The Insurance Pyramid – how insurance, reinsurance and retro-insurance fit together

Insurance, Reinsurance and Retro-insuranceHow do insurance, reinsurance and retro-insurance all fit together? We look to our Egyptians friends to find out. It is now known that it was the Bosnians who constructed the first pyramid about 10,000 years ago and the Egyptians copied / stole / pilfered the idea (probably saw it on TV). Actually, pyramids popped up in many civilisations across the world and guess what? It’s still happening!

Over the last 100 years or so, the insurance industry have constructed a pyramid of their own: the insurance pyramid. Insurance sits at the bottom of the pyramid, closest to the floor and nearest to the foot traffic. There are thousands of insurance businesses across the world all insuring different risks and using their various expertise and experience to insure risks and make a profit.

Above the insurance companies sits reinsurers. The reinsurers don’t sell insurance to the foot traffic – the likes of you or I – they sell reinsurance products to insurance companies to help the insurance companies manage their risk and utilise their capital most effectively. There are still hundreds of companies that write reinsurance business worldwide, however there are very few global reinsurers; 2 of the largest and most well know are Munich Re and Swiss Re.

Actually a lot of overlap happens between insurance and reinsurance companies and you will find many insurance companies writing reinsurance business as well.

Then you have retro-insurers that sit at the top. They carry out a similar role as reinsurers, only they sell their products to reinsurance companies. In terms of numbers, I don’t even think there is one company that solely writes retro-insurance. Most retro-insurance is actually written by reinsurance companies or through special purpose vehicles.

So there you have it, thousands of companies write insurance business at the bottom of the pyramid, then the reinsurers insure the insurance companies in the middle. Then only a handful of retro-insurers sit at the top, providing cover for  reinsurance companies.

In terms of premiums, global premium levels were put at c.$4.3 trillion in 2010. So collectively, the insurance companies at the bottom of the pyramid will be receiving this amount of premium from their customers. This compare to the c.$160 billion (2009 figure) that was spent on reinsurance by insurance companies.

Let’s take an example to show how the pyramid works.

A property insurer based in Florida insures 100,000 houses in the state, with an exposure level of $250,000 per household. That is a total exposure level of $25 billion. If a hurricane swept through the area and destroyed every other house in the insurer’s portfolio, they could stand to lose $12.5 billion, which is far and beyond the amount of capital they would be willing to risk or indeed have.

So they buy reinsurance. The largest concern they have is that of a hurricane occurring, so they buy reinsurance to cover them against US east coast windstorms.

Though the use of complex proprietary modelling tools, they estimate that worse case scenario down from a loss of $12.5 billion to a loss of $8 billion. This is roughly one in three of their houses being completely destroyed and they are willing to bet that a windstorm will not cause damage over and above the $8 billion figure. They also only want to retain $100 million of exposure at the bottom of the program, so they buy $7.9 billion over and above the $100 million of exposure they are willing to retain.

Let’s assume there are lots of other insurance companies that have similar portfolios across the east coast of America and they also buy similar sized reinsurance programs.

Now if we look at the reinsurance level of the pyramid, one reinsurance company could not provide the capacity for that one Florida based insurer on it’s own, so the broker structures the reinsurance programme into ‘lines’, then multiple insurers take a slice of the exposure in return for a slice of the premium. The reinsurance company will in turn build up a portfolio of ‘lines’ across different geographical areas and different types of insurance to effectively risk manage their book. However, because premiums are stronger in Florida, they too have a high exposure in the state.

Therefore they buy retro-insurance. They calculate if a hurricane hits Florida they could lose up to $50 billion. They have the capacity to take the first $250 million losses and want to insure themselves against any losses above this. Retro-insurance companies take ‘lines’ much like reinsurance companies do in insurance companies, just on a larger scale for larger premiums.  Only they take fewer of them.

So this is the pyramid in action. The insurance company reinsures itself for $7.9 billion and the reinsurer buys $50 billion of retro-insurance cover.

What happens when a hurricane hits?
If a category 1 hurricane were to strike Florida, it would most likely do some damage, but the losses stay within the insurers $100 million deductable. This would severely impact their P&L, however they had accounted for this and were financially strong enough to withstand it.

The reinsurers and retro-insurers would not suffer any losses.

If a category 5 hurricane swept through Florida and destroyed everything in its path, caused a national emergency and caused $10 billion of damage to the insurer’s portfolio, the insurance company would fold. The damage caused would blow through the $7.9 billion reinsurance protection and the further $2 billion of losses would come back onto their balance sheet, which they weren’t able to pay.

The reinsurer would also suffer huge losses. Not only did they lose all their money on the line they put down with that insurer, but other ‘lines’ they put down were also blown, causing them to lose their first $250 million and use 20% of their retro-insurance cover. In this situation, the reinsurer burnt capital and as a result does not have as much capacity to write business with next year, therefore has to contract their business and try and build capital again.

For the retro-insurers, they sustained losses, but not enough to damage their portfolio. They still make a profit for the year and can write more business as a result next year.

This is the insurance pyramid. Insurance companies sit at the bottom of the pyramid in abundance and are the first to get hit if there are small losses. The reinsurers are in are in the middle and generally take the brunt of big losses if and when they occur and the retro-insurers sit at the top of the pyramid. If the retro-insurers suffer big losses, generally, multiple catastrophic events must have occurred across the world in a short period of time and the world would be having a really bad time of it.

The lines between insurers, reinsurers and retro-insurers are not as clear cut as I have made out in this example and although you do get specialist reinsurers for example, there are many insurance companies that have insurance and reinsurance books and there are reinsurance companies with large retro-insurance books.

And that is how  the Egyptians influenced our insurance industry.

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