Reinsurance can be understood as simply insurer’s insurance. Under an insurance contract, a policyholder is protected from loss by transferring risk to an insurer; analogously, under a reinsurance contract, an insurer (the cedent or ceding company) is protected from exposure by transferring risk to a reinsurer. Insurers have an increasing demand for more financial capacity when underwriting catastrophic risks. The Cologne Reinsurance Company was the first professional reinsurance company, founded in 1842 following a catastrophic fire in Hamburg the same year. For over a century, reinsurance has been the preferred vehicle to shed primary insurers’ catastrophe risk exposure. For example, reinsurers paid primary insurers 60 percent of the insured losses from the September 11 terrorist attacks, 65 percent from Hurricane Katrina, and 40 percent from Hurricane Sandy more recently.

With respect to catastrophic risks, reinsurance’s role takes several forms. Reinsurance can take a significant portion of the insured losses from primary insurers, diversify catastrophe risks globally, supply underwriting assistance, and regulate insurers’ behavior to promote risk mitigation. These roles often go beyond risk transfer and risk financing and expand to risk regulation to primary insurers. The former role has been discussed at length in the law and economics literature, but regulation by reinsurance has not been widely discussed.

In many respects, reinsurance expands to help solve catastrophic risk management issues through serving as an enforcer of compliance with government regulations and reinsurance contracts. A major difficulty with catastrophe reinsurance is moral hazard, a problem also encountered by primary insurance vis-à-vis policyholders. It is logical for primary insurers to change their behavior as soon as the risk is fully ceded to the reinsurer. As a private regulator, reinsurance provides incentives for the primary insurers to engage in mitigation and prevention of catastrophe losses, and thus reduce moral hazard. Reinsurance has a direct and significant impact on the business operation of primary insurance and even an indirect impact on the insureds, from contract design such as pricing, through underwriting and issuing of a policy, and ending with agreeing or refusing to pay for a claim.

There are four main tools that almost all reinsurers use to one degree or another to control moral hazard: (1) loss-sensitive premiums which requires that reinsurance premiums should reflect an actuarially fair cost and integrate into general techniques like deductibles, co-payments, and “ex post settling up”; (2) the duty of utmost good faith which is defined as the “most abundant good faith; absolute and perfect candor or openness and honesty; the absence of any concealment or deception, however slight” and helps reinsurers control moral hazard through “invisible” monitoring without high cost; (3) providing risk management service which can take several forms, such as entry into the market, product design and underwriting assistance, and claims processing; and (4) indirect regulation of insureds. By supplying both the incentive and the know-how that primary insurers often lack, reinsurance can provide value enhancing risk management.

However, regulation by reinsurance could have been qualified as problematic, due to catastrophe reinsurance underwriting cycles that may lead to reinsurance unavailability. The phenomenon of the underwriting cycle, which refers to the tendency of insurance markets to go through alternating phases of “hard” and “soft” markets. Hard markets are usually triggered by capital depletions resulting from underwriting catastrophic losses of unexpected magnitude. During periods of hard markets, there is often insufficient reinsuring capacity. For example, the hard market in the 1990s was caused by Hurricane Andrew (1992). The magnitude of losses from Andrew took insurers by surprise, and thirteen insurance companies even went bankrupt primarily as a result of capital depletions. After the catastrophe, prices of reinsurance increased for the 1993 renewals. It might be more costly for reinsurers to raise additional funds since capital providers cannot clearly separate performance into event losses and reinsurers’ skill in peril selection during hard markets. Furthermore, reinsurers may have market power, and supply shortages and high prices after catastrophes may occur because reinsurers have no incentive to increase their capital. By putting less money at risk and preventing new entry, incumbent reinsurers keep prices high.

Government-sponsored reinsurance, which marries the merits of both the government and private reinsurance, has gained increasing attention in the law and economics literature. Theoretically speaking, in the government-sponsored reinsurance program, private reinsurance could still conduct its business and play its role as regulation when underwriting primary insurer’s risk; meanwhile, the government does not provide reinsurance service for primary insurers but mainly support reinsurers through capital credit and thus avoid insufficient reinsurance supply during hard market. Compared with the capital shortfall of private reinsurers, the government can channel capital effectively and quickly after catastrophes since it can raise money through tax or borrow money by issuing debt or government bonds.

Government-sponsored reinsurance has increased substantially in practice, and many programs are often established when primary-insurance markets break down. Many countries use government-sponsored reinsurance to address catastrophe risks, including Turkey (Turkish Catastrophe Insurance Pool), Japan (Japan Earthquake Reinsurance Co.), and United States (Terrorism Risk Insurance Program and the Florida Hurricane Catastrophe Fund).

Take the Turkish TCIP for example. In 1999, Governmental Decree Law No. 587 on Compulsory Earthquake Insurance came into force and gave birth to the TCIP in the aftermath of the devastating Marmara earthquake. The TCIP is a public-private partnership. Insurance companies act as agents to the TCIP and cede 100 percent of all risks acquired to the TCIP, and they pay a commission from the pool. The TCIP transfers risks to international reinsurers through sharing pools under the management of international reinsurance companies, like Munich Re. The claims payment of the TCIP is dependent on international reinsurance and on the amount of funds collected (partially from the government). The first layer reinsurance arrangement under the mechanisms of the TCIP is the international reinsurers, which assume the transferred risks from the TCIP. The Turkish government provides contingent liquidity support when the payments of claims exceed the TCIP’s capacity. It could be regarded as reinsurance since it is the last resort. Therefore, the regulatory techniques of reinsurance include both international reinsurers and the Turkish government.

Since the business operation of the TCIP follows a market-oriented approach, and its underwritten risks are transferred to international reinsurers, it is reasonable for international reinsurers to charge loss-sensitive premiums to control the moral hazard of the TCIP. Loss-sensitive premiums require that reinsurance premiums should reflect an actuarially fair cost, and they constrain the TCIP to underwrite appropriately. Primary insurers act as agents to the TCIP, and the pool assumes all the earthquake risks. The duty of utmost good faith is not suitable for primary insurers. In contrast, the TCIP transfers risk to international reinsurers. From the perspective of international reinsurers, it requires the TCIP to perform the duty of utmost good faith. The organizational structure of the TCIP, to some extent, might guarantee its performance through public-private partnership. Reinsurers play an important role as consultants, especially in the conception of the TCIP. As a matter of fact, the TCIP was formed with the cooperation of the World Bank, the Turkish Government, Milli Re, reinsurance brokers, and Munich Re. International reinsurers play an important role in providing risk management services and contribute to the operation of the TCIP and catastrophe risk management in Turkey.

Currently, considering the reform of the Whole-Nation System, there is a pressing need for the Chinese government to provide reinsurance capacity as the new government-intervention approach. In 2014, China launched its first catastrophe insurance pilot in Shenzhen (“the Shenzhen Model”). The catastrophe insurance framework of the Shenzhen Model includes three different layers: the first layer is the government catastrophe insurance assistance, which is bought by the Shenzhen municipal government, with the beneficiaries being all residents of Shenzhen City; the second layer is a catastrophe fund mainly sponsored by the Shenzhen government and social donations; and the third layer is commercial catastrophe insurance. Affected parties of natural disasters, especially the catastrophe insurers, are demanding government sponsorship of their catastrophe losses in China.

There is little doubt that the government should provide reinsurance capacity as a last resort to catastrophe risk management in China. What is less clear is how to apply the proper regulatory techniques. The first two layers of the Shenzhen Model represent the social insurance protection. The third layer is related to private insurance and policies that could cover property damages. In the conception of the Shenzhen Model, reinsurers like the China Re, Swiss Re, and Taiping Re are involved. Therefore, reinsurance could and should play its role to control moral hazard of primary insurers and mitigate losses through relevant regulatory techniques.

The preceding post comes to us from Qihao He, S.J.D. candidate at the University of Connecticut, Insurance Law Center.  The post is based on his paper, which is entitled “Regulation by Government-Sponsored Reinsurance in Catastrophe Management” and available here.