Reinsurance: What You Need to Know

March 30, 2017 | Don Matz

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In the second installment of his What You Need to Know series, Tower Hill President Don Matz explains the ins and outs of reinsurance and its importance to the Florida home insurance market.

“Reinsurance” is a term that Floridians may hear or read about when they are shopping for homeowners insurance. I thought I would take this opportunity to explain reinsurance and why it is important.

Q. What is reinsurance?

Quite simply, reinsurance is insurance for insurance companies.

Q. How does reinsurance work?

Reinsurance enables insurance companies to limit or eliminate spikes in losses resulting from large claims (severity), from an accumulation of many claims (frequency), or both. For a premium, reinsurance transfers all or parts of these risks off the balance sheet of the insurance company and onto the balance sheet of a reinsurance company.

Q. Why is this important?

Without reinsurance, insurance companies would have to rely exclusively upon their surplus to pay the claims of their insureds in the event claims and expenses exceeded the premium they collected. Because surplus is designed to protect policyholders from an insurance company insolvency, insurance companies strive to maintain and grow their policyholder surplus through underwriting profits (premiums collected less claims incurred less operating expenses) and investment income.

Without the downside protection reinsurance provides, insurance companies would be forced to be far more conservative in the volume of business they write, which would ultimately lead to less competition and higher premiums for policyholders.

Q. Why then are reinsurers willing to take on this risk, and how are they able to charge insurance companies a premium that is reasonable?

Reinsurers have the ability to aggregate all types of risks from all over the world. Risks from such diverse perils as hurricanes in Florida, typhoons in Japan, earthquakes in California, passenger aircraft crashes, oil tanker spills, and many other perils too numerous to mention reside in a reinsurer’s portfolio.

The diversity of such risks, and the highly unlikely event that more than one or two of these types of disasters will occur in the same year, enable the reinsurance company to spread its risk over multiple perils and charge a premium that is reasonable to an insurance company that focuses on a more narrow set of risks, such as Florida homeowners insurance.

Q. Is reinsurance expensive?

Reinsurance is an expense insurance companies must account for in developing their premium rates. Hurricanes making landfall in Florida represent the largest natural disaster exposure in the world, so reinsurers generally charge insurance companies more for this exposure than any other exposure.

Florida homeowners insurers may reduce their reinsurance costs by diversifying their portfolio of homes throughout Florida and/or beyond Florida. In general, the more concentrated an insurance company’s risks are in a geographic region, the more expensive reinsurance will be. Depending upon the company, reinsurance will comprise 20-40% of its Florida homeowners premium.

Q. How much reinsurance should an insurance company buy?

A. That depends upon the company and multiple factors, such as its surplus, insurance in-force, and risk tolerance. Rating agencies such as AM Best, Demotech, and Standard & Poor’s all have minimum requirements if companies want to maintain an acceptable rating with them. Sophisticated computer models provide companies with their probable maximum loss, or PML, for a particular peril, such as a hurricane (or earthquake, tornado, flood, etc.), and its aggregate PML for multiple perils. The rating agencies use these PMLs, and the company’s net exposure after reinsurance to these perils, as part of their measurement of a company’s solvency and in determining an insurer’s ultimate rating.

The Florida Office of Insurance Regulation also reviews each Florida homeowners insurance company’s PMLs and reinsurance program on an annual basis to gauge the company’s solvency after a large hurricane and to determine how much the insurance company should charge for reinsurance within its premium rate structure.

Q. Does Tower Hill purchase reinsurance?

A. Yes, Tower Hill buys a lot of reinsurance — $2.3 billion to be exact! This purchase enables the Tower Hill companies to survive a large severity event, such as a hurricane loss with a 1% probability of occurrence or a rare frequency event such as four hurricanes making landfall in Florida in the same year. Reinsurance also enables Tower Hill to insure homes of all types, from single-family homes to condominiums to mobile homes, and for a wide range of values — from $50,000 to $5 million. The reinsurance we buy transfers the vast majority of our hurricane exposure to the balance sheets of extremely well capitalized reinsurers located around the globe.

With a 44-year history of buying reinsurance and an enviable track record, Tower Hill is the beneficiary of long-term relationships within the reinsurance market and a competitively priced reinsurance program.