another insurance company. The NAIC's consumer glossary describes it as "a transaction between a primary insurer and another licensed (re)insurer where the reinsurer agrees to cover all or part of the losses and/or loss adjustment expenses of the primary insurer." It adds two sentences: "The assumption is in exchange for a premium. Indemnification is on a proportional or non-proportional basis." The same glossary gives the market its vocabulary: a ceding company is "an insurance company that transfers risk by purchasing reinsurance," a reinsurer is the "company assuming reinsurance risk," and the ceded premium is the "amount of premium (fees) used to purchase reinsurance." A treaty is "a reinsurance agreement between the ceding company and reinsurer."

The reason a consumer encounters the word at all is usually a claim conversation or a company failure, and in both the same fact governs: the policyholder is not a party to the reinsurance contract. The company named on the policy owes the claim, and it owes the whole claim whether its reinsurers pay it, dispute it, or fail. Reinsurance is best understood as a financing and capacity arrangement between two insurers rather than as a second layer of protection standing behind your policy.

Why regulators care, and what they actually regulate. State insurance law does not approve reinsurance contracts. It regulates whether the ceding insurer may take credit for one. The NAIC's Credit for Reinsurance Model Law opens: "Credit for reinsurance shall be allowed a domestic ceding insurer as either an asset or a reduction from liability on account of reinsurance ceded only when the reinsurer meets the requirements of Subsections A, B, C, D, E, F or G of this section." That single sentence is the whole regulatory hinge. An insurer that has ceded risk still holds reserves against the policies it issued; taking credit is what lets it reduce those reserves, and reduced reserves are what free up capital to write new business. The simplest route to credit, in Subsection A, is that "the reinsurance is ceded to an assuming insurer that is licensed to transact insurance or reinsurance in this state," with further routes for accredited, trusteed and certified reinsurers and for those domiciled in reciprocal jurisdictions.

The model law states its own purpose as protecting "the interest of insureds, claimants, ceding insurers, assuming insurers and the public generally," and it declares an intent "to ensure adequate regulation of insurers and reinsurers and adequate protection for those to whom they owe obligations." The protection it provides to a policyholder is therefore indirect and worth naming as such: the rules exist so that an insurer cannot reduce the reserves standing behind your policy by ceding risk to a counterparty that cannot pay.

Credit is not the same as coverage, and the state guaranty association system says so expressly. The NAIC's Life and Health Insurance Guaranty Association Model Act lists among the things the act "shall not provide coverage for" a "policy or contract of reinsurance, unless assumption certificates have been issued pursuant to the reinsurance policy or contract." An assumption certificate is the document by which the reinsurer takes over the original insurer's obligation directly to the policyholder, which converts an arrangement between two companies into a promise to the individual. Absent one, the guaranty association is protecting the policy your insurer issued, not the reinsurance behind it, and the distinction only becomes visible at insolvency.

The vocabulary tells you which side of the trade a filing is describing. The same transaction is ceded reinsurance on the buyer's books and assumed reinsurance on the seller's, which the NAIC glossary carries as its own entry: "the assumption of risk from another insurance entity within a reinsurance agreement or treaty." Authorized reinsurance is "reinsurance placed with a reinsurer who is licensed or otherwise allowed to conduct reinsurance within a state," which is the same idea as credit approached from the reinsurer's side.

The capacity point is the reason the market exists. A single insurer's ability to write a large or concentrated exposure is limited by its own surplus. Ceding part of that exposure, and being allowed to take credit for it, lets the insurer stand behind more coverage than its own balance sheet could support alone, which is how coverage exists at all for risks larger than any one company would accept. That is also the honest limit of the arrangement: the capacity it creates is real, and the counterparty risk it creates is a genuine exposure the regulator supervises rather than eliminates.

1. The ceding insurer decides how much loss it wants to keep, and buys a treaty or a single-risk contract covering the rest.

2. It pays a ceded premium to the reinsurer for that protection.

3. The reinsurer's status is tested against the state's credit for reinsurance rules. Where the test is met, the ceding insurer takes the ceded risk onto its statutory balance sheet as an asset or a reduction from liability.

4. Claims are paid by the issuing insurer to its policyholders, in full, under the policies it wrote.

5. The ceding insurer then recovers from its reinsurers under the treaty. A dispute at that stage is between two insurance companies.

A hypothetical, showing the two ledgers. A regional insurer buys a catastrophe treaty that pays losses above a $5,000,000 retention, up to a $10,000,000 limit. A storm produces $12,000,000 of covered claims across its policyholders.

The insurer pays claimants the full $12,000,000, because that is what its policies promise. It retains $5,000,000 and recovers $12,000,000 − $5,000,000 = $7,000,000 from the reinsurer, which sits inside the $10,000,000 limit. Had the storm produced $18,000,000 of claims, the insurer would still owe policyholders $18,000,000, would recover only the $10,000,000 limit, and would absorb $18,000,000 − $10,000,000 = $8,000,000 itself. Nothing in either version changes what any individual policyholder is owed. Figures are illustrative.

Pros

• It lets an insurer stand behind more coverage, and more concentrated coverage, than its own surplus would support, which is what makes some risks insurable at all.
• Credit for reinsurance rules give the state a supervisory hook over the quality of the counterparty, rather than leaving the ceding insurer to self-assess.
• It smooths an insurer's results across years, which reduces the pressure to reprice or withdraw after a single bad year.
• The policyholder's contract is unaffected by it, so a reinsurance dispute does not become the policyholder's problem.

Cons

• It substitutes counterparty risk for insurance risk. A ceding insurer that cannot collect from its reinsurers has reduced its reserves against obligations it still owes.
• It is invisible to consumers. Nothing on a policy, a declarations page or a premium notice tells a buyer how much of their coverage has been ceded or to whom.
• The guaranty association does not reach a reinsurance contract unless assumption certificates have been issued under it, so the protection a reader might assume runs behind the reinsurance is generally not there.
• The rules are state law, so the credit a given arrangement earns depends on where the ceding insurer is domiciled.