REINSURANCE BASICS

What is reinsurance?
 
  • In its simplest terms, reinsurance is insurance for insurance companies. Reinsurance is a transaction in which one insurance company (the reinsurer) indemnifies, for a premium, another insurance company (the ceding insurer) against all or part of the loss that it may sustain under its insurance policies.  The fundamental objective of insurance - to spread the risk so that no single entity is saddled with a financial burden beyond its ability to pay - is enhanced by private reinsurance, which enables risks to be spread throughout the world. 
  • Reinsurance is a global business.  In 2008, 58.6% of the reinsurance risk by U. S. insurers was ceded to non-U.S. reinsurers, and 41.4% was assumed by U. S. professional reinsurers.  In 2008, reinsurance was ceded to or recoverable from over 4,900 reinsurers in over 106 jurisdictions outside the United States.

What is the role of reinsurance?

  • Reinsurance benefits insurance companies and the public at large in three ways:  (1) Reinsurance enables an insurance company to offer more coverage than it could otherwise by limiting an insurer’s loss exposure to levels commensurate with its net assets; (2) Reinsurance stabilizes an insurance company’s operating results by reducing significant fluctuations in loss experience; and (3) Reinsurance enables companies to spread catastrophic losses. 
  • Encouraging the participation of reinsurers worldwide is essential to providing much needed capacity in the U.S. for both property and casualty risks.  By way of example, reinsurers paid $57.9 billion, or 45% of the 2005 hurricane losses; and they paid over $34 billion, or 60% of the September 11 terrorist attack losses. 
  • The U.S. reinsurance industry has a lower return on equity than the U.S. property and casualty insurance industry, the U.S. commercial bank industry, U.S. diversified financial services industry, and the average of all U.S. industries.  The U.S. reinsurance industry is also subject to more dramatic negative spikes than other financial services industries. The U.S. reinsurance industry has experienced a cumulative net underwriting loss for over 20 years (for every dollar in reinsurance premiums, reinsurers pay out more than a dollar in losses and underwriting expenses).  Investment returns for U.S. reinsurers have averaged less than 6% due in large part to conservative investments required by U.S. state law and regulations.

How is reinsurance regulated?

  • Like insurance, reinsurance is regulated by the states.  
  • Insurance regulation is focused on protecting consumers and usually involves significant oversight of rates, policy forms and market conduct of insurers.  The focus of reinsurance regulation is different.  Because reinsurance contracts are between two sophisticated parties – the insurer and reinsurer – reinsurance regulation focuses on the financial solvency of the reinsurer.  Because the reinsurer’s solvency is regulated rather than the terms of the reinsurance contract, ceding insurers can negotiate reinsurance that satisfies their business needs. 
  • The U.S. regulatory system enables ceding insurers to purchase reinsurance from both companies that are licensed in the United States and those that are not.
  • There are two methods of reinsurance regulation: direct and indirect.
o    Direct regulation applies to those reinsurers that opt to be licensed in at least one state in the United States.  U.S. licensed reinsurers are subject to the same entity regulation as U.S. primary insurers, including:
-    risk-based capital requirements
-    holding company laws
-    state licensing laws
-    annual statement requirements
-    triennial examinations
-    investment laws. 
o    Indirect regulation is utilized to regulate the reinsurance transaction.  Reinsurers that do not opt to obtain a license in the United States are regulated primarily through the credit for reinsurance mechanism. 
-    Credit for reinsurance laws allows these unlicensed companies to assume risk directly from U.S. ceding insurers without restriction so long as they provide acceptable security for insurer to receive financial statement credit for that reinsurance. 
-    Credit for reinsurance laws enable a U.S. ceding insurer to treat amounts due from reinsurers as assets or reductions from its liabilities if certain defined criteria are met.  As a general matter, credit is allowed if the reinsurer is licensed or accredited in the same state where the ceding insurer does business or if the reinsurer is domiciled in a state that employs substantially similar credit for reinsurance laws to those imposed by the ceding insurer’s state of domicile.  If the reinsurer does not meet any of these criteria, it must either establish an acceptable U.S. trust fund (like Lloyds has done) or establish appropriate security in the United States, such as a letter of credit for the ceding insurer to be able to take credit for the reinsurance. 
-    The Florida legislature amended its credit for reinsurance laws in January 2007 to allow credit for reinsurance that would otherwise not meet the specified requirements of its credit for reinsurance law so long as the assuming insurer holds surplus in excess of $100 million and has a secure financial strength rating from at least two nationally recognized statistical rating organizations deemed acceptable to the Insurance Commissioner. In determining whether credit should be allowed, the Commissioner shall also consider the quality of the assuming insurer’s regulatory jurisdiction.
-    Reinsurers are also subject to U.S. federal and state antitrust laws.  The McCarran-Ferguson Act provides an exemption from federal antitrust laws for the “business of insurance,” but the exemption only applies to the extent that such business is regulated by the state and does not involve a boycott, coercion or intimidation.


A REINSURANCE PERSPECTIVE FOR THE EDITORIAL BOARD


General Goals

1.  Eliminate the risk to Florida=s economy resulting from the State’s public policy regarding homeowners’ insurance. 

2.  Eliminate/reduce the subsidies to coastal homeowners from businesses, charities, religious institutions, automobile insurance policyholders, local governments, school boards, and inland residents.

3.  Make residential insurance premiums reflect the risk, including hurricane risk.

4.  Stabilize Florida’s property insurance market by removing state disincentives to the private sector which should result in attracting more private capital into the state.

5.  Encourage homeowners to strengthen their homes (mitigation) through risk appropriate premiums and the My Safe Florida Home Program.

Reasoning

1.  Someone eventually has to pay the losses.  In the other 49 states, it’s the homeowner who pays the losses for damage to their homes and they pay for it up front in their homeowners’ insurance premium.  Once the premium is paid, after the deductible the homeowner is covered by insurance and the homeowner has no more out of pocket costs. Nor does anyone else subsidize the homeowner. For those who are unable to obtain homeowners’ insurance, most states maintain a small non-competitive state insurer of last resort

2.  In Florida, however, the public policy of the state is to have the homeowner pay a very low up front premium, and load approximately 70% of the risk and loss costs on the back end to be paid after a catastrophic event (analogous to charging the losses to a credit card).  After an event, the state sells bonds (if it can; sometimes it can’t), and the insured losses are paid from the proceeds of the bonds. The bonds, however, are not paid solely by the homeowners who paid the low up front premium, but instead most of the revenue used to amortize the bonds is obtained from businesses, charities, inland residents, automobile insurance policyholders, religious institutions, local governments and school boards (whose insurance is often called ‘commercial’ insurance).  They pay a tax (hurricane tax) on their commercial insurance and automobile insurance premiums which may be paid each year for up to 30 years.

3.  None of these entities benefits from the Cat Fund or Citizens.  They just pay the hurricane tax.

4.  These hurricane taxes are primarily used to subsidize homeowners who are most at risk from a hurricane, which are those living on the water on the coast, usually in southeast Florida.  Citizens, which derives much of its financial resources from the Florida Hurricane Catastrophe Fund, will insure these homes up to a valuation of $2 million. Ironically and illogically, Florida’s current property insurance system results in United Way and school boards subsidizing millionaires living in $2 million homes.

5.  In fact, it’s a double subsidy.  Not only are commercial and automobile policyholders paying the subsidy, but also inland residents and residents in other parts of Florida are subsidizing coastal residents in southeast Florida who are most at risk.  It is simply unfair to require people and companies who have made decisions to locate in less risky areas to subsidize those who have chosen to live on the water on the coast.

6.  But subsidies, as bad as they are, probably aren’t the major problem facing state public officials.

7.  The major problem probably is the economic risk the current homeowners’ insurance system poses to the State. The Cat Fund currently projects that it would have to bond $15.175 billion to fund the maximum statutory limit for the initial season (even though the Cat Fund estimates that in the current economic environment it could actually bond only $11 billion, thus a $4.175 billion shortfall).  The actual amount of bonds to be issued would grow to $18.675 billion if the Cat Fund had to bond to pay back its current loan proceeds of $3.5 billion which is being used for liquidity purposes.

8. To put that in perspective, current state bonds outstanding for all other state services are approximately $22 billion.

9.  Citizens current exposure is approximately $405 billion and the state-owned insurer insures over a million homeowners.  Citizens year-end cash balance was about $4 billion (not counting loans already borrowed by Citizens for liquidity, which would have to be paid back with bond proceeds if there was a hurricane).  Citizens relies heavily upon the Cat Fund for financial resources.

10.  If a catastrophic hurricane hit Florida, the Cat Fund, Citizens, and the Florida Insurance Guaranty Association (FIGA) (which pays claims for insolvent insurance companies) all would be in the bond market at the same time seeking to obtain funds to pay claims. The total amount of bonds which would need to be issued easily could exceed the $22 billion of state bonds currently outstanding.

11.  It is entirely possible that after a catastrophic hurricane, Florida public officials would discover that low homeowners’ insurance premiums has unexpectedly become the state’s number one priority -- trumping education, law enforcement, social services, and transportation, all of the traditional state budget priorities.
 
12.  Hurricane taxes are non-transparent taxes (disingenuously called ‘assessments’) because they are hidden within state entities such as Citizens and the Cat Fund and will only be known to the general public after a hurricane when they appear on the insurance premium bills. Nonetheless, they are potentially huge taxes on the commercial sector, non-profits, local governments and school boards which will have a large detrimental effect to the state’s economy.

13.  The best way to control property insurance prices is to reduce the amount of losses that will happen in a hurricane or other catastrophe.  In addition to government actions regarding building codes, code enforcement, and appropriate land use management, risk based pricing will encourage homeowners to take steps to protect their own property.  Artificially suppressed insurance premiums actually create disincentives for homeowners to improve their homes’ resistance to storms.  By permitting risk differentiated pricing, which includes recognition of risk appropriate mitigation efforts, consumers will be sent clear economic signals to demonstrate that living in an unreinforced home in ‘hurricane alley’ is risky and expensive, and that appropriate home strengthening can reduce the risk and combined cost of insurance and consumer deductible payments.  Funding of the My Safe Florida Home Program is critical to reinforce this message.  If Florida believes subsidies are appropriate, funding the My Safe Florida Home Program to provide needs based subsidies to assist financially limited homeowners to strengthen their homes is the best use of the state’s limited resources.

Legislative Goals

1.  Reform the ratemaking procedures to end the state’s suppression of rates with the goal of attracting insurance companies to Florida rather than forcing them to cut back on writing policies and leaving the state.

2.  Eliminate or reduce the homeowners’ insurance subsidies from businesses, charities, inland residents, automobile policyholders, religious institutions, local governments and school boards.

2.  Revise the law so that the Cat Fund can not sell more state reinsurance than it can fund.

3.  Convince the state to use general revenue in funding the My Safe Florida Home Program, a home mitigation program which was by all accounts very successful, but which was not funded in 2009.



Contact:
Jim Massie
Florida Counsel
Reinsurance Association of America
850.933.2108