REINSURANCE is “a transaction whereby one insurance company (the ‘reinsurer’) agrees to indemnify another insurance company (the ‘reinsured’, ‘cedent’ or ‘primary’ company or ceding company) against all or part of the loss that the latter sustains under a policy or policies that it has issued.”
And, just like in any other insurance transaction, the ceding company has to pay the reinsurer a premium. In other words, reinsurance is insurance for insurance companies.
The purpose of reinsurance is to further spread risk. The rationale can be better appreciated in times of extraordinary or catastrophic losses. In a catastrophic fire of an industrial proportion, an insurance company can be financially crippled without reinsurance. From a business standpoint, reinsurance enables an insurance company to expand its capacity to underwrite.
On the other hand, a reinsurer may in turn cede to another reinsurer called retrocessionaire. This is called retroceding, which is the act of a reinsurer of reinsuring with another reinsurer. In such a case, the ceding reinsurer will be known as the retrocedent. And, just as in direct insurance, there are reinsurance intermediaries, i.e. reinsurance brokers. Ceding is the act of passing “on to another insurer (the reinsurer) all or part of the insurance written by an insurer (the ceding insurer) with the objective of reducing the possible liability of the latter”.
There are two general types of reinsurance agreements: facultative and treaty reinsurance. In the facultative type, reinsurance is transacted on an individual risk basis where “the ceding company has the option to offer an individual risk to the reinsurer and the reinsurer retains the right to accept or reject the risk.” In treaty or obligatory reinsurance, however, the reinsurer must accept all business included within the terms of the reinsurance contract. There is no individual risk scrutiny by the reinsurer. One contract encompasses all subject risks.
Both facultative and treaty reinsurance can be grouped into two main categories: pro rata and excess of loss reinsurance. Pro rata, or ‘proportional,’ is a form of reinsurance in which the reinsurer shares a proportional part of the original losses and premiums of the ceding company. It is, in other words, a “sharing concept” where the ceding company and reinsurer share premium and losses in a determined percentage. Excess of loss or non-proportional reinsurance provides that a reinsurer indemnifies a ceding company against the amount of loss in excess of a specified retention, subject to specified limits.
A concept that needs to be understood in reinsurance is the term “retention.” This refers to the portion of a risk which the direct insurer is willing and able to carry itself. Beyond this retention, the risks will have to be ceded. Ceding insurers have to regularly submit reports to the reinsurer. One such report is the bordereau report which provides premium or loss data with respect to identified specific risks. This report is periodically furnished to a reinsurer by the ceding insurers or reinsurers.
The underlying principle making reinsurance possible is the duty of utmost good faith or Uberrimae Fidei. Under this doctrine, the reinsurer has to rely on the good faith of the cedent specifically on material facts pertaining to the ceded business. The reinsurer is not intimately involved in underwriting the ceded business. On this matter, the reinsurer has to rely on the cedent.
Corollary to this doctrine is the basic tenet of lack of privity of contract between the reinsurer and the original policyholder. The reinsurer is ordinarily not liable to the original policyholder of the ceding insurer, “it is not a co-signer of the policy issued to the original policyholder, and it is not jointly and severally obligated to make good on the benefits the policyholder sought to obtain under the insurance contract”.
Resulting from the doctrine of utmost good faith is the ‘Follow-the-Fortunes Doctrine,’ which provides that a reinsurer must indemnify a reinsured “for any payments made by the reinsured for claims covered by the underlying policy, by settlement or adverse judgment, as long as those claims are not fraudulent, collusive or made in bad faith.”
Under this rule, a reinsurer cannot dispute the good faith determinations that a risk was covered under the underlying policy, or a good faith interpretation of the policy terms.
However, it must be pointed out that the reinsurer’s obligation is not the same as the obligation of the reinsured to the original policyholder. “A reinsurer will not be held liable beyond the terms of the reinsurance contract merely because the ceding insurer has sustained a loss. The fact that the direct insurer has paid a claim does not establish that it is entitled to indemnity from the reinsurer because the claim might have been one for which the insurer was not bound to make payment.” Thus, “cedents that make ex gratia or ‘voluntary’ payments (payments made in the absence of any legal obligation to pay) are not entitled to indemnity from their reinsurers unless the reinsurance contract provides to the contrary.”
There are four crucial reasons justifying the importance of reinsurance, which all must remember. First, it protects an insurer against very large insurance claims. Second, it maintains a balanced set of underwriter results annually, avoiding the frequency of peaks and troughs. Also, reinsurance helps spread the risk among insurers and internationally. Lastly, it increases the capacity of the direct insurer, allowing them to insure a large risk through the help of other insurers.
With all the complexities of both insurance and reinsurance, at the end of the day, their existence has been so designed to keep the industry thriving and the insuring public protected.
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Dennis B. Funa is presently the Deputy Insurance Commissioner for Legal Services of the Insurance Commission. E-mail dennisfuna@yahoo.com for comments.