Chapter 27 — Key Takeaways

Reinsurance: How Insurers Insure Themselves and Why It Matters for Underwriting. One page to carry.

The core claims

  • Reinsurance is insurance bought by an insurer. The cedent transfers part of its risk to a reinsurer; the original policyholder's contract is untouched, and the cedent stays fully liable to its policyholder whether or not the reinsurer pays (privity).
  • It does three jobs: capacity (write limits bigger than you can hold alone), catastrophe protection (survive the correlated event that defeats the law of large numbers), and volatility smoothing (protect surplus and steady earnings). You pay away expected profit to reduce variance — the same trade your insureds make, one level up.
  • Two ways to cede: treaty (a whole book, automatic and obligatory, negotiated once at renewal) vs. facultative (one risk at a time, optional for both sides). Reach for facultative when a risk is bigger than, excluded from, or too exposed for the treaty.
  • Two shapes of cession:
  • Proportional — share every dollar in fixed proportion. Quota share (a fixed % of every risk) best relieves surplus strain / funds growth; surplus share (only the part above the retention, in lines) best solves the large-line problem and homogenizes the net book.
  • Non-proportional — pay only above a retention. Excess of loss (XOL) ("limit xs attachment," in layers) caps severity per event; catastrophe XOL responds to the aggregate loss from one event and is the cover standing between one storm and solvency.
  • Net beats gross at the desk. Your capacity = net retention + treaty behind it. Your price must be adequate for the risk you keep after paying for the reinsurance it forces you to buy. Your combined ratio is a net number a good program makes steadier across the cycle.
  • Reinsurance relocates risk; it does not abolish it. Retrocession spreads risk further, but an opaque loop can become a spiral (LMX) that amplifies a loss back onto the parties who thought they had passed it on.

The rules of thumb

  • Read the tower bottom-up: every loss starts in the retention; it climbs into layer 1, then 2, then 3 only as it gets big enough. Be able to walk any loss figure up any tower.
  • "\$4M xs \$1M" = reinsurer pays the band from \$1M to \$5M.
  • Ceding commission exists only in proportional reinsurance (the reinsurer shares the original premium, so it reimburses the cedent's acquisition/overhead).
  • Collectability is your risk: a cheap cession from a shaky, unrated, uncollateralized reinsurer is not a bargain — it is a deferred loss. The reinsurer's AM Best rating is part of your underwriting.
  • Watch reinstatements on cat XOL: in an active season, running out of cover is a real exposure.
  • Catastrophe-exposed and "profitable gross" is the classic trap — it can be ruinous net.

Key terms

reinsurance · ceding company (cedent) · treaty vs. facultative · quota share · surplus share · excess of loss (XOL) · catastrophe XOL · retrocession · ceding commission · (used, owned elsewhere: retention, attachment point, subjectivity Ch.13, combined ratio Ch.3, accumulation/PML Ch.30, surplus/RBC Ch.28)

The themes this chapter advanced

  • The combined ratio tells the truth — measured net: a well-bought program lowers volatility across the cycle; the gross-vs-net trap is the chapter's sharpest pricing-discipline lesson.
  • Technology augments underwriters; it does not replace them — cat models and ILS price catastrophe cover, but judgment about the cedent, the data, the model's blind spots, and aggregate/systemic exposure (the spiral) decides the deal.
  • (Also: adverse selection moves up a level into fac-oblig treaties and retrocession chains; insurance serves a social function — cat reinsurance is what makes coastal property insurable at all.)

What you could defend to your manager

"I can offer Harbor Steel the full \$20M because our surplus-share treaty sits above our \$5M net retention; our net bet on a total fire loss is \$5M, with facultative on standby only if the treaty caps below \$20M. The named-windstorm exposure is ceded through the cat XOL treaty, and I have loaded the net price for the slice of cat-treaty capacity this coastal account consumes — because a risk that's profitable gross can be ruinous net, and the rate has to be adequate for what we keep, not what we write."