Understanding reinsurance: A guide for Financial Professionals

03/14/2024 — Key takeaways:

• Offshore reinsurance risk levels are determined by misuse, not inherent in the process itself.
• Selection of a reinsuring partner is crucial, as their financial rating impacts guarantees to customers.
• Despite challenges, offshore reinsurance can be beneficial with due diligence and effective risk management.

While not widely known, reinsurance can play a crucial role in the insurance industry. In layman’s terms, it’s insurance for insurance companies, a safeguard against unforeseen risks and unexpected claims. While reinsurance might seem like a complex topic, understanding the basics of how it works and its potential impact on your client’s investments can be beneficial for both us and our clients. In this blog, we’ll dive into the world of reinsurance and discuss what you should know when talking to clients about this lesser-known industry.

What is reinsurance?

Reinsurance is an arrangement between insurance companies where one company (the reinsurer) agrees to take on a portion of the risk from another company (the insurer).¹ This allows the insurer to protect themselves from large or catastrophic losses by spreading out their risks. Transferring of some or all of the risk also transfers financial obligation of funding the policyholder’s benefit, making the financial strength of the reinsurer important.

The potential benefits of reinsurance

Safeguarding benefits

At its core, reinsurance is about security. Imagine a scenario where a natural disaster leads to an avalanche of claims. Without reinsurance, an insurer might face insolvency due to insufficient capital reserves. But with a robust reinsurance strategy, they can withstand such onslaughts, ensuring the ability to fulfill promises to policyholders.

Providing value

In addition to serving as a bulwark, reinsurance allows insurance companies to operate with less capital than would otherwise be needed. By reducing conservative capital requirements, companies can pass on savings to consumers through lower premiums or better policy features, cultivating a more value-driven market for consumers.

Potential downsides

While reinsurance has clear upsides, it’s essential to inform your clients about the potential risks involved as well. Companies must walk a fine line between adequate risk transfer and ensuring they don’t become overly reliant on their reinsurers. Since reinsurers are taking on a portion of the risk from insurers, they’re also exposed to potential losses. This means that if many claims occur or a catastrophic event happens, reinsurers could face financial strain.

Offshore reinsurance

Offshore reinsurance, a topic of considerable debate within the insurance industry, is not inherently associated with high risk. However, it’s crucial to note that the system’s misuse to lower capital or reserve requirements can lead to unwarranted extremities.

A significant factor in the equation is the financial rating of the reinsuring partner. This rating directly influences the long-term guarantees promised to the customer. For instance, if the reinsuring partner has a poor financial rating, the chances of the customer receiving their promised payout diminishes. Therefore, distribution partners must carry out thorough due diligence on reinsuring carriers, ensuring their clients’ protection.² Interestingly, it has been observed that a number of large reinsurance deals have resulted in assets being transferred to companies with much lower ratings than the original issuer. This shift has raised concerns regarding the potential risks and implications for the insured parties.

Moreover, and perhaps most importantly, offshore reinsurance isn’t regulated the same way as onshore reinsurance. This means that there is no guaranteed protection for your clients if the reinsurer goes bankrupt or becomes insolvent.³ Generally, for offshore reinsurance, different treatment of assets insurers hold to support policyholder benefits incents different behaviors that can lead to more risk. Illiquidity can become an issue, as well as the different treatment of lower credit assets and privately structured assets. Some of this difference in treatment is rational relative to hyper-conservative onshore requirements, but overall can still be harmful. Its best to be clear with clients about the potential risks.

How to choose a carrier

There are a few things clients will want to keep in mind when considering which carrier to place their trust and money in:

Understanding reinsurance affiliations

Investigate the relationships your insurer holds with its fellow companies. Are these affiliations built to share knowledge and opportunity, or are there potential conflicts of interest?

Assessing the financial rating of affiliations

Scrutinize the financial stability of the reinsurer. Credit rating agencies can offer scores that reflect a company’s ability to meet its financial commitments.

Policy offshoring considerations

Finally, establish whether the reinsurance policy will be placed with an offshore entity. Seek to comprehend the legal implications and the political and economic stability of the reinsurer’s locale.

The bottom line

Reinsurance is a fundamental aspect of the industry that aims to protect both companies and clients from unpredictable financial risks. Although it can require careful due diligence, scrupulous selection of reinsuring partners, and efficient risk management to maximize its benefits, understanding the intricacies of reinsurance can empower you and your clients to make more informed and confident investment decisions. Take the mystery out of reinsurance, and you’ll be able to leverage it as a powerful tool for your clients’ financial futures.