What it means
Ordinary reinsurance covers new risks policy by policy or treaty by treaty. Portfolio reinsurance instead transfers a defined portfolio of existing business, such as all claims from a closed line of insurance, all policies written in certain years or a block of long-tail liabilities.
The reinsurer takes on responsibility for paying the claims in return for a premium. Insurers do this for several reasons.
They may want to exit a line of business, reduce uncertainty about old claims, release capital held against those liabilities or prepare the company for sale. The transaction turns an uncertain future cost into a known price.
A common form is the loss portfolio transfer, where the insurer pays a premium and the reinsurer assumes the unpaid claims on past events. The reinsurer calculates the price by estimating when claims will be paid and what it can earn by investing the premium until then.
Because payment can be spread over many years, investment income is a significant part of the pricing. The accounting effect depends on the price relative to the reserves released.
If the premium is less than the reserves removed, the insurer records a gain, and if it is more, a loss. Regulators and auditors also check that real risk has been transferred, because a contract that merely moves timing is not true reinsurance.
For the reinsurer, the key risk is that claims turn out larger or slower than expected. For the insurer, the key risk is counterparty credit risk, since the original insurer remains liable to policyholders if the reinsurer cannot pay.
Insurers therefore choose reinsurers carefully and may require collateral. These deals can be complex and involve actuaries, lawyers, auditors and regulators, and they often take months to negotiate and complete.
The headline premium is only part of the picture, and the contract terms on limits, claims control and reporting matter just as much.
In practice
Real-world examples.
Example
An insurer decides to stop writing commercial liability cover. It transfers all its unpaid claims from past years to a reinsurer, so it can focus on its main lines. Its claims staff are reassigned to current business.
Example
A company preparing to be sold wants to remove uncertainty about old asbestos-related claims. It buys portfolio reinsurance so the buyer can see a clear price for the liabilities. The sale price improves because the uncertainty has been removed.
Example
A small insurer's regulator is concerned about its capital. By transferring a block of older policies to a reinsurer, the insurer releases capital and improves its solvency position. The regulator withdraws its request for a capital plan.
Formula
Calculation
Net result of the transfer = reserves released - premium paid to the reinsurer
Suppose an insurer holds $20,000,000 of reserves for old claims and transfers them to a reinsurer for a premium of $19,000,000.
Net result = 20,000,000 - 19,000,000 = a gain of $1,000,000.
If the reinsurer had instead charged $21,000,000, the net result would be 20,000,000 - 21,000,000 = a loss of $1,000,000.
In practice, the insurer would accept a loss only if the value of certainty, the freed capital and the lower administration costs outweigh it.Case study
Seen in the real world.
Falconer Mutual is a fictional insurer with an old block of liability claims carried at $20,000,000 in reserves. In this illustrative case, management is worried that these claims could develop adversely. A reinsurer offers to assume the whole block for $19,000,000.
The finance director calculates a $1,000,000 gain and notes that the deal also frees about $5,000,000 of capital that the regulator required against the old claims. She weighs this against the credit risk of relying on the reinsurer, which holds a strong rating.
The board approves the deal and asks for collateral to be held in a trust account, so that the reinsurer's obligations are backed even if its credit standing falls. The insurer's results become less volatile, and management can focus on its profitable lines.
Watch out
Common mistakes.
- Believing the insurer is free of all liability afterwards. If the reinsurer fails, the original insurer may still owe policyholders.
- Looking only at the premium. Limits, exclusions and claims-handling terms can matter as much as the price, and a cap on the reinsurer's payments can leave the insurer exposed.
- Assuming every deal qualifies as reinsurance for accounting. There must be a real transfer of risk.
Questions
People also ask.
What is a loss portfolio transfer?
A deal in which an insurer passes existing claims liabilities to a reinsurer for a premium, so that the reinsurer pays those claims as they fall due in the future.
Why would a reinsurer accept it?
It expects to earn investment income on the premium and to settle the claims for less than the premium, and it prices in a margin for the chance that claims prove higher than expected.
Who regulates these deals?
Insurance regulators review them, and auditors check the accounting treatment, so insurers usually discuss large transactions with the regulator before signing.
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