The quality of the reinsurance security purchased by the direct insurer is what helps to ensure that losses will be paid. It is therefore important to understand the reinsurance function, relationship, claims services, and fronting arrangements.
Risk managers and other purchasers of insurance rarely think about how reinsurance affects their company or the insurance they purchase for their company. Insurance buyers mainly focus on the direct insurers—the primary, excess, and umbrella carriers that provide the coverage.
Smart insurance buyers look for insurance companies with high financial ratings and long histories of standing by their insureds when losses occur. Other buyers rely on their broker to put together the best quality insurance program with the best insurance security available. After all, the insured must rely on the insurance policy issued by the direct insurer.
But what stands behind the A-rated insurer or the high quality insurance program for a complex commercial risk? Reinsurance. Commercial insurance cannot exist without reinsurance. The quality of the reinsurance security purchased by the direct insurer is what helps to ensure that losses will be paid.
The Reinsurance Function
Quality reinsurers provide special expertise to their direct insurer clients and assist the direct insurer in providing the best possible protection and risk management for the direct insurer's own clients. Some large professional reinsurers help small insurance companies expand into new areas and provide them with technical, actuarial, and claims expertise and training.
Reinsurance has been defined in various ways by expert commentators and the courts. In simple terms, reinsurance is insurance for insurance companies provided in the form of a contract of indemnity rather than a liability contract. Generally, the direct insurer must first pay a loss and then seek reimbursement for that loss from its reinsurer.
Stated another way, reinsurance essentially is an extension of the theory of insurance itself. The insurance risk is spread from one risk bearer to other risk bearers. This allows the initial risk bearer to continue to provide insurance products to its clients, knowing that when losses occur, others will share those losses. Reinsurance also allows a direct insurer to strengthen its balance sheet by reducing its liability for loss and replacing that liability with an asset.
The Reinsurer/Insured Relationship
The relationship between a reinsurer and the insured differs markedly from the insurer/insured relationship. Generally, there is no contractual relationship between the insured and a reinsurer, and no right of action by the insurer against the reinsurer. The insured must look to its insurer for payment of any claims, not to the reinsurer.
Under normal circumstances, the reinsurer has no interaction with the insured. Usually, the identity and often the existence of the reinsurer are unknown to the insured. Why then should the insurance buyer care about reinsurance if there is no contractual relationship or interaction between the two?
Depending on the insurance program purchased, the reinsurance standing behind that insurance may have a significant impact on the insured when losses arise. A highly leveraged insurance program that predominantly relies on reinsurance may create a substantial risk for the insured. If the reinsurance fails—the reinsurers refuse to pay or become insolvent—the direct insurer may have serious difficulty responding to claims if the direct insurer reinsured or ceded most of the risk to its reinsurance program.
Although the direct insurer is solely responsible to the insured for claims, the failure of a reinsurance program behind the direct insurer may result in the insolvency of the direct insurer. This, in turn, may result in the insured effectively becoming a self-insurer and relying on state security funds for the minimal protection they provide.
Risk Management/Claims Services
A highly leveraged insurance program also may be a sign that the direct insurer has very little interest in the program. Where the risk retained by the direct insurer is minimal, the direct insurer may not provide the level of risk management and claims services that the insured may require.
A direct insurer that cedes the vast majority of the reported loss to its reinsurers may not wish to incur loss adjustment expenses, but would rather its reinsurers shoulder the loss. While this may seem to favor the insured, whose claims will be paid and passed along to reinsurers, the lack of proper claims handling may result in unnecessary loss payments and resistance from reinsurers who expect the reinsured to handle claims properly.
Fronting Arrangements
The direct insurer's interest in the insurance program may be nonexistent because the direct insurer is merely acting as a front for the reinsurance program. Many commercial risk programs are fronted because the risk bearers with the expertise and interest in insuring the risk are not licensed to do business in the insured's state or are not licensed to write direct insurance. Generally, a fronted program is well-known to the insured and arranged in advance.
For example, it may be that the insurance market for a certain type of insurance is made only in London. The insured may be uncomfortable in accepting direct insurance through the excess or surplus lines market and may insist on licensed or admitted paper. In that case, a licensed direct insurer may write the policy and cede most of the risk to the market that provides the actual coverage.
Sometimes, however, the direct insurer retains enough of the risk so that the insured does not know the program is really fronted. The direct insurer may have little interest in the insurance program if it is merely collecting a fronting fee. The fronting insurer will even reinsure its retained portion of the risk through a separate reinsurance program, leaving it with none of the risk it originally assumed. Where the direct insurer transfers all of its risk to others, the likelihood that the direct insurer will provide the insured with any risk management services and stand by the insured when claims arise is diminished.
Conclusion
These doomsday scenarios need not come true if the insurance buyer insists on a high-quality insurer and questions the reinsurance protection standing behind the insurance program it has purchased. Reinsurance is a normal part of the risk transference system, and the insured should have comfort in knowing that its risk is being transferred in an appropriate manner to reinsurers of quality.
If the direct insurer refuses to discuss the reinsurance protection it anticipates for the program it plans to write for the insured, the insured should consider whether doing business with that insurer is the right business decision for the company.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
