FoundationsCore

Reinsurance

Q: A homeowner's claim is unpaid because the insurer is in liquidation. Can the homeowner claim directly from the reinsurer?

No, unless the treaty contains a cut-through clause — Reinsurance is a separate contract between two carriers. The policyholder has no privity with the reinsurer unless a cut-through (or insolvency) clause is expressly written in.

Q: Which of these is NOT a normal reason to buy reinsurance?

Eliminate the cedent's liability to the policyholder — Liability to the policyholder can never be transferred by reinsurance. The cedent pays the claim first and recovers afterwards.

The transfer itself

Insurance bought by an insurer to transfer part of the risk it has already accepted.

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Definition

Reinsurance is a contract under which one insurer (the cedent) transfers all or part of the risk it has underwritten to another carrier (the reinsurer) in exchange for a share of the premium. It does not alter the original policy: the policyholder still contracts only with the cedent, and the cedent remains fully liable for the claim whether or not the reinsurer pays.

Buys four things: capacity to write larger risks, stability of annual results, catastrophe protection, and regulatory capital relief.
There is no privity of contract between the policyholder and the reinsurer — the insured cannot sue the reinsurer directly (absent a cut-through clause).
It is a transfer of risk, not of responsibility. Reinsurer default (credit risk) lands back on the cedent.

Worked example

A property insurer writes a $30M warehouse. It is comfortable keeping $5M of that exposure, so it reinsures the other $25M. If the warehouse burns to the ground, the insurer pays the client $30M and recovers $25M from its reinsurers.

Scenario · figures in USD

Why a coastal insurer survives a hurricane

Gulf Coast Mutual writes $100M of premium and holds $150M of capital. Its modelled 1-in-100-year hurricane loss is $400M — more than twice its capital. It buys a single catastrophe cover of $350M in excess of $50M and a hurricane duly arrives.

Capital (policyholder surplus)	$150M
Gross loss from the hurricane	$400M
Retention (cedent pays first)	$50M
Recovery from reinsurers	$350M
Net loss to Gulf Coast Mutual	$50M
Capital remaining after the event	$100M

So whatWithout the cover the $400M loss wipes out $150M of capital and the company is insolvent. With it, a market-moving hurricane becomes a bad quarter.

Check your understanding

A homeowner's claim is unpaid because the insurer is in liquidation. Can the homeowner claim directly from the reinsurer?

No, unless the treaty contains a cut-through clause. Reinsurance is a separate contract between two carriers. The policyholder has no privity with the reinsurer unless a cut-through (or insolvency) clause is expressly written in.

Which of these is NOT a normal reason to buy reinsurance?

Eliminate the cedent's liability to the policyholder. Liability to the policyholder can never be transferred by reinsurance. The cedent pays the claim first and recovers afterwards.

Word problem

Harbour General suffers a gross loss of $250M from a single event. Its retention is $60M and it holds one catastrophe layer of $150M in excess of $60M. How much does Harbour General end up paying net, and why is it more than its retention?

Show a hint

The layer stops paying once $60M + $150M of loss has been reached. Everything above that point is unprotected.

Reveal the worked answer

Retention absorbed by the cedent: $60M
Layer covers losses from $60M up to $60M + $150M = $210M
Reinsurance recovery = $210M − $60M = $150M (the full limit)
Loss above the top of the cover = $250M − $210M = $40M, which falls back on the cedent
Net loss = $60M + $40M = $100M

Harbour General pays $100M net — its $60M retention plus a $40M gap above the top of the programme. Buying a limit is only half the question; buying enough limit is the other half.