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Arrangements between ceding insurers and reinsurers are generally formalized by a reinsurance agreement (also called a reinsurance treaty). Such agreements describe the classes of risk that will be subject to reinsurance, the extent of the reinsurer�s liability, and the procedures by which the transactions are to be carried out. These agreements are broadly classified as facultative or automatic.
The facultative agreement establishes a procedure whereby the primary insurer may offer risks to the reinsurer on an individual case basis. The essence of the arrangement is that the primary company is under no obligation to offer�and the reinsurer is under no duty to accept�a particular risk. Each company reserves full freedom of action, and each risk is considered on its merits. The arrangement takes its name from the fact that each party retains the "faculty" to do as it pleases with respect to each specific risk.
The automatic agreement, on the other hand, binds the primary insurer to offer�and the reinsurer to accept�all risks that fall within the purview of the agreement. The agreement sets forth a schedule of the primary insurer�s limits of retention and provides that whenever the primary company issues a policy for an amount in excess of the limit for each policy, the excess amount is to be reinsured automatically. The primary company does not submit the underwriting papers to the reinsurer, and the reinsurer does not have the option of accepting or rejecting the risk.
Under a facultative arrangement the primary company submits a copy of the application from the insured, together with all supporting documents, to the prospective insurer. The primary insurer also submits a form that specifies the basis on which reinsurance is desired and the proportion of the face amount that the originating company proposes to retain. This form, which constitutes the offer for reinsurance, supplies all information about the risk in the possession of the primary company, including the amount of insurance already in force on the risk. The agreement normally provides that the reinsurer will phone, telegram, or facsimile its acceptance or rejection to the primary company.
Under an automatic arrangement the reinsurer is obligated to accept a specified amount of reinsurance, including amounts for supplemental coverage on the basis of the primary company�s underwriting appraisal. The maximum amount that can be transferred automatically to the reinsurer depends on the quality of the ceding company�s underwriting staff, as well as its limits of retention. It is fairly common for the reinsurer to obligate itself to accept automatically up to four or more times the primary company�s retention. However, when the retention limits of the primary company are fairly high, the reinsurer may limit its obligation to an amount equal to the primary company�s limit. The agreement specifies that the originating company will retain an amount of insurance equal to its retention limit and will not reinsure it elsewhere on a facultative basis. In other words, if the primary company should decide to retain less than the full retention indicated for the particular classification in which the risk falls, the reinsurer is relieved of its obligation under the automatic agreement, and the entire transaction will have to be handled on a facultative basis. The agreement also usually includes a so-called "jumbo" clause, which stipulates that if the total amount of insurance in force on an applicant�s life in all companies�including policies applied for�exceeds a specified amount, reinsurance is not automatically effected. The agreement normally makes provision for facultative reinsurance of those risks not eligible, for one reason or another, for automatic reinsurance.
Cession Form
The reinsurance agreement stipulates that the primary insurer, after delivering its policy to the insured and collecting the first premium, is to prepare a formal cession of reinsurance (in duplicate), which gives the details of the risk and schedule of reinsurance premiums, including the ceding commission, if any. One copy of the cession form goes to the reinsurer; the other is retained by the primary company. The form is identical for both facultative and automatic insurance. In effect, it is the individual contract of insurance; the entire reinsurance agreement is incorporated into it by reference.
The cession form describes the basis on which the reinsurance is being effected�that is, whether it is yearly renewable term insurance, coinsurance, modified coinsurance, or some other type. If one of the coinsurance arrangements is being used, provision is made for paying a ceding commission to the primary or ceding company.
Provision is also made for the manner in which premiums are to be paid. All premiums are generally payable on an annual basis subject to prorated refunds in the event of terminations other than on policy anniversaries. The reinsurer bills the primary insurer monthly for reinsurance premiums falling due during that month. The bill also includes first-year premiums arising from cessions of reinsurance received since the date of the previous billing and refunds of premiums due to policy cancellations, as well as other small adjustments that arise from time to time.
Claims Settlement
The policyowner is not a party to the reinsurance agreement and looks to the issuing company to fulfill the obligation of the contract. Consequently the reinsurance agreement stipulates that any settlement made by the primary insurer with a claimant is binding on the reinsurer, whether the reinsurance was originally automatic or was accepted facultatively by the reinsurer. Despite this contractual right to settle claims at its discretion, the primary insurer will invariably consult with the reinsurer in doubtful cases.
If the policy is to be settled on an installment basis, the reinsurer will nevertheless discharge its liability by paying a lump sum to the primary insurer. This is true not only of settlement option arrangements but also of contracts, such as the family income and retirement income policies, which provide for settlement on an installment basis. If a policy is settled for less than the face amount, such as might happen from a misstatement of age or the compromise of a claim of doubtful validity, the reinsurer shares in the savings. If the primary insurer contests a claim, the reinsurer bears its proportionate share of the expenses incurred.
Reduction in the Sums Reinsured
Once a sum of insurance has been reinsured, the reinsurer is at risk for that amount as long as the amount retained by the primary company remains in force, subject to two important exceptions. One exception is in instances where the total amount of insurance on a particular risk is reduced after a portion of the insurance has been reinsured. This can result from the maturity or expiration of policies in accordance with their terms or through the voluntary termination of policies by nonpayment of premiums. Some agreements provide that the full amount of the reduction will come out of the sum reinsured (up to the amount reinsured), while other agreements call for proportionate reductions in the amounts held by the two insurers.
The other exception applies to increases in the primary insurer�s limits of retention and is especially significant to young and growing insurance companies. The provision states that if the primary company increases its limits of retention, it may make corresponding reductions in all reinsurance previously transferred. In the case of a $5 million policy written by a company with a $1 million retention limit, $4 million would originally have been reinsured. If the primary company later increases its retention limit for that particular class of policy to $2 million, it would be permitted to recover $1 million of the $4 million that had been reinsured. This is referred to as the recapture of insurance.
Recapture Provision
Recapture is usually permitted only after the policies involved have been in force for a specified period of time. This restriction is clearly designed to enable the reinsurer to recover its acquisition expenses. It is customary to restrict recapture of insurance arranged under a renewable term plan to policies in force for 5 or more years, while amounts ceded on a coinsurance basis must typically remain in force for 10 or more years before being subject to recapture. The recapture provision provides an effective method of recovering amounts of insurance previously reinsured when the primary company holds the reserves, as under the yearly renewable term and modified coinsurance arrangements, but it may be ineffective under the coinsurance plan, since the reinsurer is obligated to release only the cash values�not the reserves�for the amounts recaptured. If there is a differential between the surrender value and the reserve under a policy, which is likely, the primary company may conclude that it is not worthwhile to recapture the insurance, at least until the differential between the surrender value and the reserve is insignificant.
Duration of the Agreement
Subject to the provisions described in the preceding section, a reinsurance agreement remains effective for reinsured policies as long as the original insurance continues in force. For new insurance, however, most agreements make provision for cancellation by either party with 90 days� notice. During that period, the agreement remains in full force and effect, and the reinsurer must accept all new insurance exceeding the retention limit with an automatic treaty. It is anticipated that the primary company can make other reinsurance arrangements within a period of 90 days.
Insolvency of the Primary Insurer
In general, reinsurance agreements are regarded as contracts of indemnity, and the reinsurer�s liability is measured by the actual loss sustained by the primary insurer. An important exception is in the case of the primary insurer�s insolvency. Virtually all agreements provide that the reinsurer must remit in full to the insolvent carrier that issued the original policy, even though the claim against the insolvent company will have to be scaled down. Many states, including New York, will not permit a primary company to treat amounts due from reinsurers as admitted assets or to deduct reserves held by reinsurers from its policy liabilities unless the reinsurance agreement requires the reinsurer to discharge its own obligation in full in the event the primary company becomes insolvent.
It is important to note that a claimant under a reinsured policy issued by a company that is insolvent at the time of the claim is not permitted to bring action directly against the reinsurer but must look to the insolvent carrier�s general assets for the settlement of the claim. On the other hand, when the issuing company is insolvent, the reinsurer is given the specific right to contest claims against the primary insurer in which it has an interest, with all defenses available to the reinsurer that are available to the primary insurer.
It is becoming increasingly common for reinsurance agreements to contain a provision permitting a primary company to share in any mortality gains or losses arising under reinsured policies. This is a form of experience rating found in many lines of insurance, including the various group coverages written by life companies. In this case, the primary company is treated as the policyowner, and the mortality refund (or surcharge, as the case might be) is calculated on the combined experience under all reinsured amounts with a particular reinsurer. The practice originated in the 1920s but was generally discontinued in the 1930s because of the disastrous claims experience on "jumbo" risks. In recent years, there has been renewed interest in the arrangement, and there are many variations in practice. A common arrangement is to have the primary insurer participate in any gains or losses on reinsurance amounts below a specified limit and not participate in the experience on amounts in excess of such limit. The purpose of this variation is to permit the primary company to share in the favorable mortality experience of the bulk of reinsured risks but to avoid the undesirable fluctuations in its overall experience that might result from unpredictably heavy mortality among very large risks. (Note that arrangements that permit the primary insurer to share the gains from favorable mortality experience on reinsured risks lessen the importance of recapture provisions.)
Mortality refunds are a matter of accounting between insurance companies and should not be confused with dividends to policyholders, although under participating policies, all or a portion of the savings may be passed on indirectly to policyholders. Agreements that provide for sharing mortality savings on reinsured risks with the primary company are usually referred to as experience-rated agreements.
The reinsurance agreement covering life risks may or may not apply to supplementary coverages, such as accidental death benefits and total disability benefits. If the basic agreement is facultative, it is likely to cover supplementary benefits as well as the life risk; if it is automatic, a separate agreement may be used for the supplementary coverages, particularly the accidental death benefits.
Many companies have lower limits of retention for accidental death benefits than for basic life risks. For example, a company may be willing to retain $400,000 of coverage under a basic life policy but only $100,000 of accidental death coverage. Therefore a policy for $200,000 with accidental death provisions would require reinsurance for the supplementary coverage but not for the basic coverage. For this reason the reinsurance of accidental death benefits may be set up under a special agreement.
Reinsurance may be provided on either a coinsurance or yearly renewable term basis, depending on the plan used for basic life risks. If the coinsurance plan is used, the premium for the accidental death benefits is based on the premium charged the insured, less a first-year and renewal expense allowance. If the renewable term plan is used, the premium is usually a flat rate per $1,000, irrespective of age of issue or the type of contract issued to the policyowner. The benefits are reinsured on a level-amount basis, since only nominal reserves are accumulated in connection with such coverage.
Disability benefits may likewise be reinsured on either a coinsurance or a yearly renewable term basis. The premium is the same as that charged the insured, less a first-year and renewal-expense allowance. It is customary to limit the reinsurance of disability benefits to an amount not exceeding that attaching to the face amount of life coverage reinsured.
The general principles governing reinsurance of standard risks are also applicable to substandard insurance. For substandard reinsurance on either the coinsurance or the modified coinsurance basis, the primary or ceding company pays the reinsurer appropriate portions of the additional premiums collected from the policyowner, subject to a ceding commission for reimbursement of the ceding company�s acquisition expenses. If the reinsurance is accomplished on the yearly renewable term basis and the substandard risk is classified according to a multiple of standard mortality, the reinsurance premiums are usually calculated on the same multiple of the standard reinsurance rate. If the policyowner is charged a flat extra premium, the primary insurer pays the reinsurer the same premium as for a standard risk, plus an appropriate share of the flat extra premium. The flat extra premiums, however, are not reduced as the net amount at risk declines.
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