As stated previously, the two major types of reinsurance are proportional and excess of loss. Under proportional reinsurance, the ceding insurer and the reinsurer automatically share all premiums and losses covered by the contract on a pre-agreed prorated basis, thus there are no characteristics uniquely attributable to the risk associated with proportional reinsurance.
On the other hand, a great deal of uncertainty characterizes the risk associated with excess of loss reinsurance. This uncertainty stems from the fact that the level of risk is dependent on the nature of the reinsurance undertaking. In addition to the actual risk being underwritten, reinsurers must take into account the overall stability of the ceding insurer and the layer of coverage on which the reinsurer is being asked to participate.
Reinsurance, particularly excess of loss reinsurance, is characterized by low claims frequency and high loss severity, and neither is predictable. Therefore, reinsurers may absorb a disproportionate share of total losses. The lines of insurance in which liability is slowest to manifest itself or develop -- the "long tail" lines -- create the worst problems for reinsurers. Paradoxically, reinsurers must collect premiums now for future losses, which will be adjudicated in the social, legal and economic environments prevailing in the future.
Insurance loss costs are determined by a combination of frequency (how many claims per unit), severity (average cost of each claim) and the total number of units insured. Generally, the higher the number of similar units insured, the more reliable the data. This is particularly true in automobile property damage liability insurance. There are many automobiles insured and the frequency of claims is relatively stable year to year.
This method of evaluating insurance risk, however, is often not applicable to reinsurance. Relevant and credible loss data are often unavailable. In contrast to an insurance underwriter, a reinsurance underwriter depends much more on professional judgment and experience to evaluate the nature of an exposure.
General liability insurance contracts traditionally provide coverage for losses occurring during the policy term, regardless of when the loss is reported. This type of contract, called an occurrence policy, leaves the insurer exposed to claims which may be filed many years after the policy expires. Certain exposures, such as environmental liability, are particularly susceptible to this latency factor commonly referred to as the long tail.
Reporting delays create serious problems for all insurers, but marked differences exist in reinsurer loss development patterns, due primarily to the retention feature of excess of loss reinsurance. Many claims are not initially valued at ultimate cost. Because the ceding insurer's reserve is within the retention established in the reinsurance contract, the ceding insurer may not report such claims to its reinsurer.
However, when the claim is ultimately paid, it may exceed the retention. It is only at this point, usually after considerable time has passed, that the reinsurer is notified. Reinsurers are trying to mitigate this problem by requiring all serious injuries to be reported, regardless of the insurer's reserve, and by conducting on-site visits to examine ceding insurers' claims files to better determine the likelihood of losses under the reinsurance contract.
Over the past several years, commercial lines of insurance that often have long tails have demonstrated considerable instability regarding frequency and severity of losses. As a result, commercial insurers rely heavily on reinsurance.
All insurers and reinsurers set aside loss reserves for claims that have been incurred but not reported (IBNR). As claims are reported to the company, these reserves, which represent future loss payments, are reduced.
Because IBNR is such a major component of reinsurers' reserves, much effort is taken to determine and make these calculations. Despite the use of sophisticated professional techniques, however, these reserves are extremely sensitive to changes in social, legal and economic environments. Therefore, they represent a "best guess estimate" of future loss payments.
If IBNR reserves represent only a small portion of a company's total loss reserves, the impact of these unknown claims on total losses reported on past policies is likely to be small. In contrast, if IBNR reserves represent a large portion of a company's reserves, the impact on total losses reported on past policies may be significant. Reinsurers, particularly those participating in casualty and workers' compensation lines, fit into this latter category.
The impact of inflation on insurers' claims liability typically results from increases in the cost of living, increases in the number of claims paid, and increases in large jury verdicts which raise settlement costs. The impact has been most pronounced on reinsurers because their losses develop more slowly and may not be capped to a retention limit.
If losses are paid within a relatively short period following the issuance of an insurance policy, inflation has little effect on claims payments. In many instances, the reinsurer may not become aware for years of a loss it will pay. As a result, the impact of inflation on reinsurers may be dramatic. In fact, over the last decade, retention levels were reached and exceeded with unexpected frequency in nearly all lines of insurance.
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