Reinsurance Guide: Definition, Use Cases & Best Practices

Purchasing insurance coverage has been a technique of minimizing financial loss of unwanted incidents for ages. Insurers exchange money for other people’s risk. Carrying outsiders’ risks, on the other hand, might put insurance companies in a tricky position where they are unable to meet their obligations arising from customer claims.

One way for insurers to mitigate this risk is to purchase reinsurance policies, which are insurance policies for insurance firms. In this article, we will discuss reinsurance and its current importance in depth. Also, we will introduce use cases of reinsurance that will help readers to understand the benefits of reinsurance.

Reinsurance Guide: Definition, Use Cases & Best Practices

What is a reinsurance policy?

Reinsurance policies are a way for policyholders to manage their insurance risk. The policy buyer (ceding company) pays the premium in exchange for partial or complete claim payment coverage.

The rationale is that following catastrophic events such as hurricanes, floods, or earthquakes, the volume of claims can be excessive, and insurance firms may not have enough liquid assets to meet their legal duties. Thanks to reinsuring their portfolio they reduce the liabilities that will occur due to possible claims.

Reinsurance companies, on the other hand, may simply want to boost their revenues or diversify their risks. Consider a California real estate insurer. This firm can diversify the risk of earthquakes that will affect California by reinsuring a New York real estate insurer.

Virtual i Technologies’ cloud-based [VRS]™ Virtual Risk Space platform assists reinsurers by offering remote or on-site risk engineering services. Such a service assists reinsurance and ceding firms in meeting compliance requirements and making risk transparent. Virtual i Technologies can assess large-scale threats all across the world thanks to their partner network. For example, Virtual i Technologies offers risk engineering services for the reinsurance assessment of a business insurance policy that covers oil and gas production assets.

What are the types of reinsurance policies?

There are five types of reinsurance policies:

  • Partial: Only the predetermined proportion of the claim is paid by reinsurers.
  • Claims made basis: Such policies compensate any claims made to ceding companies during the policy period, regardless of when they happened.
  • Losses occurring basis: Any liabilities that arise after the agreement expires are not compensated.
  • Facultative reinsurance: Reinsurance company provides coverages for certain agreed policies of ceding company after the process of underwriting and risk scoring. Facultative reinsurance policies tend to be more expensive compared to treaty reinsurance since each policy is reassessed by the reinsurance companies.
  • Treaty reinsurance: Ceding company passes a portfolio’s risk to the reinsurance company rather than individual assets.

Why is reinsurance important now?

The risk aspects in the 2020s did not start out well. We are all affected by Covid, supply chain disruptions, climate change related disasters and cyberthreats. According to Fitch ratings, total significant losses in 2021 will be nearly 55% more than the long-term average.

The concept behind reinsurance is to shield ceding corporations from excessive claims. As a result, insurers should consider reinsurance plans more than ever.

7 Use cases of reinsurance

Reinsurance is a strategic instrument for both ceding and reinsurer organizations, and it offers them a number of advantages:

Use cases for ceding company

  • Reinsurance as a diversification strategy: The ceding company transfers some of the risk from its portfolio to the reinsurers. As a result, a ceding company’s risk is further spread out. 62% of insurance companies use reinsurance policies for reducing their risks.
  • Reinsurance for compliance: In many countries, insurance companies are required to have liquid assets sufficient to pay the policy’s written coverage. Consider an insurance firm that is looking for a new business insurance customer. The insurance firm has agreed to cover the damages up to $100M, but it only has $80M in liquid assets. To make sales in this situation, the insurance company needs a facultative reinsurance policy that covers at least 20% of the potential claim.
  • Reinsurance for income smoothing: Because reinsurance lowers insurance firms’ costs, it gives a more stable income. According to Deloitte, almost 40% of companies use reinsurance policies for income smoothing.
  • Reinsurance for surplus relief: In many nations, insurers are not required to surpass a specific premium-to-surplus ratio. Because reinsurance policies diminish premium income, they allow ceding companies to issue additional policies.

Use cases for reinsurer

  • Reinsurance as an arbitrage strategy: Arbitrage occurs when the price of the same product is different between two locations or entities. In such a case, whatever the reason, the same risk costs less for reinsurers. Thus, they exploit price differences for profit maximization. The reason for price differences might be followings:
    • Economies of scale: Variable cost of a new underwriting can be low for reinsurer companies due to greater volume of them.
    • Benefiting from regulatory differences: Lack of regulative or tax pressure in the region of the reinsurer might provide it a competitive advantage.
    • Superior underwriting: Using technologies like advanced analytics, NLP, digital twins, IoT, blockchain can let reinsurer companies to underwrite more precisely with a lower cost thanks to its automation.
    • Different risk appetites: The difference between the risk taking habits of two insurance companies might be the motivation for reinsuring.
  • Reinsurance for increasing sales: Many firms have certain KPIs regarding the revenue and reinsurance policy can help reinsurers to reach these goals.
  • Reinsurance as a diversification strategy: Reinsurers can take the risk of a portfolio which minimizes the risk.

5 Best practices for reinsurers

According to Deloitte’s report reinsurers’ current struggles are (see Figure 1):

  • Integrating high quality data seamlessly to perform risk scoring (69%).
  • Automating their operations to ensure efficiency (62%).
  • Adopting technology to improve core insurance practices (54%).
  • Using advanced analytics to improve their underwriting capabilities (38%).

Figure 1: Main struggles of reinsurers.

Reinsurance Guide: Definition, Use Cases & Best Practices

Source: Deloitte

Therefore, best practices should targeting minimizing these struggles:

  • Build a data quality management department: Data is the fuel that insurers use to evaluate risk and analyze their successes. Therefore, the data they have must be precise, complete, consistent, and comprehensive enough. The best way of ensuring such high standards is having a data quality department that constantly monitors it.
  • Use third party data providers: Since richer data implies better underwriting; reinsurers should use third party risk engineers for the facilities they cannot examine directly. Also, using data from telematics can help insurers.
  • Invest in data warehouses: 85% of reinsurance executives admit that they have a lack of data storing capabilities where they struggle to reuse it if it is needed. Data warehouses can minimize such a problem.
  • Invest in OCR and HCR: Traditionally, the insurance sector produces and uses too many written documents, optical character recognition (OCR) and handwritten character recognition (HCR) technologies can help insurers to automate their operations.
  • Cooperate with insurtechs: Insurtechs help insurance firms enhance and automate their operations by providing technology solutions and analytics. As a result, incumbents may consider partnering with insurtechs or buying their cloud computing tools as a service.

The article was originally published in the AI Multiple website and written by Görkem Gençer on March 30,2022.

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