Automatic Nonproportional Reinsurance
Automatic nonproportional reinsurance is a type of insurance that one insurance company buys from another insurance company. It’s a way for the first company (called the “insurer”) to protect itself in case a lot of the people or businesses it insures have really big losses all at once.
Here’s how it works: The two insurance companies make a deal. They pick an amount of money (called a “loss limit”). If the insurer has to pay more than that amount for losses, then the other insurance company (called the “reinsurer”) steps in and helps pay the extra amount.
Why do companies use it?
Insurance companies like having this kind of backup plan. It’s like having a really big piggy bank they can use if a bunch of expensive stuff happens that they have to pay for. It helps them feel safer about offering insurance, because they know they won’t go broke if something terrible happens and tons of the people they insure need help all at once.
Protection against catastrophes
One of the big reasons insurance companies get this kind of reinsurance is in case there’s a huge catastrophe, like a massive hurricane or earthquake. If a big catastrophe damages a lot of houses and businesses that the insurer covers, the insurer might have to pay way more in claims than it usually does. The reinsurance helps make sure the insurer can afford to pay all those claims without going out of business.
Following regulations
Insurance companies also sometimes get this reinsurance because the government says they have to. There are laws that say insurance companies need to have enough money to pay the claims they might get. Reinsurance is one way they can show the government that they’ll be able to pay, even if a whole lot of claims come in all at once.
How does it work?
There are a couple different ways automatic nonproportional reinsurance can be set up. Here are two of the most common:
Stop loss agreements
In a stop loss agreement, the reinsurer agrees to pay any losses the insurer has over a certain amount in a certain amount of time (like a year). So let’s say the insurer and reinsurer make a deal that says the reinsurer will cover any losses over $10 million in one year. If the insurer has to pay $12 million in claims that year, the reinsurer would pay the extra $2 million.
Catastrophe excess of loss contracts
In a catastrophe excess of loss contract, the reinsurer agrees to pay part of the losses from one big catastrophe, like a hurricane. The contract says how much of the losses the insurer has to pay first (called the “retention”) and then the reinsurer pays the rest, up to a certain limit.
So for example, let’s say a contract has a $5 million retention and a $20 million limit. If a hurricane causes $18 million in losses that the insurer has to pay, the insurer would pay the first $5 million and the reinsurer would pay the remaining $13 million (because $13 million + $5 million = $18 million, which is less than the $20 million limit).
The fine print
There’s usually a bunch of detailed rules and terms in the contracts for this kind of reinsurance. The insurer and reinsurer work together to hammer out all the specifics. Here are some of the things they have to figure out:
Which losses are covered
The contracts spell out exactly what kinds of losses the reinsurance will cover. For catastrophe contracts, they define what counts as a “catastrophe”. For stop loss contracts, they might exclude certain types of losses.
The limits and deductibles
The contracts say how much the reinsurer will pay (the limit) and how much the insurer has to pay first before the reinsurance kicks in (the retention or deductible). Insurers often try to negotiate higher limits and lower retentions, while reinsurers usually prefer the opposite.
The premium
The reinsurance isn’t free – the insurer has to pay the reinsurer a premium for the coverage. The contract specifies how much the premium is and when it has to be paid. The premium amount depends on things like how much coverage the insurer is buying and how risky the reinsurer thinks the coverage is.
The term
The contracts have a set time period that they cover, which is called the term. A term is often one year, but could be longer or shorter. At the end of the term, the insurer and reinsurer can renew the contract (usually with some changes) or let it expire.
The benefits
Insurers usually like having automatic nonproportional reinsurance for a few key reasons:
It makes their losses more predictable
With reinsurance, insurers have a better idea of the maximum they might have to pay in a bad year. The reinsurance puts a cap on their possible losses. This helps them plan better and feel more secure.
It frees up capital
Insurance companies have to keep a lot of money (capital) on hand in case they need to pay a bunch of claims at once. But if they have reinsurance, they don’t need to keep quite as much capital, because they know the reinsurer will help pay if things get really bad. This frees up money that the insurer can invest elsewhere to help the company grow.
It helps them take on more risk
Reinsurance is kind of like a safety net for insurers. It lets them take on clients or offer policies that they might normally think are too risky, because they know they have some backup if things go wrong. This can help them grow their business and offer their services to more people and companies.
The drawbacks
Reinsurance has some downsides too, of course. Here are a couple of the main ones for insurers:
It can be expensive
Just like any insurance, reinsurance costs money. The premiums cut into the insurer’s profits. And if the insurer does have to use the reinsurance, they often have to pay a deductible first, which also costs money. Insurers have to weigh the costs against the benefits to decide if the reinsurance is worth it.
It’s complicated
Setting up reinsurance contracts can be pretty complicated. There’s a lot of technical stuff to figure out and negotiate, often with a lot of legal jargon involved. It can take a lot of time and effort (and usually some lawyers) to get it all sorted out.
