Reinsurance and Insurance Risk Management

Reinsurance

Reinsurance Defined

The primary (ceding) insurer transfers a portion of its accepted risk to another insurer (the reinsurer).
“Insurance for insurers.”

Purposes

Spread catastrophic or large individual risks
Reduce required capital (surplus relief)
Stabilize underwriting results year-to-year
Expand underwriting capacity

Proportional (Pro-Rata) Reinsurance

Ceding insurer and reinsurer share premiums and losses in the same agreed proportion (e.g., 50/50).
Quota share and surplus share are the main forms.

Non-Proportional (Excess of Loss) Reinsurance

Reinsurer pays only when a loss exceeds a specified retention (the ceding insurer’s retention layer).
Per-risk XL, per-occurrence XL, and aggregate XL treaties.
Catastrophe (Cat) XL: the most common form for natural disasters.

Adverse Selection and Moral Hazard

Adverse Selection

Results from information asymmetry before the contract.
High-risk individuals are more likely to seek insurance.
If insurers cannot distinguish risk levels, rates rise → lower-risk people drop out → pool quality declines → rates rise further (the “death spiral”).

Responses to Adverse Selection

Rigorous underwriting (application review + medical exams)
Risk classification and tiered pricing
Mandatory participation (social insurance eliminates it)
Waiting periods and exclusions for pre-existing conditions

Moral Hazard

Arises after the contract is issued.
The insured takes less care to prevent loss because losses are now covered (e.g., leaving a car unlocked because it has comprehensive coverage).
Extreme form: intentional loss (fraud, arson).

Underwriting

Underwriting

The process of evaluating risk and deciding whether to accept it and at what premium.

Life / Health Underwriting

Medical history review and, for large cases, a paramedical exam
Occupation: hazardous occupations may carry a table rating or flat extra
Non-smoker discount: standard in most markets
Build (height/weight ratio), driving record, hobbies

Auto Underwriting

Age, gender (in states where permitted), driving record
Vehicle make/model/year, garaging location, annual mileage

Declination Reasons

Severe pre-existing conditions (uninsurable risk)
High-hazard occupations or extreme sports participation
Prior insurance fraud or excessive loss history

Responses to Moral Hazard

Deductibles and copayments (skin in the game)
Coinsurance requirements
Special investigation unit (SIU) for suspected fraud claims

Key Concept Cards

Reinsurance = Insurance for Insurers ★★★★★ : The primary insurer cedes a portion of risk to the reinsurer. Memory hook: Re-insurance = insurance of insurance

Adverse Selection = High-Risk Concentration Pre-Contract ★★★★★ : Information asymmetry causes the insured pool to skew toward higher risk. Memory hook: Adverse selection = before binding

Underwriting = Risk Evaluation Before Acceptance ★★★★☆ : Every application is assessed to determine terms, price, and eligibility. Memory hook: Underwriting = screen before you insure

Practice Quiz

Q. What is the difference between adverse selection and moral hazard, and how does each affect insurers?

Adverse selection is a pre-contract problem: those who know they are high-risk disproportionately seek coverage, distorting the insured pool. Insurer response: underwriting, health exams, tiered pricing, waiting periods. Moral hazard is a post-contract problem: having insurance reduces the insured’s incentive to prevent losses; at the extreme, fraud occurs. Insurer response: deductibles, coinsurance, SIU investigations. Both stem from information asymmetry — the insured knows more about their own risk than the insurer does. Mandatory participation (as in social insurance) eliminates adverse selection by forcing low-risk individuals into the pool.

Q. What is the difference between proportional and non-proportional reinsurance?

Proportional (pro-rata): the ceding insurer and reinsurer split every premium and every loss dollar in the same agreed ratio — e.g., 60/40 quota share. Suitable for spreading frequency of small-to-medium losses. Non-proportional (excess of loss / XL): the reinsurer only pays when a single loss (or aggregate losses) exceeds a retention threshold. The ceding insurer pays nothing to the reinsurer until losses pierce the layer. Catastrophe XL — the most common form — protects against infrequent but very large events (hurricanes, earthquakes). Non-proportional is better for protecting against severity; proportional is better for sharing volume.