The Concept
Any insurance company portfolio is characterised by a number of policies. Each policy is a physical risk or exposure, which the insurance company writes against fortuity. These risks vary in nature and size and the claims experience is unpredictable. The claims experience is normally influenced by major losses (accumulation losses) arising from one event, where each major loss being made up of many individual losses.
— the high frequency of many small losses,
— changes in the structure of any risk owing to changes in economic, political, technology and social environment.
Unless appropriate measures are taken a portfolio will therefore be unbalanced. A direct consequence of lack of balance is that results fluctuate. Depending on their size, fluctuations in the course of results will affect values which are vital to the company, such as solvency, liquidity and the continuity and/or stability of results. One of the corporate goals of an insurance company is to restrict fluctuations in the results to within certain parameters. There are generally three ways of achieving this, viz. self-retention, coinsurance and reinsurance.
Self-retention
For the portfolio to absorb the fluctuations, the direct insurers must set their acceptance limits at a correspondingly low level, writing only small shares in order to achieve a portfolio which is as homogeneous as possible. The possibilities for acquiring business are restricted as a result. However, the direct insurers also thereby limit their opportunities for growth in markets with competition, since their competitors can write business with higher acceptance limits. Insurers who opt for self-retention will be stunted in growth.
Coinsurance
Insurers opting for the coinsurance route must come to an agreement with selected competitors and also divulge information about their customers. In addition, insurers organised in a coinsurance arrangement must take special care to ensure that the assumption of risk arranged in this way does not result in any disadvantages for their insureds. In practice, the principle of coinsurance is chosen above all for special and/or very large risks.
Reinsurance
Where insurers opt for the third method, they are said to purchase reinsurance cover. Insurers may use reinsurance cover for different purpose, for instance to reduce their commitment to a single major risk, to cover catastrophe risks like those arising from the natural hazards of earthquake or flood, for example, or to protect themselves against major variations in the loss experience of entire portfolios. Insurers and reinsurers agree between themselves the reinsurance solution which meets the insurers’ specific needs, with account also being taken of the insurers’ market opportunities. Their position in the market should be strong and outwardly independent, without insureds being aware of the reinsurers.
It is an established norm that the fundamental concept of insurance is spreading of risks based on law of large numbers. Thus, the purpose of reinsurance is purely extension of the aforesaid concept. It is a means which an insurance company uses to reduce the possible losses, of the perils it has accepted and thereby stabilise the results.
The fundamental principles of reinsurance are similar as those of the insurance, viz. principle of indemnity and principle of utmost good faith.
The reinsurer operates on the premise that in the absence of detailed underwriting information about the risk on which he is committed, control of his underwriting destiny must rest upon his knowledge of the professional status and integrity of the insurer and the underwriting skill and qualifications of the underwriter who is committing him on the portfolio underwritten, without detailed selection on the part of the reinsurer.
As mentioned above, the need for reinsurance would also follow the same business and financial considerations as an original insured would require to insure with any insurance company.
The insurance companies by insuring property, persons or liability representing great values at risk and for large sum insureds, often wish to be able to accept the whole or substantial part of the risk for their own account. However, the financial strengths of each insurance company constraints it from doing so, as it would not be prudent for any organisation to trade on its capital for more than its own worth, or for that matter keep every single risk for its net account. This makes it imperative to reinsure a single risk or its portfolio. Thus, reinsurance gives protection against eventualities and supplements the need of insurance companies by limiting their loss from any single incident or accumulation of losses arising out of any event.
It is also desirable that the affairs of the insurance company are regulated to avoid widespread fluctuation from year to year. Due to financial constraints mentioned above, an insurance company cannot retain full volume of business for its net, as major fluctuation in claims cost, resulting out of inadequate spread of risks can seriously undermine the financial strengths.
Apart from the above, the practical considerations of protecting the solvency margins also leads to reinsurance. The local regulation for any insurance company may limit the retained premium income in relation to capital and free resources, thereby necessitating to offload the surplus risks by means of reinsurance. Apart from the above, considerations like inflationary trend, composition of insurance portfolio, also play an important role in the decision of buying reinsurance protections. Reinsurance also can be a means or tool of profit gearing or expense sharing for any new and start-up insurance company to bring stability to its results and at the same time protect it’s balance sheet.
Evolution
Reinsurance has its origin much after the concept of insurance was established in the early sixteenth century. Need for protecting large risks naturally led to the form of co-insurance, which subsequently was still found to inadequate. Therefore, to spread the risks further, it was necessary to protect it with markets beyond the existing local markets.
What was initially reinsured as individual risk on facultative basis gradually developed into a portfolio protection for each class. Facultative reinsurance was the most common form of reinsurance in the initial years whereby risks were common form of reinsurance in the initial years whereby risks were reinsured on individual basis. Subsequently, for the purpose of bringing stability to the portfolio of the insurance companies, it was designed to give protection for the whole portfolio of any particular class. Such protection of portfolio was on the concept of partnership and ceded proportionately in form of treaties. Subsequently, Lloyds introduced the concept of excess of loss reinsurance, whereby for an agreed premium the reinsurer accepts liability for any loss exceeding an agreed figure. This new pattern of reinsurance was useful to protect portfolios against catastrophe hazards like earthquakes, windstorms etc.
Methods of Reinsurance
The specific needs of insurers are as varied as the reinsurance solutions. There are three broad types of reinsurance covers available to display the requirements of each insurer.
Facultative Reinsurance
Where the subject matter involves reinsurance an individual risk, this is known as facultative reinsurance. The insurer cedes part of the risk to one or more reinsurers and is, therefore, known as the cedent. As the word facultative implies, the cedent may offer the risk, or part of it, for reinsurance, i.e. it may offer the business if it wishes. The reinsurers, for their part, are at liberty to accept or reject the offer.
Reinsurance Treaty
A treaty is arranged for the reinsurance of a specific portfolio, with risks being ceded automatically for the entire portfolio within the terms of the treaty. Cedents do not have to decide whether or not to cede each individual risks but undertake to cede the entire portfolio. Nor do the reinsurance have to go through an individual acceptance procedure, since they are contractually bound to accept the entire portfolio.
Thus, for the reinsurance of individual risks, facultative treaties are arranged, while for the reinsurance of entire portfolio, treaties are arranged. Treaties are again segregated into two types, viz. proportional and non-proportional (excess of loss).
Proportional Treaty
The proportion is the central feature of proportional treaty reinsurance. What is specifically involved here is the proportion which the treaty limit of the relevant reinsurance cover bears to the individual original risk ceded. The terms used here is proportionality principle. In fire insurance, liability is defined as the total sum insured (maximum liability based on the full value) or as the highest estimated loss (i.e. estimated maximum loss or maximum possible loss). In the third party liability business the liability is determined to be the limit of compensation required to rectify a loss. This corresponds total value. Besides the proportionality principle, the product proportional treaty reinsurance is associated with another feature, viz. the direct insurers cede the risks at the original conditions agreed between them and the policyholders. The reinsurers are, therefore, involved in the risk under the same terms and conditions as the direct insurers.
Quota Share Treaty
In a quota share treaty, the proportion is defined as a fixed, invariable percentage which is generally applied to the entire portfolio of risks as the quota share ceded to reinsurance. The exceptions are risks which exceed the amount of the quota share limit. An absolute quota share limit of this kind is agreed because the quota share reinsurance could otherwise be too unbalanced, and the reinsurers would no longer know their maximum liability per risk. With risks for which the quota share limit is not high enough, the percentage is reduced in the ratio, quota share limit to the original risk. The cedent’s liability on any one risk is, therefore reduced by the define percentage as the quota share ceded.
Surplus Treaty
This treaty allows variable percentages for the retention and for business ceded to reinsurance, depending on the size of the individual risk. As can be seen below, compared to quota share reinsurance, the system of surplus reinsurance is more complex.
The liability in the cedent’s retention is defined as a fixed amount. Risks within this amount are retained by the reinsurer in full for its own account. Only risks on which the cedent’s liability exceeds the amount of the retention are ceded to reinsurance, cession being effected on the basis of the ratio, portion of liability over and above the retention to overall liability. The percentage for cession varies depending on the size of the overall liability.
The surplus reinsurance eliminates the peaks in the portfolio for the insurer, thus providing its portfolio with certain homogeneity and also automatic capacity.
Non-proportional Treaty
Unlike proportional reinsurance, which is based on original liability and proportional cession, with non-proportional reinsurance it is the amount of loss and the cover, which is limited in amount, which are considered. This is also termed as excess of loss reinsurance. The essentials of an excess of loss treaty are:
• one or more classes of business from which losses are reinsured;
• a fixed limit – the deductible or excess point, up to the amount of which insurers bear all losses for their own account;
• a limit of cover, termed as layers, up to the amount of which the reinsurer pays portions of claims above the deductible.
Non-proportional reinsurance offers insurers another way of cutting probable claim peaks back to the level of retention they find acceptable. The fact that the distribution of claims and the distribution of liabilities in an insurance portfolio differ is of relevance here. The occurrence and amount of a loss are fortuitous, with varying degrees of probability. As far as the period of time is concerned, basically only the losses occurring during the agreed period of the contract are covered. In reinsurance terminology this is referred as years of occurrence. Unlike proportional reinsurance, non-proportional reinsurance cover is separate from the original portfolio and, therefore, from the terms of the original policies and from the original premiums.
Excess of loss treaties primarily can be broad based on:
• Protection against losses for any one risk with the per risk excess of loss cover (generally termed as working XL).
• Protection against losses for any one accumulation event with the per event catastrophe excess of loss cover (Catastrophe XL).
• Limitation of the claims burden from the retention for any one year with the aggregate excess (stop loss) reinsurance cover (for Balance Sheet protection).
Reinsurance in the Context of the Indian Market
Existing Arrangements: Prior to nationalisation in 1973, there was very little reinsurance prevalent in the local market. The branches of the foreign companies operating in India were protecting their portfolio within their parent company’s global programme, overseas. Similarly, most domestic companies did not have to purchase huge reinsurance protections as their portfolios consisted of mainly householders and small to medium commercial and industrial risks.
For the purpose providing reinsurance capacity in a limited way there existed an Indian Insurance Pool whereby the local companies were members. The purpose of the Pool was to share the business underwritten by each company and thus try to stabilise the result of the market as a whole, in a limited way. Apart from the Pool, obligatory cessions were made for 10% each to India Re, a local reinsurance company owned by the Government and Indian Guarantee, a subsidiary of Oriental Fire and Marine Insurance Company Limited. The purpose of forming the above was to retain premiums domestically to the extent possible.
Subsequent to nationalisation, the aforesaid companies were merged into the statutory entity, viz. General Insurance Corporation of India (GIC). Post nationalisation, the erstwhile companies were merged into four regional companies, which in turn were made wholly owned subsidiaries of the GIC. Thus, GIC became the parent body to oversee the affairs of the general insurance industry. As such, a common agenda was followed in conducting business including reinsurance.
By virtue of the merger of the aforesaid India Re and Indian Guarantee, GIC continued to receive the obligatory cessions for 20%. Apart from receiving these cessions, the role of being the local reinsurer was thrust upon GIC. Thus, the onus of arranging reinsurance protections for the insurance companies, was upon GIC. Keeping in mind Government’s agenda to create maximum retention capacity within the local market and thus retain premiums locally, a common integrated reinsurance programme for the whole market was embarked upon. The composite financial strength assisted in gradually increasing the retention levels of the market as a whole. Coupled with the aforesaid, the tariff structure operating in most classes has assisted in reflecting good underwriting results, thereby strengthening the financial results of all the companies.
This in turn has resulted in more and more retentions especially for classes which have achieved a greater degree of homogeneity in the portfolio as well as volumes. At the present time less than 10% of the gross direct premium is ceded as reinsurance premiums. Reinsurance is now primarily purchased for peak and/or non-homogenous/special risks like Air India, Indian Airlines, ONGC etc. or for new classes such as directors and officers liability, errors and omissions cover, liquidated damages cover, kidnap and ransom cover, performance bonds etc. for which there is not sufficient volumes and spread of business.
The above explains how pivotal a role the prevalent reinsurance programme had played in the development of the local market in terms of risk retention capacity, developing automatic reinsurance capacity and thereby retaining more premiums, creating investible surplus and strengthening the balance sheets. The existing companies have become strong financial entities to be classified as Financial Institutions and are well geared to face competition in the newly liberalised set up. At the macro level this has boosted investments in industrial and infrastructural sectors assisting in the growth in the economy at large.
Review of the Existing Reinsurance Programme: The existing reinsurance structure is integrated programmes for the whole market that each company commonly adopts, irrespective of their financial capabilities, profitability etc. in this context, it is insensitive to true net retention of each company.
Reviewing the features of the integrated reinsurance programme, comparison has to be made between the levels of the market retention for each class against the reinsurance cessions to examine how much profit is retained and thereby establish whether the current levels of retentions are as profitable as they can be. Thus, optimum retention and not the maximum retention is the primary focus around which the whole programme is structured.
Empirically, the retention for any one risk should be between 1% to 2% of the shareholders funds (share capital and free reserves). Applying this yard stick will reveal that the composite financial strength of the Insurance companies is capable of retaining at much higher levels than the current maximum retentions fixed for various classes.
The retention levels, amongst other considerations like premium volumes, risk profile, growth portfolio, be viewed from the angle of diminishing utility of retained exposure equating in less and less monetary benefits, beyond the optimum level of retention for a particular portfolio. Under the prevalent programme it may be noted that the current level of retention is lower than what could be retained by the market on a composite basis. Due care has also been exercised though to a lesser degree, to lend sensitivity to financial strengths of each company in isolation, because all the companies do not have identical net worth.
Apart from the above aspect, considerations have also been given for additional financial exposure arising out large catastrophe events. In India’s fast growing economy most private and public and public entities require various forms of insurance. Thus, GIC and the subsidiaries interact with all levels of the society as being the sole provider of insurance for every single policyholder. This puts GIC and its subsidiaries in a position of not just strength but also vulnerability. Strengths are derived as being a sole provider and vulnerability comes from responsibility to underwrite every single policy, thus the lack of selectivity. The strengths and vulnerabilities increase rapidly as the economy continues to grow.
Thus, strategically the retention levels are pegged to address the above issues.
As a case study, the fire portfolio is reviewed in detail. This would be the true reflection of how reinsurance programmes are structured in India as,
• the fire portfolio is largest amongst all classes
• has the highest per risk sum insured for any class
• the existing reinsurance programme maximizes the full retention capacity of the market and has full automatic capacity without requiring to approach the international market for facultative terms. Thus obviating the need of being influenced by the market for facultative terms. Thus obviating the need of being influenced by the market cycles of the international reinsurance market. Also requires less vertical capacity.
• Fire portfolio is fully tariffed and thus insensitive to market competition in terms of rating.
The cessions pattern and the retention of each company is based on quantitative definitions of the risks. Within the fire portfolio the risks are divided in three segments based on Probable Maximum Loss (PML) limits, viz.
1. Small risks up to sum insured of Rs. 50 million
2. Medium-sized risks ranging between sum insured of Rs. 50 million and PML of Rs. 250 million
3. Listed Risks-PML exceeding Rs. 250 million. There are approximately 600 risks currently within this category.
Each of the reinsurance arrangement is explained in detail below.
1. Net Retained Account
(a) Obligatory cessions
20% of the small risks and medium sized risks are currently ceded to GIC.
Listed risks are also ceded for 20% subject to a maximum monetary limit of Rs. 50 crore.
GIC’s maximum retention is capped at Rs. 50 crore PML basis.
• Based on study of the profile of top 30 risks on October 1, 2000 the above retention equates to only 2.1% of the top risk
• This is protected by the Per Risk and Catastrophe excess of loss programmes further reducing it to Rs. 6 crore on absolute net basis.
(b) Market pool
GIC is the manager of the pool. Currenly 30% of each risk is ceded to the pool and retroceded back which is fully retained by the companies, subject to a monetary limit of Rs. 750 crore PML.
This is protected by the Per Risk and Catastrohe Excess of Loss Programmes further reducing to Rs. 9 crore on Absolute Net Basis for all companies combined.
(c) Net retention of each company
Comparative analysis of Maximum Net Retention and Absolute Net Retention for Each Company for the Fire Portfolio
Maximum net retention for each company is Rs. 125 crore PML.
Absolute net retention for each company is Rs. 15 crore.
Based on the capital and reserves as on March 31, 2000 of each company the retentions are as follows:
Company Maximum Net Retention Absolute Net Retention
National 6.60% 0.79%
New India 2.91% 0.35%
Oriental 6.99% 0.84%
United India 5.77% 0.69%
Currently GIC purchases excess of loss cover up to Rs. 300 crore PML for per risk and Rs. 600 crore PML for per event (catastrophe) for the net retained amount. The cost of purchasing the above programmes is 2.14% of the gross direct premium (retained) which is competitive considering the large limits of indemnity which GIC is purchasing.
The programme has been of utility over the years and have responded adequately in terms of claims recovery for events of high severity such as Gujarat cyclone (1998) and Orissa cyclone (1999).
The absolute net retention level of each company should be based on its financial strengths and will vary from company to company. However, the current programme being market driven, the amount retained per company is uniform and thus is insensitive to this aspect.
The net retained portion each of the obligatory cessions, cessions to market fire pool and the net retention of each company is on combined basis protected by net account excess of loss protection on per risk and catastrophe basis separately.
2. Surplus Treaties
The surplus treaty of each company under the existing programme mirrors identical in terms of cession limits and the portfolio ceded. Cessions to the company’s surplus treaty currently start at a much higher level, above Rs. 2,500 million PML and are mere capacity providers. Cessions to these treaties are geared on line basis. Currently the capacity of each treaty is Rs. 7.50 crore PML, equating in a total capacity of Rs. 30 crore PML. The Surplus treaties are utilised to fill up capacity and thereby achieve as much automatic capacity as possible.
3. Market Surplus Treaty
The market surplus treaty over the period of time has worked as a second surplus and functioned as a capacity provider. Cessions to this treaty are made after full capacity of the underlying treaties is exhausted. Currently risks in excess of Rs. 280 crore PML are ceded to this treaty.
4. Facultative
Currently all risks which fall above the limits of the market surplus property are ceded to GIC on facultative basis. GIC writes the full facultative requirements of the market. This is possible as they are fully backed by an facultative excess of loss protection which can absorb risks up to any limit. Cessions to this programme are on proportional basis, with a small second retention of Rs. 5 crore PML indemnity split into different layers. Each risk is ceded in the same percentage to the second retention and the indemnity of the programme. Therefore, the premium paid for this protection is much lower than the premium received by GIC.
GIC derives benefit from this facultative excess of loss programme which has been in existence since many years. This facility has utility of writing domestic facultative business for unlimited capacity. On the backing of this reinsurance facility all facultative business of the Indian market are absorbed within the automatic capacity.
To summarise, the above capacities are stacked one above the other as shown in the Schematic Diagram, providing unlimited vertical capacity. This is achieved successfully because of the integrated approach, whereby the risks could be absorbed horizontally such as utilising all the companies retention capacity as well as utilising the capacity of the companies surplus treaties.
The volumes have also helped to drive the programme in achieving the unlimited automatic capacity.
For other classes like marine (hull and cargo), engineering and miscellaneous accident the structure of the programme is similar to the fire programme with minor changes, depending upon the type and feature of risks for each class.
For classes like energy, aviation, liability etc. which are not driven by volumes, the propensity is to keep low retention for the net account and reinsure the balance amount by the facultative method.
Reinsurance in the Liberalised Market
Role of the National Reinsurer: Following the liberation of the insurance industry and the with delinking of the existing subsidiaries, GIC’s role will be solely to function as a national reinsurer. Therefore, the existing market reinsurance programme would disintegrate and that capacity would now be defrayed amongst existing and new entrants who would be arranging their own reinsurance programmes.
The national reinsurer may have no control for arranging the insurance companies reinsurance programmes but will be looked upon to provide reinsurance capacities. Therefore, it should endeavour and absorb as much of the reinsurance offered by the domestic insurance companies in order to maintain its position as a leading reinsurer in the Indian market.
Objectives of the National Reinsurer
— Receive statutory cessions.
— Provide maximum reinsurance capacity in the domestic market for other than statutory cessions and thereby retain maximum premium within the local market.
— Play a pivotal and influential role as a pro-active reinsurer for the domestic insurance companies and assist to develop their portfolio for writing large and complex risks.
The disintegration of the existing composite programme for the market poses fresh challenges and thus GIC has to design for a fresh programme which would be solely for its protection. This leads to rather anomalous situation at a crucial juncture when its role is most important for the market, because at one end the financial strength of GIC will be reviewed in isolation from its existing subsidiary companies, resulting into reduced retention and acceptance levels. At the same time the need of this market will require more and more local reinsurance capacity.
Furthermore, GIC will still continue to interact with all segments of the general insurance business because in its new role of a statutory reinsurer it will still continue to be the sole provider for insurance for every single policy underwritten.
The above makes an interesting challenge for GIC to respond to its new role and quickly establish leadership with much smaller resources than in the past.
Domestic Market Considerations
• Liberalisation of the local market bringing in new entrants from the private sector.
• Autonomy of local subsidiaries.
• Future growth in the industry following economic reforms.
• Demand for more flexible and comprehensive products.
• Reduction in the tariff.
Outlook for the Domestic Market for the Future
• India is an expanding market and, therefore, there will be increase in demand for insurance vertically and horizontally.
• Greater requirement for new insurance products.
• Further competition following liberalisation.
• Dismantling if the tariff structure at a later date.
How to Achieve the Objectives?
Meeting the challenges of reduced financial structure and the need for increasing capacity can be achieved in the following manner:
• Provide maximum reinsurance capacity to the domestic insurance companies and thus assist to develop and grow the direct portfolio.
• Design and structure reinsurance programmes for the domestic insurance companies especially for the net account and thereby play an important role as a partner for developing direct business and to a lesser extent even influence the rating for non-tariff business.
• GIC to arrange their own reinsurance programme to meet with the above requirements.
GIC’s reinsurance programme will be a blend of XL protections, proportional treaties and automatic capacity like facultative XL programmes, line slips etc. Pursuant to the new set up and following the possible disintegration of the current programme there will be need for more vertical capacity as perhaps companies underwriting business will not be compulsorily required to utilise the available capacity of other insurance companies.
As the insurance companies will have to necessarily utilise the available market capacities before approaching international markets for purchasing reinsurance, thus GIC will have to provide more capacity for the peak risks. This is achievable by utilising the exist automatic reinsurance facilities like the facultative excess of loss programmes for fire portfolio or lineslips for engineering and so on.
To address the above situation retention levels will have to be revised from the existing levels wherever possible. Fortunately, the current net worth of approximately Rs. 2,200 crore shall enable GIC to achieve this end. Increased retentions will facilitate to achieve more capacity for the surplus treaties as they are geared on line basis. The volumes arising due to receipt of statutory cession will also drive their own reinsurance capacities.
The challenges will be more for providing capacity for classes which do not have spread of risks or the volumes of premium. For such risks it would be desirable to cede these classes along with the more established classes and thereby trade on profitable business.
For the insurance companies, especially the new entrants designing reinsurance programmes will be interesting. The relatively smaller net worth will make it difficult to maintain high retentions and thereby create vertical capacities. Also, arranging such reinsurance programme will be expensive in terms of high cost for the net account as also low commissions which will be achieved if the proportional treaties are too unbalanced. Thus, the companies will seek more support from the domestic reinsurer during the formative years till such time their portfolio and results stabilise.