In life insurance, reinsurance may be undertaken for one of two general reasons: (1) to transfer all or a specific portion of a company�s liabilities or (2) to accomplish certain broad managerial objectives, including favorable underwriting results and the reduction of surplus drain from writing new business. Reinsurance undertaken for the purpose of transferring all or a substantial portion of a company�s liabilities is called portfolio or assumption reinsurance. Reinsurance arranged for general business purposes is referred to as indemnity reinsurance.

There are a number of reasons for assumption reinsurance. A traditional use has been to bail out insurance companies that find themselves in financial difficulties. Rather than liquidate the company, with almost certain losses to policyowners, two companies frequently work out a procedure whereby a solvent insurer assumes the policy liabilities of the company in distress in exchange for the assets underlying the liabilities and the right to receive future premiums under the policies. If the assets are not sufficient to offset the liabilities�a likely circumstance�the reinsurer may place a lien against the cash values of the ceded policies until the deficiency can be liquidated through earnings on the policies. A merger is another situation in which all the business of one company may be ceded to another.

In many instances assumption reinsurance involves only a segment of the ceding company�s business. For example, a combination company may decide to restrict its future operations to ordinary insurance and arrange to cede all of its outstanding industrial business to another company. Likewise, a company may decide to withdraw from one or more states and, in so doing, reinsure all policies outstanding in that geographical area. Assumption reinsurance is always tailored to the particular facts and requirements of the case under consideration and does not lend itself to generalization. Hence, it will not be further discussed in this book.

Indemnity reinsurance is characterized by a series of independent transactions whereby the primary insurer transfers its liability with respect to individual policies, in whole or in part, to the reinsurer. It is extremely widespread and may be used for any one of several reasons.

The most fundamental and prevalent use of indemnity reinsurance is to avoid too large a concentration of risk on one life. All companies, including the giants of the industry, have deemed it prudent to limit the amount of insurance that they will retain on any one life. These maxima, called retention limits, reflect the judgment of company management as to many factors, but they are strongly influenced by the volume of insurance in force, the amount of surplus funds, and the proficiency of the underwriting personnel. The limits range from $1,000 in small, recently established companies to well over $20 million to $30 million in the largest companies. There may be various limits within one company, depending upon the plan, age at issue, sex, and the substandard classification. Retention tends to be smaller at the lower and upper age groups and for plans under which the risk element is relatively large. It is clearly in a company�s interest to retain as much of the risk as is consistent with safety, so the retention limit or limits are usually raised as the insurance in force and amount of surplus funds grow. To remain competitive and to retain the services of a qualified agency force, a company must be in a position to accept applications for any reasonable amount of insurance, regardless of its retention limit. Thus a company must have facilities for transferring amounts of insurance in excess of the amount that it is willing to retain at its own risk.

A closely related use of reinsurance, as yet limited in scope but receiving increasing attention, is to stabilize the primary company�s overall mortality experience. This function is associated with so-called nonproportional reinsurance, one form of which transfers to the reinsurer all or a specified percentage of that portion of aggregate mortality claims for a given period in excess of a stipulated norm. Another form of nonproportional reinsurance provides protection against an undesirable concentration of risk on several lives, such as might be found among the passengers of a jet airliner or the employees of an industrial plant.

A third use of indemnity reinsurance is to reduce the drain on surplus caused by writing new business. As pointed out earlier, the expense of putting a new policy on the books greatly exceeds the first-year gross premium. This alone creates a strain on surplus, but when the insurer must also set aside funds to cover all or a portion of the first-year reserve, the strain is intensified. Under certain plans of reinsurance (to be discussed later), the burden of meeting first-year expenses and reserve requirements can be shifted to the reinsurer, thus permitting the primary company to write all the acceptable business produced by its agency forces.

A fourth use of indemnity reinsurance is to take advantage of the reinsurer�s underwriting judgment. This is most likely to occur with applications from impaired lives. Some types of impairments are encountered so infrequently that even the largest companies do not have much opportunity to develop any experience with them. Those responsible for the selection of risks, upon encountering such an impairment, cannot evaluate the risk with the same degree of confidence they feel in dealing with the more common varieties of impaired risks. For their own peace of mind, they are likely to seek the benefit of reinsurance, knowing that the selection of impaired risks is a special service of reinsurance companies. Even if the impairment is a common one and the underwriter has no hesitation about classifying the risk, the case may be submitted to one or more reinsurers to demonstrate to the soliciting agent that the most favorable terms were granted.

A fifth application of indemnity insurance, closely related to the fourth, is to transfer all policies of substandard insurance. This use is brought into play when the primary insurer does not write substandard insurance on any basis. Yet in order to offer a full range of services to its agency force, the company may work out an arrangement whereby it can channel all applications from substandard risks to a reinsurer equipped to classify and underwrite such risks. A variation of this arrangement is to reinsure all substandard insurance policies that fall within a class above a stipulated percentage of anticipated mortality, such as 200 percent.

A company may also enter into a reinsurance agreement with another company to receive advice and counsel on underwriting matters, rates, and policy forms. This purpose is usually associated with small, newly organized companies that cannot afford a large enough staff to deal with all aspects of its operations. In the relationship between the primary company and the reinsurer, the latter becomes thoroughly conversant with the primary company�s operations and is in a position to provide expert advice. While extremely valuable, this service of indemnity reinsurance is usually subsidiary to the fundamental function of spreading the risk.

Finally, with group insurance and pension plans, the company with which the master contract is placed may transfer portions of the coverage to several other insurers under instructions from the policyowner. Such an arrangement is specially fashioned and arises because the policyowner, for business reasons, wishes to divide the coverage among several insurers while looking to one for overall administration of the case.