**The World Bank Primer on Reinsurance**

## _Donald A. Mclsaac and David F. Babbel_

# BASIC CONCEPTS

Reinsurance is a mechanism used by the insurance industry to spread the risks it assumes from policyholders. Through it, the industry's losses are absorbed and distributed among a group of companies so that no single company is overburdened with the financial responsibility of offering coverage to its policyholders. Catastrophes, unexpected liabilities, and a series of large losses that might be too great for an individual insurer to absorb are able to be handled through reinsurance. Without reinsurance, most insurers would be able to cover only the safest of ventures, leaving many risky but worthwhile ventures without coverage.

<!-- Start of picture text --> Insurance, Reinsurance, and Retrocessions<br>Reins u ra ct<br>/Insurance Cotracts\<br>t .Rlss .) . :Risks. .) (Rik.J<br><!-- End of picture text --> A reinsurance contract is essentially an insurance policy issued by one company -the assuming insurer or reinsurer - to another company, usually called the ceding company, primary carrier, or the direct underwriter. The ceding company is the insurer that underwrites the policy initially, and then later shifts part or all of the liability for coverage to a reinsurer by purchasing reinsurance. This reinsurance provides reimbursement to the ceding insurer for claims payments covered by the reinsurance agreement. It does not alter the underlying reinsured policies or the obligations created by those policies. However, it does provide protection to the ceding insurer against frequent or severe losses. Nonetheless, the ceding company remains obligated to pay policyholder claims without regard to its reinsurer's performance or financial condition. Typically, the policyholder has no direct claim on the reinsurer - i.e., the policyholder does not "look through" to the reinsurer as the source of indemnification.I IThere is currently some debate over the "look through" treatment of reinsurance. When insolvency of an insurer occurs, claimants of the insolvent company may wish to be able to collect directly from the reinsurer rather than see the payments from the reinsurer in respect of their claims become part of the pool of assets of the failed company that will be distributed among all its creditors. Claimants feel they should have a first call on those reinsurance payments since they are occasioned by their claims. This is particularly true of professional risk managers working with very large risks, who may insist on a "look through" agreement with assent on the quality of reinsurers. For example, he may want to insure a building for $7 million, but is aware that the insurer has capacity for only $5 million. He also knows that the additional coverage will be obtained through "facultative reinsurance" (discussed later), that the facultative reinsurance will apply specifically to his building and no others, and that he will be paying for this facultative reinsurance as part of his premiums. Asking for a "look through" clause would seem to be a wise thing to do. In some countries, all such "look through requests" have been denied by the Courts. In response to such denials, some insurance clients have used an alternative mcchanism that has similar effects by arranging for an "assignment" of reinsurance proceeds in favor of the ultimate beneficiaries. Insurance regulators have found that "look through" agreements and "assignments" pose serious questions of equity in the event of an insolvency. Instead of payments going to the insolvent firm, to be distributed equitably among the firm's

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