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PROPORTIONAL REINSURANCE

A number of plans have been developed for transacting indemnity reinsurance. The basic or traditional plans, designed for individual risks, are called proportional reinsurance, since under these plans a claim under a reinsured policy is shared by the primary company and the reinsurer in a proportion determined in advance. The precise manner in which a claim payment is shared depends on the type of plan employed.

Types of Plans

Proportional reinsurance is provided under two distinct plans: yearly renewable term insurance and coinsurance. A variation of the latter plan, called modified coinsurance, has also been developed.

Yearly Renewable Term Insurance

The yearly renewable term plan derives its name from the fact that the primary company, in effect, purchases term insurance on a yearly renewable basis from the reinsurer. The amount of term insurance purchased in any particular reinsurance transaction is the net amount at risk year by year under the face amount of insurance transferred to the reinsurer. This can be illustrated by a $1 million ordinary life policy issued on a male aged 35 by a company with a retention limit of $200,000. Under such circumstances $800,000 of insurance would ostensibly be transferred to the reinsurer. However, in the event of the insured�s death, the reinsurer would pay not $800,000 but only the net amount of risk under an $800,000 policy. If the insured should die during the first policy year, the reinsurer would be liable for $800,000 less $8,820.96, the first-year terminal reserve under the policy in question. If death occurred during the 8th policy year, the reinsurer would remit $727,213.52 to the primary company�the face amount less the 8-year terminal reserve of $77,786.48. The reserves under the $800,000 of life insurance transferred to the reinsurer are held by the primary insurer and, in the event of the insured�s death, would be added to the reinsurer�s remittance to make up the full payment of $800,000 due under the reinsured portion of the original policy. The primary insurer would, of course, also be solely responsible for payment of the $200,000 of coverage it retained�which, in turn, would be composed of the net amount at risk and the accumulated reserves under $200,000 of coverage.

Whenever a policy is to be reinsured on a yearly renewable term basis, either the primary company or the reinsurer prepares a schedule of the amount at risk for each policy year under the face amount being reinsured. The reinsurer quotes a schedule of yearly renewable term premium rates that will be applied to the net amount at risk year by year. These rates are extremely competitive and usually reflect the lower mortality associated with the selection process.

The premiums are generally graded upward with duration under a wide variety of schedules. Some schedules grade the premium upward over a period as long as 15 years. There may be no charge other than a policy fee of nominal amount�for example, $5 or $10 for the first year of reinsurance coverage. The premium schedule may also reflect, through a policy fee or in some other manner, the amount of insurance involved. The expense loading is lower than in direct premiums since the primary company pays all commissions, medical fees, and other acquisition expenses connected with the policy. (Under most reinsurance agreements the premium tax is borne by the reinsurer in the form of a "refund" to the primary company.) As a further cost concession, some agreements of this type provide that the primary company share in any mortality savings on the reinsured business. Since it holds all the reserves, the primary company is responsible for surrender values, policy loans, and other prematurity benefits.

There are several advantages associated with the yearly renewable term basis of reinsurance. It permits the primary company to retain most of the premiums, giving rise to a more rapid growth in assets�a matter of special concern to small and medium-sized companies. For the same reason, it may be favored when the reinsurer is not licensed to transact business in the domiciliary state of the primary company, which would mean that the primary company would not be permitted to deduct the reserves on the reinsured policies from its overall reserve liability. (The same situation may lead to the use of a modified coinsurance arrangement.) This plan of reinsurance is also easier to administer than the more complicated coinsurance arrangements. Finally, it is thought to be more suitable for nonparticipating insurance where costs are fixed in advance.

Coinsurance

Under the coinsurance plan the primary company transfers (or cedes) the proportion of the face amount of insurance called for in the cession form, but the reinsurer is responsible not only for the net amount at risk but also for its pro rata share of the death claim. In the example cited under yearly renewable term insurance, the reinsurer is liable for the payment of $800,000, irrespective of the policy year in which the insured died. The reinsurer is also responsible for its pro rata share of the cash surrender value and other surrender benefits. In effect, the reinsurer is simply substituted for the primary company with respect to the amount of insurance reinsured. The primary or ceding company, however, remains liable to the policyowner for the full amount of any benefits if the reinsurer becomes insolvent or otherwise cannot pay its share of claims.

The primary or ceding company pays the reinsurer a pro rata share of the gross premiums collected from the policyowner, and the reinsurer accumulates and holds the policy reserves for the amount of insurance ceded. Inasmuch as the ceding company incurs heavy expenses in putting the original policy on the books, it is customary for the reinsurer to reimburse the primary insurer for the expenses attributable to the amount of insurance reinsured. This reimbursement takes the form of a "ceding commission," which includes an allowance for commissions paid to the soliciting agent of the ceding company, premium taxes paid to the insured�s state of domicile, and a portion of the overhead expenses of the ceding company. Paying a portion of the primary company�s overhead recognizes the fact that not only does a reinsurer incur relatively lower expenses on that portion of the face amount assumed by it, but the average amount of insurance per reinsurance certificate is also larger than the average size of the primary insurer�s policy. Hence, the administrative expense per $1,000 of insurance is lower on that portion of the insurance reinsured than on the ceding company�s normal business, and the reinsurer is willing to share the savings with the company that originated the business. There is normally no sharing of medical and other selection expenses, based on the theory that such expenses are incurred on a per-policy basis and vary only slightly with the amount of insurance. The amount of the ceding commission is negotiated between the ceding insurer and the reinsurer.

If the original policy is participating, the reinsurer must pay dividends on the portion of insurance it assumes according to the primary company�s dividend scale. This can prove burdensome if the net investment earnings of the reinsurer do not approximate those of the primary company or if the mortality under the ceded policies is not as favorable as that underlying the dividend scale. As a matter of fact, the mortality rates on reinsured policies as a whole tend to be higher than those on direct business, possibly because of the larger amounts of insurance involved and the less rigid underwriting standards of the many small and medium-sized companies that rely heavily on reinsurance. The anticipated higher mortality is taken into account in arriving at the ceding commission.

In the event that the original policy is terminated voluntarily, the reinsurer is liable for its pro rata share of the cash surrender value. If the policy is surrendered for reduced paid-up insurance, the reinsurer may remain liable for its proportionate share, or its share may be reduce paying the appropriate cash surrender value to the primary insurer. Should the policy be exchanged for extended term insurance, the reinsurer usually retains its proportionate share of liability, although its share may be reduced by any policy indebtedness. The reinsurer does not ordinarily participate in policy loans, settlement options, or installment settlements under family income or maintenance policies. The reinsurer�s obligation in the event of the insured�s death is discharged by a single-sum payment to the ceding company.

Modified Coinsurance

Many companies regard the reinsurer�s accumulation of substantial sums of money as an unessential feature of a reinsurance arrangement and one that can be disadvantageous to the primary company. Apart from a company�s natural desire to retain control of the funds arising out of its own policies, it may be apprehensive about entrusting another company to accumulate the funds necessary to discharge the primary company�s obligations under a policy. This apprehension is heightened by the knowledge that the primary insurer�s basic liability to the policyowner or beneficiary is not affected by the reinsurer�s inability to make good on its obligation to the primary company. This problem is of more immediate concern when the reinsurer is not licensed to operate in the primary company�s home state. In many states the primary company is not permitted to include sums due from the reinsurer as assets in its balance sheet. These considerations have led to a modification of the coinsurance method, under which the primary company retains the entire reserve under the reinsured policy.

Under this arrangement the ceding company pays the reinsurer a proportionate part of the gross premium, as under the conventional coinsurance plan, less whatever allowances have been arranged for commissions, premium taxes, and overhead. At the end of each policy year, however, the reinsurer pays over to the ceding company a sum equal to the net increase in the reserve during the year, less one year�s interest on the reserve at the beginning of the year. In more precise terms, the reinsurer pays over an amount equal to the excess of the terminal reserve for the policy year in question over the terminal reserve for the preceding policy year, less interest on the initial reserve for the current policy year. It is necessary to credit the reinsurer with interest on the initial reserve since a part of the increase in the reserve during the year is attributable to earnings on the funds underlying the reserve, which are held by the ceding company. The reserves are usually credited with interest at the rate used in the primary company�s dividend formula or, in the case of nonparticipating insurance, a rate arrived at by negotiation.

Under this arrangement the reinsurer never holds more than the gross premium, as adjusted for allowances, for one year. Under one variation of this method, the anticipated increase is deducted in advance from the gross premium. In many reinsurance transactions using the modified coinsurance plan, the foregoing adjustments are based on the aggregate mean reserves, rather than on the individual terminal reserves. Apart from the reserve adjustment, the modified coinsurance basis is identical to the straight coinsurance basis, and the description of the coinsurance arrangement in the preceding section is equally applicable to the modified form.

The modified coinsurance plan bears such a strong resemblance in net effect to the yearly renewable term basis of coinsurance that one might question why modified coinsurance would ever be used. One answer is that the premium paid by the primary company is geared to the premium received from the policyowner, rather than being arrived at through negotiation. The second answer is more complex but rests on the fact that under a modified coinsurance plan, reinsurance costs reflect the incidence of expense and surplus drain incurred by the primary company. Under the yearly renewable term plan, the ceding company is responsible for maintaining the reserves at the proper level. Under the modified coinsurance arrangement, however, the reinsurer, out of the premium received from the primary company, must each year turn back a sum equal to the increase in reserves (less one year�s interest on the reserve at the beginning of the year), as well as the ceding commission. Over the lifetime of the reinsured policy, the total cost of modified coinsurance and yearly renewable term should be approximately the same, but the net cost of reinsurance in the early years is normally less under modified coinsurance.

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