What it means
When an insurer cedes part of its risk, it also expects to be repaid for the matching share of claims. The amount due on claims that have already been paid is recoverable immediately, while the share of reserves for claims not yet settled is recoverable later.
Together these make up the reinsurance recoverable. The balance sheet usually shows the recoverable as an asset, separately from the insurer's own liabilities.
The insurer still shows the full claims liability to policyholders, and the recoverable is shown alongside it. This gross presentation makes the dependence on reinsurers visible.
The main risk is credit risk. If a reinsurer becomes insolvent or disputes a claim, the insurer may not collect in full, although it remains liable to its policyholders.
Insurers therefore assess the financial strength of their reinsurers and may require collateral, such as letters of credit or funds held in trust. Insurers set aside an allowance for amounts that may not be collected, based on the reinsurer's credit quality, age of the balance and any disputes.
Auditors and regulators focus on this area because recoverables can be very large relative to capital. Slow payment can also affect the insurer's cash flow.
For analysts, the size and quality of recoverables show how exposed the insurer is to its reinsurance partners. A high ratio of recoverables to equity, concentrated with a few weaker reinsurers, is a warning sign.
Diversifying reinsurers and holding collateral are ways to manage the risk. Timing matters as much as size.
A reinsurer that pays promptly turns the recoverable into cash within weeks, while one that disputes the claim can leave the balance outstanding for years. Insurers monitor the ageing of recoverables, which shows how long balances have been unpaid, and chase old items first.
In practice
Real-world examples.
Example
After a hailstorm, a property insurer pays $15,000,000 of claims. Its excess of loss treaty covers $6,000,000 of the total, so it bills the reinsurer and records a recoverable until the cash arrives.
Example
An insurer's auditor reviews the reinsurance balance and notes that 60% of it is owed by a single reinsurer. The auditor asks management to explain how it monitors that reinsurer's strength and collateral.
Example
A reinsurer in financial difficulty delays payments. The insurer raises its allowance for uncollectible amounts and demands additional collateral to protect itself. The chief financial officer reports the change to the audit committee at its next meeting.
Formula
Calculation
Reinsurance recoverable = reinsurers' share of paid losses still unpaid + reinsurers' share of unpaid loss reserves
An insurer cedes 30% of its business under a quota share treaty. It has paid $10,000,000 in claims, of which 30% is $3,000,000, and has collected $1,200,000 so far, leaving $1,800,000 due. Its unpaid claim reserves are $20,000,000, of which the reinsurers' 30% share is $6,000,000. Total recoverable = $1,800,000 + $6,000,000 = $7,800,000.Case study
Seen in the real world.
Greystone Mutual is an illustrative, fictional insurer that relied on one large reinsurer for most of its catastrophe cover. After a major storm season, the recoverable from that reinsurer rose to nearly twice the insurer's equity.
The board asked for a review and learned that the reinsurer's credit rating had been cut. Management moved part of the business to two other reinsurers and negotiated collateral on the existing balance. Greystone's finance team also stress-tested its capital by assuming that the weakest reinsurer paid only half of what it owed. The result showed that the company could absorb the shortfall, but only just. The illustrative lesson is that recoverables look safe on the balance sheet only if the reinsurer is able to pay.
Greystone also began reporting the ageing of its recoverables to the board each quarter. Items outstanding for more than 90 days were investigated at once, and the balance of overdue amounts fell by half within a year.
Watch out
Common mistakes.
- Treating recoverables as cash, when they are amounts owed that can be delayed, disputed or lost.
- Assuming the insurer is freed from its obligations once risk is ceded, when it remains liable to policyholders if the reinsurer fails.
- Ignoring concentration, when a large balance owed by a single reinsurer can threaten an insurer's capital.
Questions
People also ask.
What is collateral in reinsurance?
It is security such as a letter of credit or a trust account that the reinsurer provides to support the amounts it owes.
Do recoverables include future claims?
Yes, they include the reinsurers' share of reserves for claims that are not yet settled, as well as amounts due on claims already paid, which is why the balance can move when reserves are revised.
How are they audited?
Auditors check the contracts, confirm balances directly with reinsurers, and test the allowance for amounts that may not be collected, paying particular attention to disputed and long-overdue items.
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