An introduction toreinsurance swiss re

An introduction to reinsurance An introduction to reinsurance 2 Contents 1. The history of insurance and reinsurance 4 2. The history of Swiss Re (SR) 8 3. A definition of reinsurance 11 4. The nature and function of reinsurance 12 5. Who offers reinsurance? 16 6. Who are the largest reinsurers? 17 7. From policyholder to retrocession 18 Risk sharing with reinsurance: a schematic diagram 8. Basic forms of reinsurance 20 9. Basic types of reinsurance: 21 proportional and non-proportional 10. Direct insurers and reinsurers: a comparison 31 11. Freedom and its consequences 32 Sources 34 Technical terms 34 Classes of business 36 An introduction to reinsurance Foreword To the reader, Many authors have written a great many works on reinsurance, and Swiss Re’s publication of An introduction to reinsurance is adding yet another title to this long list. You may justifiably ask, “Do we really need this brochure?” We believe that the answer is yes– and for good reason. To our way of thinking, introductions to reinsurance are either too rudimen- tary or too comprehensive: the first do not provide the examples necessary for a clear understanding of the subject, while the second go too much into detail, and are addressed to readers already familiar with the reinsurance basics or who have easy access to more specialized literature. This publication is meant to be different. An introduction to reinsurance is designed as a training text: it limits itself to the basics of reinsurance, and explains them in an understandable way. Compiled from diverse sources and enriched with examples and illustrations, it also says a good deal about the way Swiss Re does business. And because our environment is dynamic and rapidly changing, we have not written An introduction to reinsurance as a definitive work, one for all time, but as one that we will expand and– when necessary– update as the situation demands. Product Management Knowledge Transfer 3 1. The history of insurance and reinsurance Striving for security, making provisions Man’s desire for security, his wish to provide against future uncertainty, is as old as the human race itself. At first, he could only try to satisfy this need by helping himself; later, he found support in the family, the clan, the guilds. It is this idea– the notion of community, of “one for all and all for one”that is very basic to insurance. In a world where labor is increasingly specialized and value is increasingly concentrated, insurance has grown steadily in importance. Once, Henry Ford I heard a visitor to New York express wonder at the sight of the magnificent city with its soaring buildings. Ford’s reply fittingly characterized the significance of insurance in our modern world: “This has only been made possible by the insurers,”he said. “They are the ones who really built this city. With no insurance, there would be no skyscrapers. No investor would finance buildings that one cigarette butt could burn to the ground.” The origins of insurance It is in marine commerce that we first find the idea both of direct insurance and of reinsurance. Yet while we have evidence of transport cover going back to before the Christian era, the oldest known contract with reinsurance characteristics was concluded much later: in the year1370, in Genoa. Economic upturn favored development As trade expanded in the late Middle Ages and the economy flourished– especially in the Italian city-states, Flanders and the cities of the Hanseatic League– a true commercial insurance business grew up. Insurers of the period worked without statistics, rates, or calculations of probability, relying solely on their personal assessment of the risks 1 . Thus, when news of a loss came through, many an insurer had to ask himself fearfully whether he had taken on too much risk. To protect himself against such situations, he soon learned to transfer part or all of the risk to another insurer willing to accept it by way of reinsurance. Besides reinsurance which at that time covered only individual risks (see “Facultative reinsurance”in Chap.8), the period’s other main risk-sharing instrument was co-insurance 2 . As an English law of 1746 virtually prohibited reinsurance, direct insurers had to band together into syndicates if they were to cover risks beyond their individual financial means. Thus the law unintentionally strengthened Lloyd’s of London, the world’s most famous insurance institution (see Chap.5). 4 1 In underwriting, the term risk refers not only to abstract hazards but also to the actual object insured: a ship, for example. 2 Co-insurance: when several direct insurers participate on a single risk. The first insurance companies After marine insurance, the first great step in the history of the insurance industry, came the second: insurance against fire hazards. For example, after a number of serious fires struck Hamburg between 1672 and1676, the Ham- burgische Feuerkasse (Hamburg Fire Fund) was set up: today, this is the world’s oldest existing insurance company. In1706, the founding of the Amicable or Perpetual Assurance in London finally marked the breakthrough of actuarial science as a means of assessing risks and setting rates. Other foundation stones of the modern insurance industry were laid during the nineteenth century: this age witnessed the founding of numerous insu- rance companies still in business today. Innovations included the rise of a modern form of reinsurance aimed at balancing portfolios on an inter- national level; the addition of new classes of insurance to the industry; and the creation of social insurance plans. Insurance’s rapid evolution in the last century can only be explained in the context of economic development: the transformation of technology, the remodeling of society, the change in ways of thinking. Within a few decades, an entirely new, rational world-view took hold: it tore man away from his relative immaturity and forced him to adopt an independent, responsible attitude to life and the world around him. The increased need for security which this new age brought with it was the origin of the insurance business as we know it today. From the individual risk to the portfolio Reinsurance, too, in its modern form, was the product of these events. As industrialization produced concentrations of value, insurance companies’ demand for reinsurance cover boomed. Treaty reinsurance, which provided cover for portfolios (groups of risks), took its place beside the single-risk, facultative form of reinsurance customary until that time. Treaties, which are still in use today, are discussed under “Obligatory reinsurance”(Chap.8). Another catastrophic fire in Hamburg in 1842 gave the immediate impulse for the founding of Cologne Reinsurance Company, the first professional reinsurance company. 3 The reserves of the locally-based Hamburg Fire Fund, only 500,000 marks, had not been nearly sufficient to cover the loss of 18 million marks. Thus, as a result of this event, insurers finally addressed the need to distribute entire portfolios of policies among several risk carriers (see Chap.4). 5 3 A professional reinsurance company such as Swiss Re engages exclusively in rein- surance. Professional reinsurers Though at first it was mainly the financially stronger direct insurers who engaged in reinsurance, the Cologne Reinsurance Company was the pre- decessor of a long line of professional reinsurance companies founded soon after. Among these were: – Aachen Re in1853; – Frankfurt Re in 1857; – Swiss Reinsurance Company in 1863; and – Munich Reinsurance Company in 1880. The founding of such professional companies specializing in reinsurance was of great importance for insurance operations and the further develop- ment of the industry. Under the co-insurance arrangement used until then, participation on the same policy by several insurers meant that each had knowledge of the others’ underwriting, a situation that encouraged unfair competitive practices: the reinsurer eliminated this disadvantage. In addition, specialization allowed new forms of reinsurance to develop, while the globe- spanning activity of the reinsurers not only permitted risks to be spread more effectively, but also provided international experience. This has improved the protection offered by reinsurance, and contributed indirectly to improving the conditions which reinsurers are able to offer their clients. The insurance industry reaches maturity The twentieth century, too, has been characterized by a wave of new rein- surance companies founded in numerous countries. In addition, the direct insurers have intensified their reinsurance activities. Today, Standard& Poor’s lists approximately135 professional reinsurers worldwide, as well as around 2000 direct insurers that also write reinsurance business. The great number of direct insurers and reinsurers is proof that the insurance industry’s prime, which began with the full flowering of the industrial revo- lution in the last century, is far from over. Today, however, at the end of the twentieth century, the European insurance industry in particular finds itself confronted with a new development. Liberalization as a result of the European single market is bringing about the disappearance of the strictly supervised, nationally regulated system which has existed for generations. Today, deregulation of the insurance business is leading to more intensive competition. 6 The basis of modern insurance: the law of large numbers To set premium rates, insurers must be able to predict future losses. How- ever, it is impossible to predict the exact moment fate will strike any one individual, or the extent of the loss that this blow will cause. Thus insurers consider large groups of their clients under the assumption that each is exposed to the same types of risk, and that each loss is a separate event. In such cases, the larger the group, the closer the average loss will approach a definite value. This is the result described by the law of large numbers, discovered by Jakob Bernoulli around1700. Thanks to this law, an insurer can predict the total annual loss to be expected for the group much more accurately than for any one individual. The pro- jected losses are then distributed among those insured, thereby determining the premium. Today, insurers make extensive use of statistics to calculate the expected losses and distribute them over the individual premiums. Statistics are always based on the past, but the laws of probability make it possible to apply these data to the present and to predict future trends. Though the theory of probability is highly developed, there may be differences between prediction and reality: this is known as underwriting (or actuarial) risk (see Chap.4). This is why reinsurance is needed. Example: No one can know beforehand when a particular individual will die. However, based on experience and observation, we can predict with fair accuracy how many female (or male) newborns will attain the age of 20 years, for example, or 50 years, or 60 years. 7 2. The history of Swiss Re (SR) From 1863 to World War I: the pioneering age Like the Hamburg fire of 1842, the1861 fire in Glarus, Switzerland made painfully clear that the reserves normally set aside by insurance companies were inadequate for such catastrophes. To better prepare for such risks, the Helvetia General Insurance Company in St.Gall, Credit Suisse of Zurich and the Basle Commercial Bank founded the Swiss Reinsurance Company in Zurich in1863. The bylaws, approved by the Governing Council of the Canton of Zurich, bear the signature of the Swiss poet Gottfried Keller, the canton’s First Secretary at the time. Although Swiss Re concluded treaties with foreign ceding companies as early as1864, it proved difficult to gain a firm foothold abroad. It was not until the devastating San Francisco earthquake and fire of 1906, which brought the company a gross loss of 8.4 million Swiss francs (50% of total annual fire premiums), that Swiss Re’s prompt, accommodating settlement of claims brought it a worldwide reputation. The result was a commensurate increase in business: Swiss Re established its first branch office in New York in 1910. Between the wars: a period of expansion Swiss Re’s initial wave of expansion into the US and Great Britain was followed by a second during the1920s which concentrated on continental Europe. At this time, Swiss Re acquired an interest in a total of 31 direct insurers and reinsurers in11 countries, predominantly in Germany. Despite the collapse of currency (1919–1924) and Black Friday on the New York Stock Exchange (1929), Swiss Re remained a solvent and reliable company. The global economic crisis triggered by the1929 Wall Street Crash did leave its mark on Swiss Re’s results, however, and huge losses had to be overcome. Nevertheless, between the wars, Swiss Re succeeded in becoming the world’s leading reinsurer. 8 After World War II: consolidation and adjustment to the new world order During World War II, wartime economic measures and Swiss neutrality enabled Swiss Re to maintain most of its worldwide business relations. How- ever, the post-war years brought sweeping changes. Although it was possible to establish new subsidiaries and branch offices in various Western nations, Swiss Re’s strong position in eastern Europe was lost when states of the newly-formed Soviet bloc nationalized their assets. Also, the decolonization of Africa and Asia made it necessary to adjust to completely new market structures. The economic boom that began in the1960s placed considerable demands on the company’s flexibility and innovative capacity. Swiss Re met the new challenges in a number of ways, notably the foundation of the Swiss Insurance Training Centre (SITC), originally for the training of insurance specialists from third-world countries. To help it adapt to the new situation, Swiss Re also made various changes in its organizational structure, such as setting up its market-oriented departments in 1964 and adopting a triadic organization (market/product/technical) in1973. A larger-scale reorganization took place in1989 with the aim of combining the technical and marketing departments; and in1992, the company was given a new management concept. Reinsurance training was also modified at this time to reflect changed conditions: modular courses for reinsurance specialists replaced the prior curriculum, so that new employees could be prepared selectively and efficiently for their specific duties. Business growth and the steadily increasing number of staff (from 208 employees in1910 to 480 in1960, 1315 in 1990, and1800 by1995) made it necessary to build or buy new premises: the New Building in 1969; the Escher and Lavater Buildings, purchased in1972; the“Mythenschloss,”occupied in 1986. Beginning in1992, departments were relocated to the Gotthardstrasse, to Sood/Adliswil, and to the Bederstrasse. In1984, a new corporate strategy was drawn up to create a more diversified range of reinsurance products that included supplementary services as well as the core business of reinsurance cover. At this time, Swiss Re was able to consolidate its position as the world’s second largest reinsurance company. 9 [...]... settlement and payment of claims from the time of their occurrence until settlement Swiss Reinsurance Company Annual Report 1994 Swiss Reinsurance Company, Zurich, 1995 Claims incurred: All claims payments plus the Swiss Reinsurance Company Historical Highlights – 125 Years Swiss Re Swiss Reinsurance Company, Zurich, 1989 Swiss Reinsurance Company Questions and Answers Swiss Reinsurance Company, Zurich,... also well suited to limiting the risk of random fluctuation and risk of change across an entire portfolio Example Direct insurer’s retention Reinsurance quota share Sum insured (SI) of the insured object Direct insurer retains 70% Reinsurer assum es 30% Prem ium rate is 2‰ Direct insurer retains 70% Reinsurer receives 30% Loss Direct insurer pays 70% Reinsurer pays 30% 23 70% 30% 10 m illion 7 m illion... hazards and risks from the direct insurer Transfer of risk to the direct insurer 11 Transfer of risk to the reinsurer 4 The nature and function of reinsurance 4.1 The basic function of reinsurance Reinsurance is therefore insurance for insurers Reinsurance allows direct insurers to free themselves from the part of a risk that exceeds their underwriting capacity, or risks which, for one reason or another,... Insurer Profit commission: Contractually agreed >commission paid by the >insurer or >reinsurer in proportion to his profit in a particular piece of insurance or reinsurance business Proportional cover, proportional reinsurance: See under Treaty reinsurance Quota share reinsurance: See under Treaty reinsurance Reinsurance commission: See Commission Reinsurance premium: See under Premium Reinsurance treaty:... (compare Unearned premium) Gross premium: Insurance premium before deduction of the ceded premium (cession); reinsurance premium before deduction of the retroceded premium (retrocession) Net premium: Insurance premium after deduction of the ceded premium (cession), or reinsurance premium after deduction of the retroceded premium (retrocession) Single premium: A single-payment life in- surance premium... and claims reserves Technical result: Result from reinsurance operations, including allocated investment return and proportionate administrative expenses Treaty reinsurance (also obligatory reinsurance): Reinsurance in which the >reinsurer participates in certain sections of the >insurer’s business as agreed by treaty Contrast with facultative insurance Financial reinsurance: Form of reinsurance treaty... the coherent expansion of its reinsurance business… 10 3 A definition of reinsurance “Reinsurance is insurance for insurance companies.” More precisely, “Reinsurance is the transfer of part of the hazards or risks that a direct insurer assumes by way of insurance contract or legal provision on behalf of an insured, to a second insurance carrier, the reinsurer, who has no direct contractual relationship... opposed to annual premium payment Reinsurance premium: Premium paid to the >reinsurer by the >insurer for the >risk accepted Retrocession premium: Premium paid to the retrocessionaire for the part of the >risk accepted Unearned premium (also Premium reserve): Premiums received for future financial years and carried over to the next year’s financial statements (compare earned premium) Primary insurer: See... the >insurer are shared proportionally by the >insurer and >reinsurer Quota share reinsurance: Form of >propor- tional reinsurance, which provides for the >reinsurer to accept a specified share of each of an >insurer’s >risks in a specified class of business Surplus reinsurance: Form of >proportional reinsurance which provides for the reinsurer to accept a specified share of each of an insurer’s risks... the reinsurer a contractually agreed share of the risks defined in the reinsurance treaty; the reinsurer is obliged to accept that share: hence the term obligatory The reinsurer cannot therefore refuse to provide insurance protection for an individual risk falling within the scope of the treaty, nor may the direct insurer decide not to cede such a risk to the reinsurer As a rule, obligatory reinsurance . the policyholders Direct insurer Transfer of risk to the direct insurer Transfer of risk to the reinsurer takes on hazards and risks from the direct insurer Reinsurer 4. The nature and function of reinsurance 4.1. basic function of reinsurance Reinsurance is therefore insurance for insurers. Reinsurance allows direct insurers to free themselves from the part of a risk that exceeds their under- writing capacity,. exclusively in rein- surance. Professional reinsurers Though at first it was mainly the financially stronger direct insurers who engaged in reinsurance, the Cologne Reinsurance Company was the pre- decessor