Letter to the Federal Insurance Office (FIO) - New York City Bar ...

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associated with reinsurance have developed over centuries (the earliest reinsurancearrangements and markets predate even the founding of the American colonies). Likeany financial market or product, reinsurance is imperfect and imposes risks. However,we believe that those risks are sufficiently localized to the insurance sector itself thatreinsurance cannot be said to cause systemic risk. Reinsurance largely promotesfinancial stability and economic activity as opposed to concentrating risks or distortingmarkets. In addressing reinsurance issues from a public policy standpoint, publicofficials should carefully distinguish between reinsurance and the sectors of the financialmarkets that contributed to the events of 2008. By the same token, the success ofreinsurance does depend on thoughtful regulatory involvement. Although generallyencouraged by recent developments in reinsurance regulation, we do urge continuedefforts to reduce regulatory ambiguity and uncertainty and to regulate from the standpointof widely shared public policy priorities.Purposes and Effects of ReinsuranceReinsurance is a form of insurance, both parties to which are themselves insurancecompanies. It is a contract of indemnity, pursuant to which one insurance company (mostoften called the "direct insurer" or "ceding company") is insured against the liabilities ithas assumed under one or more insurance policies it has issued. The insurance companythat provides this protection to the ceding company is most often called the "reinsurer" orthe "assuming company". It is "the ceding by one insurance company to another of all ora portion of its risks for a stipulated portion of the premium." 2 Put another way, theceding company reduces its maximum exposure in the event of a loss by purchasing theright to reimbursement from the assuming company for all or a portion (that is, thereinsured portion) of the loss.The key characteristics of reinsurance are that it is a contract of indemnity and not onecreating a primary obligation, that it does not generate fresh premiums and that theinsurable interest of the entity reinsured is its insurance liability. 3 Reinsurance differsfrom direct insurance by conferring an immediate financial benefit on the indemnifiedentity. While a homeowner, for illustration, cannot recognize the loss until his home isdestroyed, his insurer must establish current liabilities as a result of issuing a policyinsuring his home against destruction. These liabilities include an "unearned premiumreserve" representing the portion of the booked premium that corresponds to theunexpired portion of the policy term and loss reserves reflecting the amounts estimated tobe necessary in order to pay losses under the policy. Subject to regulatory requirements,reinsurance permits the insurer to record a reduction in both those current liabilities.The use of reinsurance reduces volatility of direct insurers' operating results, promotesthe efficient use of capital and underwriting resources and allows for a greater number ofinsurers to participate in the market. Absent reinsurance, only the very largest insurers23CPAM: 4886365.12Skandia America Reins. Corp. v. Schenck, 441 F.Supp. 715, 724 (S.D.N.Y 1977).As insurance companies themselves, reinsurers also cede reinsurance. That transaction is called a"retrocession" and the reinsurer that assumes the retrocession is called a "retrocessionaire". Theretrocessionaire can retrocede, and so on, diversifying exposure to loss throughout the world-widepool of insurance capital.2
that have enough capital to withstand major loss events or to finance the strain on capitalfrom writing new business could exist.Risk management. First, and most importantly, reinsurance lays off risk, therebytransferring it to entities better able and more willing to bear it. This allows a directinsurer to calibrate its risk tolerance levels with more precision. For example, an insurermay wish to cap its losses from a particular event or exposure. In the property/casualtyarena, the covered losses could be all losses from a single catastrophic event or fromsingle peril (e.g., windstorm or earthquake) or in a single geographic region. In the lifeinsurance arena, reinsurance may serve to cap morbidity and mortality risk, persistencyrisk (the risk associated with policyholders' allowing policies to lapse or surrenderingtheir coverage) or investment risk (credit, interest rate and reinvestment). In theseexamples, reinsurance allows these risks to be dispersed among multiple reinsurers,which may agree to be exposed to either "vertical" (losses above or below certainattachments points) or "horizontal" (pro rata exposure to a single tranche of losses) slicesof the same risk.The ability to cap or reduce risk exposure is critical to insurers, because otherwise theywould have to hold more capital (for regulatory, rating and risk-management reasons) asa cushion against greater-than-expected losses or losses that are expected but with lessfrequency. 4 In addition, in the absence of reinsurance, insurers might face undiversifiedrisks to specific geographic regions or perils. Reduced balance-sheet and earningsvolatility resulting from reinsurance can moderate these effects and enable insurers toattract capital from investors to support their underwriting activity.Increases underwriting capacity. Reinsurance increases ceding insurers' underwritingcapacity by reducing net premiums and liabilities. Most states have laws that limit aninsurer's net exposure to any single risk to 10 percent of its policyholder surplus.Regulators, rating agencies and market analysts closely watch individual insurers'premium volumes and total liabilities relative to their capital base to determine whetherthey are operating with too much leverage. Reinsurance, ceteris paribus, serves to reducean insurer's net liabilities and net written premiums for purposes of calculating applicableratios and net exposure. The principle underlying this accounting treatment is that therisk has been laid off to the reinsurer, as discussed above.For example, an insurer that cedes 50% of its premiums and losses to a reinsurer willneed to hold only half of the additional capital that it otherwise would need to hold foreach additional policy (though the insurer may have a capital charge for cededreinsurance), and the risk will be cut by half for purposes of applying the 10% single riskrule. In the life insurance arena, "ceding commissions" paid by reinsurers helpcompensate the ceding insurer for expenses borne by it in acquiring the risks in the first4CPAM: 4886365.12Insurers are required to hold capital as a cushion in case losses under their policies exceed theassets they set aside as reserves. Insurance regulators and rating agencies monitor capital levelsand form judgments concerning whether insurers are operating with a capital cushion that isadequate in relation to the volume of their insurance business or the size of their liabilities. Theydo this by calculating premium-to-surplus and liabilities-to-surplus ratios and risk-based capitaland other similar ratios that they use to monitor insurers' activities. Commercial counterpartiessuch as lenders and other investors will also be alert to insurers' capital adequacy.3
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Letter to the Federal Insurance Office (FIO) - New York City Bar ...

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