The American Bar Association Standing Committee
on Lawyers Professional Liability and the ABA Center for Continuing
Legal Education Present
Legal Malpractice Insurance Cost and Availability in a Changing
Marketplace: Reinsurance 101
By Michael Elliott
© 2002 American Bar Association. All rights reserved.
I. What is Reinsurance?
What is reinsurance, what does it do, why is it
important to me? These are questions that many of you have asked at
one time or another. Today I am going to remove the mystery and
mystique surrounding reinsurance. It is simple, really! Reinsurance
is insurance for insurance companies. Let me explain.
Everyone knows what insurance is. Indeed,
everyone buys insurance in some form or another to protect their
possessions and their loved-ones in case of accident, harm, or
disaster. Take your home for example. All of you purchase
homeowner’s insurance to protect yourself if your house catches fire
or is destroyed or damaged by windstorm, hurricane, or other similar
peril. You are the insured, a company such as Safeco or Hartford is
For some of the very same reasons you buy
homeowner’s coverage to insure your possessions, nearly every
insurance company in the world buys coverage to reinsure its
portfolio of business from accident, harm, or disaster. In this case
a mythical XYZ Insurance Company is the reinsured, and companies
such as Converium Re or St Paul Re are its reinsurers.
II. Definition of Reinsurance.
Many definitions of reinsurance exist. A
typical definition would refer to reinsurance as: AA form of
insurance, being the insurance of one insurer (the reinsured) by
another insurer (the reinsurer) by means of which the reinsured is
indemnified for loss under insurance policies issued by the
reinsured to the public.
Public policy and common law have established
the following about reinsurance:
Reinsurance is a form of insurance. As such, a
contract of reinsurance is an insurance contract.
Only a entity empowered to write insurance may
reinsure its policies.
The insurable interest of the reinsured is its
insurance policy obligations.
The reinsurance provider must also be empowered
A contract of reinsurance is a contract under
which one insurer agrees to indemnify another with respect to actual
loss sustained under the latter’s policy or policies of insurance.
III. What is the Purpose of Reinsurance?
The single most important problem for insurance
companies today is no different then it was 400 years ago when it
all started. That problem is to make the law of large numbers work
within a portfolio of insurance risks assumed. Reinsurance helps
make the law of large numbers succeed. Put another way, reinsurance
allows the original insurer to assume risks in such a way that its
book of business is no longer a series of blind bets or wagers.
Usually an insurance company will buy
reinsurance for one or more of the following reasons:
1. Market Capacity.
2. Stabilization of Result.
3. Catastrophe Protection.
4. Strengthening of its Financial Structure.
Lets examine Market Capacity first. There is a
highly respected rule of thumb in the insurance industry. Never
expose more than 5% of a company’s Capital and Surplus on any one
risk. But, what if, that company is being pressured to offer larger
policy limits to its customers in order to stay in business. What
then? Reinsurance of course! Reinsurance is a means by which an
insurer can write more business at higher limits than its own
resources would otherwise permit.
A second reason for reinsurance is for
Stabilization of Results. To put it another way, giving your
investment people a level playing field in order to maximize
investment results. After all, investment income is a significant
source of revenue for an insurance company. In order to gain a
maximum yield from its investments, a company’s management team must
have assurance that there will be no drastic calls for cash to pay
unexpected or abnormal losses. Reinsurance while it is not a banking
transaction, does fulfill a financing function. In this case by
providing for the amortization of insurance losses over time. A few
examples of how stabilization can be achieved include:
1. Control of the exposure-to-loss factors on
each individual risk.
2. Control of the total of all accumulated
losses arising during the year.
3. Adjusting the mix of business.
One of reinsurance’s main and customary roles
has always been that of providing Catastrophe Protection. If yours
is a company writing homeowners coverage in Florida, you would need
protection from hurricanes. A property insurer in California is
concerned with earthquakes. A writer of professional liability is
concerned with large shock losses from unfavorable jury awards or
from a change in the legal climate which could leave it vulnerable
to unexpected legislative or court imposed exposures or coverage not
Lastly reinsurance can be used to Strengthen
the Financial Structure of a company by providing such things as:
1. Surplus relief.
2. Improvement to the company’s financial
3. Improvement of Best’s and S & P ratings.
4. Meeting the requirements of regulatory
5. Modification of the company’s tax
I will elaborate on how to strengthen an
insurance company’s financial situation using reinsurance in greater
detail later in this discussion.
IV. The Two Types of Reinsurance.
When all is said and done, there are really
only two types of reinsurance:
1. Facultative Reinsurance.
2. Treaty Reinsurance.
Facultative is the oldest form of reinsurance
there is. Essentially facultative is reinsurance purchased on a
“case by case” basis. In the case of our XYZ Insurance Company,
specific reinsurance for a very large law firm would make an
excellent example of a possible facultative placement.
Treaty reinsurance on the other hand covers an
entire portfolio or class of business underwritten by an insurance
company. By class of business I mean for example, XYZ insurance
Company might reinsurer its Lawyers Professional Liability, but keep
for its own account a small book of “Office Business Owners” package
policies because it views the exposure from those policies to be
What is the difference between facultative and
treaty? The main difference is one of obligation. In the case of
facultative reinsurance, XYZ is under no obligation to place
individual risks with anyone. By the same token the reinsurers are
under no obligation to accept any business from XYZ either. Both
parities have the facility to act as they deem in their individual
best interest without having to consider any prior contract.
A reinsurance treaty on the other hand is an
obligatory reinsurance agreement whereby the ceding company (in this
case XYZ) is required to cede and the reinsurers are required to
accept a specified share of all risks to be reinsured. These
requirements and obligations are fully spelled out in the treaty
wording which has been agreed upon ahead of time.
V. Methods of Reinsurance.
When you get right down to it, there are really
only two methods of reinsurance:
1. Proportional Reinsurance - usually referred
to as Pro Rata or Quota Share.
2. Non-Proportional Reinsurance - usually
referred to as Excess of Loss.
Quota Share reinsurance is reinsurance in its
most simplistic form. A quota share treaty allows a reinsured such
as XYZ to cede a fixed percentage of every risk that is written to a
group of reinsurers who are a party to such a quota share agreement.
Quota Share Example:
# 80% Quota Share
# Reinsurer receives
80% of the premium less a commission which is retained by the
Reinsured to pay for its operating expenses.
# Reinsurer pays 80% of
each and every loss no matter how big or small
# Often used for
surplus relief or where an excess of loss program is inappropriate.
# Usually has some form
of a profit contingent arrangement to reward the reinsured for doing
a good job.
# Variations of this
are called surplus treaties.
Excess of loss reinsurance on the other hand
grew primarily out of the requirement of the original insurer (the
Reinsured) for protection from a catastrophe or the need to issue
high limits of liability. Excess of loss reinsurance may be best
described as an agreement whereby the reinsurer agrees to reimburse
the reinsured for all losses over a set dollar amount. For example
this year XYZ’s reinsurance program protecting its book of lawyers E
& O policies begins to respond when losses exceed $500,000. Think of
that $500,000 if you will as XYZ’s reinsurance deductible.
Excess of Loss Example:
# $500,000 excess
# The reinsurance
premium is expressed as a percentage of the original premium. In
other words a rate.
# Can be written in
layers in order to facilitate the limits of liability required by
# Lower layers may be
written with a profit contingency.
# Can be written on a
per risk or per occurrence basis.
# Can be written with
an aggregate deductible.
VI. The Reinsurance Market Place.
Just who are these reinsurers that I keep
talking about. They are either professional reinsurance companies
whose sole enterprise is reinsurance or they are reinsurance
divisions of conventional insurance companies which also accept
reinsurance to diversify their book of business. There are insurance
and reinsurance companies all over the world, but for practical
purposes there are four markets:
1. London (where it started):
i. Lloyds of London
ii. London based insurance
iii. Other companies with
London offices such as and Swiss Re U.K..
2. United States:
i. Reinsurance divisions of
ACE Tempest Re
St Paul Re
CNA Re U.S.
ii. Professional Reinsureres
i. Hannover Re
ii. Munich Re
iii. Cologne Re
iv. Converium Re
i. XL Insurance Company
ii. Stockton Re
iii. Chubb Atlantic
VII. The Reinsurance
Reinsurance is a dollar intensive business.
Because most risks which require reinsurance are too big for one
insurance company to write alone, so to is the need for more then
one reinsurance company to cover such risks. A reinsurance program
such as that placed for XYZ must have the support of the world wide
reinsurance marketplace. The reinsurance intermediary is an
indispensable link in forging a successful reinsurance program. A
truly good reinsurance intermediary such as ourselves has the market
knowledge and experience necessary to handle all negotiations
between the parties. It is our job to reduce the time, effort, and
expense of the ceding company in securing superior reinsurance. The
mandate of the reinsurance intermediary is to provide its client
with impartial, experienced counsel and to negotiate on its behalf
the best reinsurance program available at the best possible price.
VIII. The Reinsurance Process.
What kind of Reinsurance does an insurance
company need and why? Reinsurance is purchased for many reasons.
Some of the key considerations include:
1. The size of the company.
2. The financial strength of the company.
3. The lines of business written.
4. The Experience of the company.
5. The ownership of the company. Stock or
6. The state or states of domicile
7. The agenda of management or the
8. The need to grow or diversify with new
9. The need for higher limits.
Reinsurance then, as stated in the beginning,
is little more the “an insurance company’s insurance protection. It
is a necessary yet often misunderstood product, which has a great
deal of influence over all that the insurance consumer has available
to him or her when the seek to protect their business and families.
The Insurance/Reinsurance Players
Agent – Insurance is often sold to the public
through an Insurance Agent. This agent may represent many insurance
companies or only one or two. An agent representing many companies
is generally refereed to as being part of the Independent Insurance
Network. An agent representing only on or two companies is generally
referred to as a “Captive Agent”. Often the latter is an employee of
the insurance company he or she represents. An Agent will be
appointed by the insurance companies he represents and is considered
the representative of those insurance companies.
Broker – Technically a Broker represents the
policy Holder who are their clients. A broker will select an
insurance company, or several insurance companies and present his
clients needs and exposures to them for quotations and ultimately
binding of coverage. Like agents, brokers are paid on a commission
basis by the insurance company.
Direct Writer – Some insurance companies sell
coverage on a “direct” basis. In other words, employees of the
insurance company deal directly with the prospective insured,. The
application and other necessary underwriting details are submitted
directly to the insurance company which provides a quotation and
will accept the order to bind coverage if acceptable.
Reinsurance Company – a insurance company that
accepts the transfer of coverage and risk from another insurance
company. The original insurance company is commonly referred to as
the reinsured or ceding company. The company accepting the
reinsurance is referred to as the reinsurer. The transfer of such
reinsurance is often called a cession.
Reinsurance Intermediary – A professional
broker licensed to negotiate and transact reinsurance contracts,
cessions, and claims as necessary on behalf of a reinsured and a
reinsure or group of reinsurers.