Financial Guaranty Reinsurance

Reinsurance Defined
Reinsurance is a transaction that indemnifies a primary insurer against loss. When an issue is reinsured, the primary insurer cedes all or part of the risk of a default to a second company, the reinsurer. The reinsurance contract does not affect the initial obligation between the issuer and primary insurer. The issue still receives the credit rating of the primary insurer and the primary insurer guarantees timely payment of principal and interest. Rather, reinsurance protects the primary insurance company against frequent or severe losses and stabilizes underwriting results.

Benefits of Reinsurance
Reinsurance adds a further level of financial strength and stability to the financial guaranty market. The primary purpose of reinsurance is to help insurers manage their risk capacity. By ceding risk to a reinsurer, the base of available capital reserves is expanded. This is important for purposes of statutory accounting, which is used by the rating agencies to determine the financial strength, or capital adequacy, of an insurer. The value of reinsurance or the credit that a particular rating agency will give for reinsurance ("soft" capital) as opposed to cash ("hard" capital) depends on the credit rating of the reinsurer.

Types of Reinsurance Contracts
There are two basic types of reinsurance contracts:

Treaty reinsurance requires the reinsurer to underwrite or assume part or all of a ceding company's book of business for one or more specific classes of business. This means that the reinsurer is automatically bound to reinsure any business the company writes within the specified classes. Insurers typically have treaty reinsurance agreements with several reinsurers.

Facultative reinsurance is the reinsurance of part or all of a single policy subject to a separate negotiation of terms and conditions. Facultative reinsurance is used to reduce the ceding company's exposure to an individual risk. It helps primary insurers fill in gaps in a treaty reinsurance program, such as when it must insure a large or unusual piece of business for which treaty coverage may be too costly or unavailable.

Hybrids of treaty and facultative contracts, called automatic facultative agreements, have developed because some companies may write a large number of similar policies within a particular line of business. These agreements may be obligatory, in which case the primary insurer must cede all conforming risks to the reinsurer and the reinsurer must accept them; or non-obligatory, where the company has the ability to pick and choose those risks it wishes to cede and the reinsurer may have the right to reject any risk.

Types of Reinsurance Agreements
Both Treaty and Facultative reinsurance agreements can be structured on either a "proportional" or "non-proportional" basis depending on the mix of business of the ceding company.

With proportional agreements, as the term implies, the primary insurer and reinsurer share the liability risk proportionately. In the case of a quota share agreement, the primary insurer and reinsurer share in the premium and losses of a policy on a fixed percentage basis.

Non-proportional agreements, also known as excess of loss agreements, say that in the case of a default, the primary insurer is liable for a predetermined dollar amount of loss. Any losses beyond that amount must be paid by the reinsurer up to the limit of the agreement.

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