* * * * *Purpose of Reinsurance
In the last article in this series, we looked at insurance contracts and how they function. Although insurance companies are in the business of assessing and accepting risks, there are situations where insurers look to limit their risk exposure. The primary tool for insurance risk management is through reinsurance. Reinsurance treaties (as such contracts are traditionally denominated) are complex and high-dollar business arrangements by which insurance companies achieve certain financial goals—risk reduction, volatility reduction, and capital management.
With respect to risk reduction, an insurance company might review its block of business and note that it is vulnerable to a particular risk. For example, a property insurer might note that it has a high volume of insured properties in areas at risk for hurricanes or tornadoes. Or perhaps an insurer notes it has insured multiple office buildings in a single block or fire station district, making it vulnerable to heavy losses in a large-scale fire. In many cases, an insurer might want to write policies with large benefits (e.g., a $5 million life insurance policy or a $2 million dollar homeowners policy), but be uncomfortable being at risk for the full policy amount, particularly where the insurer writes a decent volume of such policies. And sometimes an insurer will write a special endorsement or surplus lines policy to accommodate an insured's special risk needs, but the insurer will be uncertain it has properly underwritten the risk. In each of these situations, an insurer would seek out reinsurance in order to reduce its risk profile by laying off some portion of the excess risk.
Reinsurance assists insurance companies with volatility reduction by smoothing over differences in year-to-year loss experience. Reinsurance treaties tend to involve long-term, multi-year relationships between insurer and reinsurer. In a given decade, an insurer might have three years with massive underwriting losses which are offset by the other seven years of moderate to significant underwriting gains. Yet the years with large losses might interfere with the insurer’s long-term business plans. By sharing the risk with a reinsurance partner, the insurer is able to achieve smoother, more predictable cash flows, enabling it to maintain a longer term business perspective (e.g., holding premium levels steady rather than raising premiums—and losing market share—in an attempt to immediately recoup losses).
Finally, reinsurance is a key tool for capital management by insurance companies. Insurance companies are subject to strict regulations meant to ensure they will be able to meet their obligations to policyholders. The cornerstone of these solvency regulations is statutory accounting, which places greater emphasis on the balance sheet and liquidity than do the generally accepted accounting principles (GAAP) commonly used in most other industries. An insurance company can only write more new policies if it has sufficient surplus (positive working capital) to support the policy. Yet, under statutory accounting, when a new insurance policy is written, the full amount of the actuarial reserves and policy acquisition costs (e.g., commissions, expenses, and other overhead) must be immediately posted to the balance sheet as liabilities, rather than amortized over time. So, writing new business quickly erodes surplus, leading to surplus strain. In such a situation, an insurance company can find new capital, stop writing new business, or find surplus relief by laying off part of the policies (and their attendant reserves) on its books through reinsurance.
Reinsurance can be structured in a number of ways, but the basic forms are facultative and obligatory (a/k/a treaty) reinsurance (see SwissRe's "Essential Guide to Reinsurance", pp. 22-24). Facultative reinsurance is where a large individual risk or policy is ceded to the reinsurer; e.g., a multimillion dollar property policy on a commercial building or a multimillion dollar life insurance policy on a company’s CEO. Obligatory reinsurance, by contrast, allows a block (portfolio) of similar risks or policies to be ceded as a unit; e.g., a block of all automobile liability policies written by a company during 2014.
Risk allocation under a reinsurance treaty can also be structured in several ways (see SwissRe's "Essential Guide to Reinsurance", pp. 25-30). In quota share reinsurance, the insurer and reinsurer(s) each receive a proportional amount of the premiums and pay proportional amounts of losses, with the primary insurer being paid a commission by the reinsurer for the costs of selling and administering the policies. For example, a primary insurer might keep 25% of the premium (plus its administrative commission) and cede the remaining 75% to one or more reinsurers (it is common for multiple reinsurers to take from 5% to 50% stakes in the ceded risk). When losses become payable, the insurer pays the claims and then is reimbursed by each reinsurer for their share of the losses.
Other kinds of reinsurance risk allocation methods operate by permitting the primary insurer to retain the first full layer of risk and associated premiums (the retention) with all risk and premiums/losses above that amount allocated in various fashions to one or more reinsurers (again, the primary insurer is paid a commission by the reinsurer for the costs of selling and administering the policies). Such arrangements include surplus share, excess of loss, and stop loss agreements which are tied to particular blocks of policies, as well as catastrophe and aggregate agreements which are tied to losses caused by a single large-exposure event (e.g., a hurricane, thunderstorm cell, or large fire) or by a series of large-exposure events (e.g., multiple hurricanes or storms), respectively. For example, a reinsurance treaty might provide that the primary insurer will retain the first $500,000 of risk per policy, and reinsurers will assume and share responsibility for losses above $500,000 per policy. Or, a primary insurer with high storm loss exposure could enter into a combined “catastrophe aggregate” reinsurance treaty in which the primary insurer would retain the risk for losses of $10 million per storm and $100 million per year, with reinsurers sharing losses above those retentions.
Reinsurance v. Bookmaking
Despite its complexity, reinsurance shares some traits in common with simpler and more common gambling world concepts. Consider, for example, a typical local or retail sports book operator. The bookmaker’s business model is essentially a specialized form of insurance—attempt to take roughly even bets on each side of a given game or wager, pay the winners with the wagers of the losers, and keep his commission (“vig”).
However, the bookmaker faces two financial risks. First, betting may fall unusually heavily on one side of a wager; if that side wins, the bookmaker will need to pay the winners out of his own pocket. Second, a bookmaker might face an unexpectedly large individual wager or a high volume of wagers (perhaps on the NCAA tournament or the Super Bowl). Here, the bookmaker faces a financial risk if there is a notable default rate by losing bettors. The solution? In both cases, the bookmaker retains the amount of wagers he is comfortable with keeping in light of his risk appetite and working capital. The bookmaker then passes along (“lays off”) those wagers he is not willing to risk—along with the accompanying risks and profits—to a larger bookmaker, online sports book, or even a legitimate sports book. In other words, the bookmaker is limiting his risk exposure through use of what are essentially stop loss, catastrophe, and aggregate reinsurance principles.
Reinsurance v. Poker Staking
Reinsurance also bears strong resemblance to the practice of poker staking. In general, poker staking is an arrangement where a poker player receives some percentage of the buy-in to an individual or series of tournaments or cash game sessions in exchange for a roughly commensurate share of any profits. The staking agreement can have one or more backers, and each backer may have a different share in the agreement. Typically, the player will retain a piece of the action, and will be paid a premium (“markup”) in compensation for the investment opportunity and the player’s efforts in actually playing in the tournaments or cash game sessions. Essentially, poker staking is analogous to a specialized version of quota share reinsurance—facultative if only for certain high-stakes tournaments or cash games, obligatory if for a set series of tournaments or period of time, with markup playing the role of the commission paid by the reinsurer to the insurer for administrative costs.
Poker players seek staking arrangements for the same three reasons insurers seek out reinsurance—bankroll (capital) management, risk reduction, and volatility reduction. Bankroll management is essentially a working capital issue. A poker player might have a positive expected value advantage in, say, the World Series of Poker or a cash game session with some wealthy whales in Bobby’s Room at Bellagio. But the player might not have enough money to buy in to the tournaments or cash games without putting too large a percentage of their liquid working capital at risk. Staking gives the player the ability to take advantage of these potentially profitable games while maintaining prudent bankroll reserves. Similarly, even if a player can comfortably afford to buy in to the tournaments or cash games, poker results can show high volatility, creating a financial risk for even the best player. A staking arrangement, particularly for a single high cost tournament (e.g., the WSOP Main Event or a high roller event) or an expensive series of tournaments (e.g., the full WSOP tournament slate), can both reduce financial risk and smooth out the inherent volatility of poker results. This reduction in risk and volatility, of course, comes at the price of reduced profits from successful tournaments and cash game sessions subject to the staking arrangement.
Even more interesting is the alignment in interests between reinsurers and those who stake poker players. Reinsurers are seeking out high rates of return from specialized investments; so are poker stakers. Reinsurers want to be able to participate in an insurance market without the hassle and expense of getting licensed and dealing with regulators, not to mention designing, selling, and administering a block of insurance policies. Likewise, poker stakers want to participate in the opportunity to make money in poker tournaments or cash games, but without the hassle of actually playing. Reinsurers tend to bring highly sophisticated risk analysis to bear in evaluating potential deals; though this skill is not necessary for successful poker staking, the best poker stakers demonstrate a keen evaluation of poker playing skill when choosing players to stake.
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Additional articles in this series (links will be added as each section is posted):
Part I—Meet the Aleatory Contracts
Part II—Insurance: Gambling on Catastrophe
Part IV—Derivatives and Daily Fantasy Sports
Part V—Hedgers and the Law
Part VI—Speculators and the Law
Part VII—Risk Creation v. Risk Management