Ch8. 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.

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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).

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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

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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

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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.