American Agricultural Insurance Company REINSURANCE BASICS A I CA

Transcription

1 American Agricultural Insurance Company REINSURANCE BASICS A I CA

2 REINSURANCE BASICS A I CA American Agricultural Insurance Company Suite 300W 1501 E Woodfield Rd Schaumburg, IL Suite 580 One Easton Oval Columbus, OH Third Edition 2006

3 Preface The purpose of this book is to introduce the reader to reinsurance and to American Agricultural Insurance Company (AAIC). It explains the principles of reinsurance and how it functions. Specific reference is made to reinsurance contracts written by AAIC, but this book is not intended to alter the meaning of any AAIC reinsurance agreements. AAIC commenced business May 18, 1948, with capital and surplus of approximately one million dollars sponsored by the Farm Bureau insurance companies and the American Farm Bureau Federation. For fifty-one years, AAIC existed primarily to reinsure Farm Bureau insurance companies. In 1999, AAIC purchased Nationwide Mutual Insurance Companyʼs Office of Reinsurance in Columbus, Ohio, and thereby acquired a substantial broker assumed book of domestic and international reinsurance. The AAIC Board of Directors is drawn from the Farm Bureau property-casualty insurance companies. An Advisory Committee made up of Farm Bureau property-casualty insurance company CEOs acts as an advisor to the AAIC Board of Directors. AAIC Mission Statement We exist to assist the Farm Bureau insurance companies achieve financial stability and growth through a long-term partnership based on mutual integrity and trust. AAIC Operating Principles Through our unique relationship with Farm Bureau insurance companies, we: Retain maximum feasible risk within the Farm Bureau family. Maintain internal expenses substantially below industry norms. Offer Farm Bureau insurance companies opportunities to assume reinsurance exposures through pool participation and direct placements. Facilitate the gathering and distribution of information pertaining to Farm Bureau insurance companies. Provide financial modeling, underwriting/claim reviews, seminars and workshops. Facilitate the cooperative efforts of Farm Bureau insurance companies by the use of advisory committees and coordinating: conferences, financial assistance, research and development, volume purchase discounts, company peer reviews, catastrophe claim assistance, technical assistance, and personnel openings. American Agricultural Insurance Company

4 Through a professional reinsurance staff that is customer focused, we: Service individual reinsurance needs in the best interest of the Farm Bureau insurance companies. Provide innovative and flexible products and services that are uniformly available. Use sound actuarial principles to price equitably and consistently based upon individual company experience and exposure. Set price for contracts to be self-supporting over time. Provide prompt and long-term collectability of claims. Manage risk so as to mitigate adverse short-term operating results. Maintain strong business relationships with key worldwide reinsurance markets and access their expertise. Continue long-term capital growth to meet ever-increasing capacity needs. Maintain a strong balance sheet through adequate reserves and high quality diversified investments. Examples of specific AAIC services to Farm Bureau insurance companies are: Managing reinsurance pools that allow the companies to combine and share premiums and losses for given classes of business, such as property catastrophe, thereby trading the volatility of a single stateʼs or regionʼs experience for the more stable results of a national or international spread. Preparing the Solvency Analysis and Financial Evaluation (SAFE) tests for the AAIC Advisory Committee that give each Farm Bureau company an early warning of adverse financial trends. Coordinating and leading Company Peer Reviews (CPRs) when requested. A team of Farm Bureau insurance professionals reviews the operations of the host company for the purpose of exchanging ideas and suggesting improvements. Publishing an annual Operating and Financial Indicators booklet of operating results and other Farm Bureau insurance company statistical data. Publishing several newsletters and special interest legal research. Maintaining a website ( with Farm Bureau insurance employee access to contracts, claims billings, property reinsurance submissions, presentations, AAIC and Farm Bureau insurance financials, Farm Bureau directories, etc. Coordinating catastrophe claims assistance when a company suffers catastrophic loss. Catastrophe modeling. Providing companies the opportunity to participate in group purchases of goods and services at discounted prices. Performing Claims and Underwriting Reviews. Facilitating conferences and other educational functions such as reinsurance seminars and PRISMS classes. Reinsurance Basics

5 Table of Contents What is Reinsurance?...1 Types of Reinsurance Agreements...2 Property Reinsurance Quota Share...4 Surplus Share...5 Excess...6 Catastrophe Covers...7 Occurrence Catastrophe...8 Aggregate Catastrophe...9 Catastrophe Modeling...10 Casualty Reinsurance Excess Liability Agreement...11 Quota Share Umbrella...13 Excess Umbrella...14 Farm Pollution...15 Professional Liability...15 Crop Reinsurance Crop Hail...16 Multiple Peril Crop...17 Reinsurance Ratemaking...18 Reinsurance Contracts...21 Reinsurance Pools...25 Conclusion...27 American Agricultural Insurance Company

6 What is Reinsurance? Reinsurance is a form of insurance: risk transfer for a premium. The terms of the transfer are set out in a contract between the reinsurer (who assumes the risk) and the reinsured company (who cedes the risk). The reinsured company is also referred to as the primary insurer or the ceding company. The primary insurer pays a premium to the reinsurer. In return, the reinsurer agrees to pay a portion of losses occurring under covered policies issued by the primary insurer. Ideally, the relationship between reinsurer and the primary insurer will be longterm and beneficial for both. The primary insurer wants reinsurance at a reasonable cost; the reinsurer wants to collect sufficient premium to cover expenses, any claims, and some profit. Both companies must feel comfortable with each other. Their relationship is based on utmost good faith, i.e. honesty and full disclosure of circumstances relating to the risk transferred. The reinsurer needs to have confidence in the underwriting and claims handling practices of the primary insurer. If that confidence exists, then the reinsurer will generally follow the fortunes of the primary insurer when losses occur. The primary insurer expects the reinsurer to be able to respond promptly when claims are made or other assistance is needed. Reinsurance serves many purposes. The most common purposes are: To provide capacity: A primary insurer may feel uncomfortable writing large risks. It can cede (transfer) some of the risk to a reinsurer. To promote financial stability: Frequency and severity of losses may fluctuate during any period. Reinsurance has a leveling effect on financial results. To protect against catastrophe: The accumulation of losses from major occurrences, such as storms, is a concern for most insurers. Reinsurance allows transfer of some of the risk, thereby softening the financial impact of catastrophic loss. To provide surplus relief: Risk can be transferred to a reinsurer enabling a primary insurer to write more business without adversely impacting its premium-to-surplus ratio. A reinsurer may pay ceding commissions to a primary insurer to cover some costs. To facilitate acquisition of a new line of business with which the primary insurer is not familiar. In addition to sharing in the losses, a reinsurer can provide expertise in underwriting and claims. To allow a primary insurer to cut off exposure on an existing line of business or in a geographic area. Reinsurance can be purchased to cover discontinued operations. To gain access to a reinsurerʼs expertise in underwriting, claims, accounting and actuarial. American Agricultural Insurance Company 1

7 Types of Reinsurance Agreements There are two general types of reinsurance agreements: Facultative: Individual risks are submitted to a reinsurer for consideration. Coverage terms and conditions are negotiated. The primary insurer has no obligation to cede the risk and the reinsurer has no obligation to accept the risk. Treaty: Covers an entire book of business. All risks falling within the scope of the agreement must be ceded by the primary insurer and must be accepted by the reinsurer. Coverage is automatic. It envisions a longterm relationship. Reinsurance agreements operate as proportional or excess: Proportional, or pro rata, reinsurance involves the primary insurer sharing premiums and losses with the reinsurer in the same predetermined percentage on every risk covered by the agreement. The percentage of the total loss paid by the reinsurer is derived from the percentage of the total premium that was ceded to the reinsurer. Excess reinsurance is non-proportional. When a reinsurance agreement is described as excess, it always means excess of loss. The primary insurer retains losses up to a certain amount (its retention), and the reinsurer pays up to 100% of the excess loss subject to a maximum limit of liability. Unlike proportional agreements, there is no correlation between the percentage of the total premium ceded to the reinsurer and the percentage of the loss the reinsurer pays. 2 Reinsurance Basics

8 Property Reinsurance Property Reinsurance is written as either a working cover or catastrophe cover. The reinsurance agreements cover a specified book of business subject to excluded exposures. Working Covers apply to everyday (higher frequency, lower severity) losses on individual risks. This is the level of losses a primary insurer expects to occur within a book of business based on loss history and anticipated trends. Working covers can be proportional or excess, as described on the preceding page. Furthermore, Proportional property reinsurance can be either Quota Share or Surplus Share: Under Quota Share, premiums and losses are shared in the same predetermined proportion on every risk, regardless of risk size. With Surplus Share reinsurance, the size of the risk determines the sharing proportion. If the risk size exceeds a stated retention, then premiums and losses for a given risk are shared in the same proportion. The proportion varies by risk. No premiums or losses are shared on risks under a certain size (below the retention). Be careful not to confuse the surplus share retention described here with loss retention. The purpose of the surplus share retention is to establish the risk size that can be ceded to the surplus share agreement. Loss retention, on the other hand, is the amount of loss a primary insurer must retain under an excess reinsurance agreement (similar to a deductible). Catastrophe Covers most commonly apply to an accumulation of losses from a single event (occurrence basis). They can also cover against a series of events that accumulate throughout the year (stop-loss or aggregate basis). Catastrophe covers are always excess reinsurance. The following three pages give examples of Quota Share, Surplus Share and Excess reinsurance. American Agricultural Insurance Company 3

9 Quota Share Primary insurer retention: 70% Reinsurer participation: 30% Reinsurer limit of liability: $150,000 any one risk Primary Insurer Reinsurer 70% 30% With Quota Share reinsurance, a predetermined percentage of every risk is ceded to the treaty, and the reinsurer pays the primary insurer a commission on premium ceded. The reinsurer receives premiums and pays losses from the ground up equal to the percentage of liability that has been ceded on each and every risk. Losses may be limited on a per-occurrence and/or per-risk basis. Coparticipations by the primary insurer may also apply to further limit the reinsurerʼs exposure. Under the example shown above, the reinsurer would receive 30% of the premium and pay 30% of the loss on each risk ceded to the treaty, regardless of the size of the risk. Example 1 Losses on a $300,000 risk would be divided as follows: On a $10,000 loss, the primary insurer recovers $3,000. On a $100,000 loss, the recovery is $30,000. On a $300,000 (total) loss, the recovery is $90,000. Example 2 If the risk size was $500,000: On a $10,000 loss, the primary insurer recovers $3,000 (same as above). On a $100,000 loss, the recovery is $30,000 (same as above). A $500,000 (total) loss results in a $150,000 recovery. 4 Reinsurance Basics

10 Surplus Share $900,000 treaty limit with $100,000 retention With Surplus Share reinsurance, the primary insurer retains a fixed dollar amount of exposure on each risk ($100,000 in this example), and cedes the balance to the reinsurer. Example 1 Risk Size is $200,000 Primary insurer retains 50% ($100,000/$200,000) of the premium and cedes 50% to the reinsurer. Primary insurer retains 50% of any loss and the reinsurer pays 50%. The reinsurer would pay $25,000 on a $50,000 loss, $50,000 on a $100,000 loss, etc. Primary Insurer 50% Reinsurer 50% Example 2 Risk Size is $500,000 Primary Insurer Reinsurer Primary insurer retains 20% ($100,000/$500,000) of the premium and cedes 80% to the reinsurer. Primary insurer retains 20% of any loss and the reinsurer pays 80%. A $400,000 loss results in a $320,000 reinsurance recovery. 20% 80% Example 3 Primary Insurer Risk size is $50,000 Primary insurer retains the entire premium because the risk size is below the $100,000 retention. 100% Primary insurer pays the entire loss, should one occur. As with other proportional contracts, the net cost may be adjusted by fixed or sliding scale commissions, per occurrence or per risk loss limits, and/or coparticipations. To simplify ceding and loss recovery, AAIC uses risk size categories with ceding and recovery based on the average risk size in each category. American Agricultural Insurance Company 5

11 Excess Treaty limit: $900,000 Retention: $100,000 $900,000 $100,000 Reinsured Loss Retained Loss Excess reinsurance is only concerned with the amount of loss. In the above example $100,000 would be subtracted from each loss. The primary insurerʼs loss would have to exceed $100,000 before it could collect anything from its reinsurer. Example 1 Loss is $200,000 Primary insurer retains $100,000 $100,000 Reinsurer $100,000 Primary Insurer Reinsurer pays $100,000 Example 2 Loss is $1,000,000 Primary insurer retains $100,000 Reinsurer pays $900,000 Example 3 Loss is $50,000 Primary company retains $50,000 Reinsurer pays $0, since the loss did not exceed the $100,000 retention $900,000 $100,000 $50,000 Reinsurer Primary Insurer Primary Insurer These three examples assume the reinsurer pays 100 percent of the excess amount. Some agreements require the primary insurer to participate in the excess amount. 6 Reinsurance Basics

12 Catastrophe Covers Catastrophe reinsurance is always excess reinsurance. It protects against an accumulation of losses on multiple risks from a common cause, usually associated with a severe storm. Catastrophe covers may apply on an Occurrence or Aggregate basis. Occurrence Catastrophe reinsurance covers multiple losses from specific perils during a specific time period. The most common perils are windstorm and hail, which are often associated with hurricanes or tornados. The time period during which losses from these perils is covered under one occurrence is usually 72 hours. Other insured events such as flood, winter storm and earthquake have a 168-hour occurrence period. Loss payments are added together and other recoveries (salvage, other reinsurance, etc.) are deducted. If the remaining loss exceeds the per occurrence retention, the reinsurer pays the excess amount. The retention amount may be a percentage of the primary insurerʼs subject earned premium on reinsured risks, or it may be a fixed dollar amount. The primary insurer participates in the excess amount of loss, typically 5% - 10%. The cost of Occurrence Catastrophe reinsurance is based on loss experience, exposure, market conditions, and judgment. Judgment is involved due to low frequency and high severity of loss. It is important to determine whether past conditions reflect current coverage conditions. A claim reduces the amount of catastrophe coverage remaining, and it must be reinstated to provide the same coverage for a subsequent event. AAIC offers reinstatement covers to soften the financial burden of both retaining a portion of cat losses and paying additional premium when storms occur. Other cat coverage options available from AAIC include a no-claim bonus, profit sharing, and loss adjustment expense coverage. Retentions can also drop down once a certain level of damage is reached. Auto physical damage coverage can be written separately or combined with property coverage. Auto coverage inception and recovery can be indexed to the amount of property damage sustained. Aggregate (also called Loss Ratio or Stop Loss) reinsurance is written on an annual basis. It protects against the accumulation of losses during the entire year from a series of storms or other covered events, which may not be catastrophic occurrences individually. The primary insurer recovers after a) all other reinsurance recoveries are credited, and b) the retention is exceeded. The primary insurer also participates in loss above the retention, typically 5% - 10%. Examples of reinsurance recoveries under catastrophe covers are on the next two pages. American Agricultural Insurance Company 7

13 Occurrence Catastrophe Reinsurance $25,000,000 Treaty Limit: Reinsurance coverage purchased $20,000,000 NEP: Net Earned Premium on protected policies $2,000,000 Retention (10% of NEP) 5% Participation: Primary insurerʼs share of loss above retention $4,000,000 Losses from a Hurricane $500,000 Other Reinsurance Recoveries, e.g., Property Surplus Share $20,000 Salvage Recoveries $27,000,000 $2,000,000 Treaty Structure COVERED LOSS 95% RETENTION P A R T I C I P A T I O N 5% Calculations $4,000,000 Gross Loss - 520,000 Recoveries $3,480,000 Subject Loss - 2,000,000 Retention $1,480,000-74,000 Participation (5%) $1,406,000 Recoverable Loss (95%) 8 Reinsurance Basics

14 Aggregate (Stop Loss) Catastrophe Reinsurance $10,000,000 Treaty Limit $20,000,000 Subject Earned Premium (SEP) $7,000,000 Retention (35% of SEP) 10% Participation $25,000,000 Losses from Covered Perils $600,000 Property Surplus Share Recoveries on Covered Perils $8,000,000 Occurrence Catastrophe Reinsurance Recoveries Treaty Structure $17,000,000 $7,000,000 COVERED LOSS 90% RETENTION P A R T I C I P A T I O N 10% Calculations $25,000,000 Gross Loss - 600,000 Property Surplus Share Recoveries - 8,000,000 Occurrence Cat. Reins. Recoveries $16,400,000 Subject Loss -7,000,000 Retention $9,400, ,000 Participation (10%) $8,460,000 Recoverable Loss (90%) American Agricultural Insurance Company 9

15 Catastrophe Modeling Catastrophe modeling combines meteorological, engineering and insurance information to produce estimated insurance losses from catastrophic events. Catastrophe models predict all possible events that could happen. Examples of perils included are severe thunderstorms (tornados, hail and straight line winds), hurricanes and earthquake with fire following. The models are run on high-speed computers using the latest technology. For the models to predict insured loss for a company, they first simulate an event. The event generated is distinguished by peril, location and intensity. Once the event is identified, it is applied to company-specific exposure data. The exposure data can range from risk location to data aggregated to the county level. Building structure characteristics (e.g. age, construction and occupancy) are taken into consideration to calculate the damage to the structure from an event. An average value is assumed if the structure information is not in the company data. Once the loss to a structure is determined, the policy deductible and limit is applied to determine the insured loss. Losses for all insured structures are accumulated to obtain the insured loss for the event. The models simulate thousands of events. Return periods are calculated from these events. The return periods are the probability of an event of a given size or greater occurring. For example, the probability of a loss the size of the 100-year event or greater occurring is 1%. Companies can use the results of the models to assist in making underwriting decisions, formulating underwriting guidelines, managing aggregate exposures, developing rates and making reinsurance decisions. 10 Reinsurance Basics

16 Casualty Reinsurance Excess Liability Reinsurance Agreement Casualty treaties reinsure a primary insurerʼs liability policies. AAICʼs basic casualty treaty is called the Liability Excess of Loss Reinsurance Agreement. The types of policies it reinsures include Comprehensive Personal Liability, Farmers Comprehensive Liability, General Liability, and Automobile Liability. AAIC also writes a combination Excess Liability/Umbrella treaty that includes up to $5 million of Umbrella coverage. Workersʼ Compensation reinsurance can be included as a separate coverage with distinct terms or in combination with other casualty lines. Per Risk Property coverage can also be included to form a Multi- Line contract. Casualty treaties are generally written on an excess of loss basis for an occurrence. An occurrence includes all applicable policies for one or more involved insureds. Under an excess treaty, the insurance company retains a set dollar amount of each loss. The reinsurer pays 100% of the portion of Ultimate Net Loss that exceeds the retention. Payments included in the Ultimate Net Loss of an Excess Liability contract are liability, medical payments, uninsured and underinsured motorist, No- Fault/Personal Injury Protection, and allocated loss adjustment expenses. Any payment up to policy limits is 100% included, and currently Excess-of-Policy Limits (XPL) and Extra-Contractual-Obligation (ECO) payments are 90% included. Workersʼ Compensation includes payments for medical, lost wages and disability, and loss adjustment expense. The contract is divided into different layers as shown below. $21,900,000 CAPACITY LAYER $1,900,000 $400,000 WORKING LAYER RETENTION American Agricultural Insurance Company 11

17 Retention In the example shown, the primary insurer retains the first $400,000 of any loss covered under the treaty. Even if the total loss exceeds $400,000, the primary insurer receives no recovery for the first $400,000 under this treaty. As is true with all excess covers, most of a primary insurerʼs loss activity will occur within the retention layer. If a retention did not apply, the reinsurer would be obligated to reimburse the primary insurer from the first dollar of each loss. This would make the treaty much more costly to the primary insurer, as the reinsurer would need to increase the premium in order to cover losses in this layer. The premium charged is less when the primary insurer retains more loss. In addition, the retention guarantees that the primary insurer maintains a financial stake in the claim settlement, thereby encouraging it to investigate diligently and adjust claims economically. Working Layer The Working Layer is excess of the primary insurerʼs retention. The Working Layer is flat-rated based on exposure and experience. The rate is applied to the subject premium. A final adjustment is made at year-end when the actual subject premium is known. It is expected that the Working Layer will produce losses. The coverage limit for this layer normally coincides with the maximum policy limits written by the primary company. Capacity Layer The Capacity Layer is also called the Catastrophe, Excess Catastrophe or Clash Layer. It attaches above the Working Layer and covers exposure created when multiple insureds and/or policies are involved in an occurrence. It also covers situations where coverages such as UM/UIM are stacked or XPL and ECO are involved. While a catastrophic loss is easy to visualize for property exposures, it is not as obvious with casualty losses. One example is a single automobile accident involving more than one of the primary companyʼs insureds. The exposure can be far greater than the limits of a single policy. The capacity layer provides reinsurance protection for an accumulation of losses resulting from a single occurrence. In some states, auto No-Fault coverage is written without a limit, as is Workers' Compensation. Since there is no policy limit, a capacity cover is needed to cover losses with long-term disability, multiple employees, etc. 12 Reinsurance Basics

18 Umbrella Reinsurance (Quota Share Basis) Umbrella insurance policies provide excess liability coverage over primary underlying policies with required minimum limits. In some situations, the umbrella will also drop down to provide the primary coverage in excess of a stated self-insured retention (SIR). Umbrella policies are heavily reinsured because a primary insurer often has the underlying coverage as well, and thus would retain a substantial portion of the primary policy loss. Umbrella coverage in excess of $1,000,000 is usually 100% reinsured. Following is an example of an umbrella policy with the following attributes: $2,000,000 limit $500,000 underlying primary coverage 10% participation by primary insurer on 1 st million of umbrella coverage $2,500,000 UMBRELLA 2 ND MILLION REINSURED 100% $1,500,000 UMBRELLA 1 ST MILLION REINSURED 90% P A R T. 10% $500,000 UNDERLYING PRIMARY COVERAGE Loss Example Loss is $2,000,000 $500,000 covered by underlying primary policy Umbrella pays $1,400,000 of the $1,500,000 balance: $900,000 (90% of 1 st million) + $500,000 (100% of the balance) American Agricultural Insurance Company 13

19 Combined Excess Liability and Umbrella Farm Bureau companies can opt to have their umbrella policies reinsured through their Liability Excess of Loss Reinsurance Agreement instead of through the Quota Share program described on the preceding page. In this case, the umbrella policies would be reinsured on an excess basis. Umbrella policy losses would be ceded along with underlying primary policy losses to the Liability and Umbrella Excess of Loss Reinsurance Agreement. Pricing of the combined Liability and Umbrella Excess of Loss contract would be based on experience, limits profile and written premium. Since the umbrella is reinsured in an excess contract, American Ag would have no input into the umbrella rates charged by the primary insurer. However, American Ag would offer pricing assistance should the primary insurer request it. Advantages Primary insurer cedes less Umbrella premium to American Ag Primary insurer sets their Umbrella rates and underwriting guidelines A single retention would apply in a given occurrence Possible Disadvantage An Umbrella loss could adversely affect the experience of the entire Liability Excess of Loss Reinsurance Agreement, resulting in a higher reinsurance rate for the entire contract in following years. 14 Reinsurance Basics

20 Farm Pollution Liability Reinsurance AAIC formed the Farm Bureau Pollution Pool in 1987 for the purpose of reinsuring farm pollution liability policies written by Farm Bureau insurance companies. The policies provide a $1,000,000 per incident/aggregate policy limit with a $500 deductible. They cover bodily injury and property damage claims made by third-party claimants on a claims-made basis. Another form of coverage is by the Pollution Liability Endorsement to a Farm Liability policy that is reinsured under the Liability Excess of Loss Reinsurance Agreement. Several levels of coverage are available, including first party property cleanup. Loss experience is kept separate from other losses, and the reinsured company can select a retention from zero to 100%. Professional Liability Reinsurance AAIC reinsures two types of professional liability coverages written by Farm Bureau insurance companies. Insurance Agents Professional Liability protects insurance company agents for liability for errors of omission or commission in the performance of their duties. Insurance Company Professional Liability (ICPL) is reinsured under the Liability Excess of Loss contract for claims arising out of adjustment of losses otherwise covered under that contract. Other ICPL and Directors and Officers (D&O) Liability are not currently reinsured directly by AAIC, but AAIC facilitates this coverage for Farm Bureau companies through another insurer. D&O protects Farm Bureau corporate directors and officers for liability while acting in their official policy-making capacities. American Agricultural Insurance Company 15

21 Crop Hail Reinsurance Crop Hail insurance indemnifies a farmer when hail damages or destroys his crops. This is a line of business where the experience can be volatile. The key to underwriting Crop Hail insurance is to spread the risk. Spreading the risk can be accomplished by pooling. Participants cede business to a pool and assume a share of the pool experience. AAIC manages the Farm Bureau Crop Hail Reinsurance Pool. The pool cessions are based on liability within a township with details shown below. 1. Quota Share: The issuing company cedes a fixed 75% of its premium and liability to the pool. It assumes back 90% of the premium amount it cedes (AAIC assumes the other 10%). 2. First Surplus: The issuing company cedes 90% of its premiums and liability on a Surplus Share basis. It retains the other 10% net for its own account. 3. Second and Third Surplus: 100% of the premium and liability is ceded on a Surplus Share basis. 4. Aggregate Stop Loss: This protects the ceding companyʼs results when its loss ratio exceeds a certain attachment point on the business it retains. It covers 90% of the loss above the attachment point. A Typical Crop Hail Program $4,000,000 $2,500,000 $1,500,000 $500,000 Third Surplus 100% Ceded Second Surplus 100% Ceded First Surplus 90% Ceded Quota Share 75% Ceded 10% Retained 25% Retained 16 Reinsurance Basics

22 The ceded premium base used is the Anticipated Loss Ratio (ALR). The base information is generally from the National Crop Insurance Association and is evaluated by the Farm Bureau Crop Reinsurance Committee. The ceding company billing is based on the ALR plus a varying loading factor for the individual layers: Quota Share First Surplus Share Layer Second Surplus Share Layer Third Surplus Share Layer 5.0% load 7.5% load 15% load 25% load Rates and premiums are adjusted from year to year based on all years' experience. Multiple Peril Crop Insurance Multiple Peril Crop Insurance (MPCI) provides protection to a farmer in various ways depending on the selected coverage type. The majority of the program guarantees are based on actual production records, and the basic MPCI program provides coverage against all natural perils. In addition to production guarantees, revenue programs are available to guarantee revenue to a certain level. The revenue protection to farmers is also available for selected livestock/aquaculture producers in selected states. The policy wordings, rates and operational guidelines are established by the Federal Crop Insurance Corporation, an agency under the U.S. Department of Agriculture. The insurance company is required to provide coverage for all eligible farmers and cannot deny coverage to any qualified applicant. As a tradeoff for this requirement, the insurer assigns the specific crop policy to various funds that serve to minimize their financial exposure in areas and crops that are less adequately rated. The company can utilize an Assigned Risk Fund which manages their loss potential. However, it also significantly reduces the potential gain. The intermediate level risks are placed in the Developmental Fund. The highest quality risks are placed in the Commercial Fund. These policies allow a maximum retention of the underwriting gain, but in a loss year the companies are responsible for a higher percentage of the adverse experience. The individual Farm Bureau companies have the option of ceding their retained MPCI exposures into a proportional pool managed by American Ag. American Ag assumes 10% of the exposure and premium ceded to it. This pool was designed to spread the risk to a broader geographic basis rather than being restricted to the weather pattern that may impact one state or an entire region. The participating companies assume a share of the business back with the benefit of a spread across multiple states. Additionally, the individual Farm Bureau companies have the opportunity to purchase an aggregate stop loss cover from American Ag. American Agricultural Insurance Company 17

23 Reinsurance Ratemaking The four components of reinsurance premium are: Profit Expenses Risk Load Expected Losses Expenses are the reinsurerʼs costs of acquiring, writing and servicing the applicable line(s) of business. Risk Load is a provision for adverse deviation from expected losses. There are two rating methods, normally used in combination: Experience rating is based on loss experience. It is retrospective if based on actual experience during a treaty period and prospective if based on expected experience during a future treaty period. Exposure rating is based on primary insurerʼs subject premium, total insured value and policy limits written. 18 Reinsurance Basics

24 The reinsurer gets loss, premium and policy limits information from the primary insurer via data calls. The data gathered is manipulated by: Trending: Inflating premiums and losses for monetary inflation, court rulings and statutory changes, and changes in exposure. Loss development: Bringing losses to ultimate settlement value. On-level premium adjustment: Adjusting historic premium to current primary insurer rate levels. Credibility: Measuring statistical significance. The primary insurer gets credit for investment income the reinsurer is likely to earn on premiums until losses are paid. Property Per Risk coverage is both experience and exposure rated using limits profiles and historic premiums, losses and exposures. It employs industry curves for loss as a percentage of total value applied to primary insurer limits profiles. AAIC uses data from the most recent five years trended and developed. Experience contributes more in lower layers (due to frequency), and exposure is more important in higher layers. Property Surplus Share and Quota Share treaties employ prospective experience rating and may employ retrospective experience rating. The reinsurer makes a loss ratio projection and sets a target margin, but has no direct control over what the primary insurer charges its customers. The primary insurer determines what primary premium they will be sharing, and the reinsurer follows the fortunes of the primary insurer. The net cost of share reinsurance is reached by using: Ceding commissions that are either fixed or variable (adjusted later based on treaty loss experience). Per risk and/or per occurrence loss limits. Co-participations that reduce recoveries when the treaty loss ratio exceeds a specified point. The ceding commission, if provisional, may be on a sliding scale. That means it changes in relation to the actual treaty loss ratio, but not necessarily on a 1-to-1 basis. Good loss experience leads to additional commission for the primary insurer, and poor experience results in the primary insurer returning commission to the reinsurer. American Agricultural Insurance Company 19

25 Property Occurrence Catastrophe reinsurance exposure rating uses exposure and loss data by county, zip code or other geographical location. Catastrophe modeling is used to project losses from various scenarios. Experience is more significant in lower layers where more loss activity occurs. The risk load is larger in higher layers where expected losses are relatively infrequent. If a reinsurer expects there will be one total loss (or several partial losses) on a $10 million program over ten years, then the loss portion of the annual rate-on-line (ROL) is 10%, or $1 million annual premium for a $10 million reinsurance layer. Risk load, expenses and profit would need to be added to the 10% expected loss rate to derive the final ROL. Aggregate Catastrophe reinsurance rates are adjusted for primary insurer rate changes (on-level premium) and inuring reinsurance such as Surplus Share, Quota Share, Per Risk Property, and Occurrence Cat. All-Lines covers take these factors into account as well as other inuring reinsurance, plus the primary insurerʼs business plan, annual statement and anticipated changes. Excess Liability exposure rating uses Increased Limits Factors (ILFs) published by the Insurance Services Office. For example, if the premium for a $100,000 liability limit is $1,000, and the ILF factor at $300,000 is 1.2, then the premium for a $300,000 limit would be $1,200. There are different ILFs for personal liability, commercial liability, split limits, single limits, etc. The exposure rate may be small if the limits written are low relative to the retention selected. Worker s Compensation exposure rating uses National Council on Compensation Insurance (NCCI) data by state and hazard group. 20 Reinsurance Basics

26 Reinsurance Contracts A primary insurer seeking reinsurance may contact reinsurers directly or through a broker. The terms of the reinsurance contract (also called a reinsurance agreement or treaty) are negotiated to the satisfaction of both parties. A cover slip or binder may be drawn up to reflect the basic terms of the partiesʼ understanding. It serves as a substitute for the contract until a full, final document is completed. For reinsurance contracts entered into, renewed or amended on or after January 1, 1994, the NAIC requires the full contract to be finalized, reduced to a written form and signed by the parties within nine months of its effective date. If it is not, that reinsurance will be treated as retroactive reinsurance, and the primary insurer will lose some of the accounting benefits of the reinsurance. Parties negotiating a reinsurance contract are considered under the law to be on equal footing, with both parties having knowledge and expertise of the subject matter and terminology. Therefore, a reinsurance agreement, unlike an insurance policy, is not a contract of adhesion. Most AAIC reinsurance agreements are effective January 1 through December 31. They are continuous until terminated, but rates and other terms are subject to review and change annually. Therefore, Farm Bureau insurance companies usually make decisions about coverage changes (e.g. increased limits, retention and participation changes) in November and December, and these changes become effective January 1. AAIC reinsurance contracts currently consist of the following sections: Preamble: Sets forth the contract name, the parties to the contract and the effective date of the contract. Treaty Provisions: This is the main text of the contract. Typical clauses are set forth on the following pages. Numeric Values Addendum: Similar to a declarations page of an insurance policy. The elements will vary depending on the agreement, but can include the following: a reinsured companyʼs retention, participation, reinsurance premium rate, expected subject premium, estimated reinsurance premium, deposit reinsurance premium and minimum reinsurance premium. It can also include the treatyʼs limit and the treatyʼs capacity, which are not synonymous terms. Limit indicates the maximum amount that the reinsurer will pay under the agreement. Capacity, on the other hand, refers to the total amount of loss in excess of the primary insurerʼs retention that is covered by the reinsurance agreement and includes the primary insurerʼs participation. American Agricultural Insurance Company 21

27 Many of the clauses in the Treaty Provisions of the agreement are standard in the reinsurance industry. Typically, these clauses include: Commencement and Termination: Explains when the agreement takes effect, what procedures must be followed to terminate it and what circumstances can cause one of the parties to terminate the agreement early. Lines of Business: Lists the insurance lines of business that the agreement covers. Limits of Cover and Definition of Occurrence: Typically used in Occurrence and Over Other Protections reinsurance agreements, it defines a loss event and occurrence by perils and indicates how the agreement applies to multiple occurrences. Exclusions: Lists risks and lines of business that are excluded from coverage under the agreement. Typical exclusions include nuclear incidents, losses resulting from terrorism, and losses resulting from environmental hazards. Reports and Remittances: Establishes the frequency in which the primary insurer must provide premium payment and information to the reinsurer. Notice of Loss: Requires that the primary insurer promptly advise the reinsurer of claims and subsequent material developments and sets forth the specific elements to be reported. Late notice can affect reinsurance coverage of a claim. Claims: Establishes that the primary insurer is obligated to investigate and defend claims at its own expense, and that the reinsurer has the option to participate in the defense or control of a claim. It further requires the primary insurer and reinsurer to cooperate in order to reach the most favorable disposition of a claim. Premium Computations: Explains how the reinsurance premium rate is applied to subject premium and how estimated premium, minimum premium and deposit premium apply. Ultimate Net Loss: Lists the types of claims that are covered and the extent to which they are covered. Payments and Recoveries: Establishes a maximum time period (after receiving notice of loss) in which the reinsurer must pay its portion of the loss. 22 Reinsurance Basics

28 Inspection: Gives the reinsurer the right to review the primary insurerʼs claim and underwriting records and requires that the primary insurer make these records available for review. Errors and Omissions: Provides a mechanism for allowing the primary insurer to correct errors and omissions, once they are discovered, without voiding the reinsurance agreement. Arbitration: Sets out a procedure for non-litigated dispute resolution if the reinsurer and primary insurer are unable to resolve the dispute on their own. Insolvency: Requires that the reinsurer reimburse the primary insurer fully, even if the primary insurer becomes insolvent. The reinsurerʼs obligation is not reduced when the primary insurer sustains financial problems. Assignment and Third Party Liability Limitation: The reinsurance agreement is strictly between the reinsurer and primary insurer only. It cannot be assigned without written consent of both parties. Third parties (e.g. the primary insurerʼs policyholders) are not parties to the reinsurance agreement and have no enforceable or assignable rights under the reinsurance agreement. Reinsurance contracts may include additional terms and conditions tailored to the specific needs of a primary insurer. Examples include: Cut-Through Endorsement: Obligates the reinsurer to pay an insured directly in the event the primary insurer fails to pay a covered loss. Special Acceptance: Allows specific insurance policies to be reinsured under a reinsurance contract even though the policies cover a line of business or a class of insured that is typically not covered by the contract. Reinsurance agreements generally follow the obligations established by the primary insurerʼs covered policies. However reinsurance contracts can expand indemnification to include: Excess of Policy Limits (XPL): Liability payments in excess of its policy limits for which the primary insurer is held liable due to failure to protect its insured from uninsured liability. An example would be a third party jury verdict for more than policy limits after the primary insurer could have but failed to settle the claim within policy limits before trial. American Agricultural Insurance Company 23

29 Extra-Contractual Obligations (ECO): Adds coverage for payment of a judgment or settlement to an insured or third party by the primary insurer for any losses not covered by the primary policy that arise out of tortious claim handling by the primary insurerʼs representatives. An example would be payment of a judgment or settlement for bad faith claims handling. Once a reinsurance contract is terminated, its coverage can be ended on a cutoff or run-off basis. Cut-off means that the reinsurer is not liable for losses that occur after termination and usually involves the return of unearned premium from the reinsurer to the primary insurer. Run-off means that the reinsurer remains liable for losses under in-force reinsured policies until such policies expire. 24 Reinsurance Basics

30 Reinsurance Pools A pool is an arrangement where many exposures are brought together for the purpose of spreading the risk over as large a base as possible. This is beneficial for several reasons. As the number of exposures in a pool increases, losses become more predictable. This is referred to as the Law of Large Numbers. If a company insures only 100 exposures, a difference of only a few losses from the number of losses that were predicted could prove devastating. However, if a company insures 100,000 exposures, the difference between the number of predicted losses and actual losses that occur will be a much smaller percentage of the total number of exposures. This means that losses become more predictable, and a company is better able to plan for losses by setting rates accordingly. However, many companies are unable to increase the number of exposures they insure to the point where loss prediction is credible. That is where a pooling arrangement is beneficial. By combining its exposures in a pool with those of other companies, the total number of risks increases, thereby enhancing loss predictability. The pool enjoys a much greater level of loss predictability than any of the participants could achieve alone. Another advantage of pooling is the geographic spread of risk that can be achieved. Assume that Company A writes property insurance in an area that is susceptible to windstorms, while Company B, located in a different geographic area, has higher hail exposure. To lessen the impact of one of these events striking either company alone, they pool all of their exposures and agree to share the losses and premiums. If Company A suffers a severe windstorm, Company B will assist it through the pooling arrangement. It is less likely that both companies will experience poor results in any one year, so in those years where one company has poor experience, the other company is there to assist. Only two companies are used in this example, but most pools consist of many companies. This substantially decreases the chances that a majority of the pool participants will suffer large losses in the same year. The overall results of the pool should be more stable than the participants could have achieved on their own. This example illustrates a geographic spread of risk for property exposures, but pooling has a similar effect on casualty and other lines of business. Diversity of exposures is similar to spread of risk. A company may lack diversity in the types of business it writes. It may be unable to capture a substantial share of the market from its competitors, or it may not be comfortable expanding into new lines. Failure to diversify its book of business could adversely affect a company if the lines of business it writes are unprofitable. Quite often other lines of business can provide support for the lines that lose money. A pooling arrangement can alleviate the problem by permitting a company to share its results with others that write different lines of business. There is a mutual benefit to all participants as their particular niche of business is assimilated into the pool. The mix of exposures reduces the effect of the lack of profitability of one or two lines of business. American Agricultural Insurance Company 25

31 Pooling agreements are by no means standard. Sometimes the pool is managed by one of the larger pool participants on behalf of all the pool members, or it may be managed by an outside agency that has no participation. The terms of a pooling agreement may be pre-established by the pool manager, with each participant merely signing on to the agreement. In other arrangements each participant will negotiate its own participation separately, subject to acceptance by the other members. Each company that writes business cedes all or a portion of its exposures to the pool. In return it receives a percentage of the premiums ceded and also assumes a percentage of the losses that the pool suffers. The liability assumed by each company is often a direct proportion of the percentage of business ceded to the pool, but that does not have to be the case. The concept of pooling exposures is not limited to reinsurance companies. Primary insurers engage in pooling every day. Premiums are collected from each of the primary companyʼs insureds, and a portion of those funds is distributed to the few clients who suffer losses. However, the similarity with a reinsurance pool ends there. The primary companyʼs insureds do not buy insurance for the purpose of pooling their assets with others, nor are they obligated to accept a percentage of the liabilities to which the primary company is exposed. Pooling arrangements can present unique problems for insurance carriers. An insurer may be reluctant to participate in a pool if other members are major competitors, as it would need to share customer data, rating loss information, and perhaps even marketing strategy with them. An insurer may also feel it is losing some control over its own destiny by relying on the profitability of other insurers. The company may be unfamiliar with some pool participants, or it may deem them undesirable business partners. It may have no authority to approve of the insurers participating in the pool. Finally, while a pooling arrangement may appear viable, it is possible that the forecast mix of business, spread of risk, quality of business, or anticipated loss results will not be achieved. The Farm Bureau system offers many advantages for pooling arrangements not available to other insurance carriers. Farm Bureau companies are generally not competitors with each other. Farm Bureau companies offer a stable and competitive facility, regardless of outside market conditions. Because Farm Bureau companies exist in most states, they can achieve an almost nationwide spread of risk, which helps a single state or regional company diversify its exposures. As the reinsurer of most of the Farm Bureau companies, AAIC is in a unique position to establish and manage pools for the member companies. It has a long-standing relationship with each company. Because AAIC reinsures all of the pool members, it has superior knowledge of the financial and other company data necessary to operate a pool. AAIC communicates with the Farm Bureau companies on a daily basis, so information is readily available to pool participants. The individual Farm Bureau companies are also valuable resources to AAIC, affording the opportunity to utilize and share the expertise that each company has to offer. 26 Reinsurance Basics

32 In Conclusion The proper reinsurance program can play a major part in the financial success and growth of a primary insurance company. Insurance companies cannot operate without a sound reinsurance program. In the long run, both the primary insurer and reinsurer should gain from the relationship between them. However, there are some things that reinsurance cannot do. It cannot turn a poor risk into a good risk or a poor book of business into a good book of business. Reinsurance is not a profit center. It must be looked on as a cost of doing business. Good underwriting and claim handling by a primary company can lower the cost of its reinsurance. Special thanks to the staff at American Ag for contributing to and editing this publication. American Agricultural Insurance Company 27

33 American Agricultural Insurance Company Suite 300W Suite E. Woodfield Rd. One Easton Oval Schaumburg, IL Columbus, OH (847) (614)