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Published 6/1/2010
Thomas B. Fleeter, MD

Understanding reinsurance

Protection for the companies that protect you

Everyone understands the basic principle behind insurance. Individuals or groups reduce their financial risk by pooling their money with others who have a similar risk. When a loss occurs, a large fund is available to offset it.

Similarly, insurance companies are faced with the problem of how to make the law of large numbers work to their advantage. Most insurance companies use their reserves to provide a significant source of revenue as investment income. Any unexpectedly large loss would interfere with that income stream, and having to pay the full amount of every claim could affect the company’s ratings and even its ability to stay in business. For that reason, nearly every large insurance company buys “reinsurance” coverage.

Reinsurance coverage helps to stabilize expected results, strengthening the primary insurer’s financial situation and protecting against catastrophic losses. In its simplest form, reinsurance, sometimes known as secondary insurance, indemnifies the primary insurer for a portion of losses sustained beyond a certain limit in exchange for a premium payment.

Reinsurance requires large amounts of money. Most risks requiring secondary insurance are too big for any one company to underwrite alone. As a result, a worldwide marketplace has developed to share these risks. Although any insurance company can technically write reinsurance, a small group of companies—including Lloyds of London, Swiss Re, Berkshire Hathaway Re, Hartford Re, and Everest Re—dominates the reinsurance market.

Reinsurance rates are not regulated but are negotiated. In 2007, primary insurance companies collected $861 billion in total premiums while reinsurance companies had total premiums of $96 billion. Reinsurance intermediaries assist the primary insurers in obtaining high-quality, low-cost reinsurance. With their broad access to reinsurance companies, intermediaries serve a valuable role in shopping the market for the most competitive rates and negotiating reinsurance contracts. Typically, a reinsurance broker is paid a percentage of the premiums to locate willing reinsurers and help negotiate the rates and terms of the reinsurance policy.

Types of contracts
There are two types of reinsurance contracts: treaty and facultative. In treaty insurance, the reinsurer accepts a specific level of risk from the primary insurer. The primary insurer must cede and the reinsurer must accept all risks that fall within terms of the agreement. Treaty insurance is a partnership in which the insurer and reinsurer share risks at an agreed-upon level.

Risk sharing under a treaty reinsurance contract may be determined in two ways. Under a quota sharing arrangement, the primary insurer and reinsurer share in the premiums and losses of every policy on a fixed percentage basis. Under a surplus sharing arrangement, the insurer selects the amount of risk at or above a minimum retention level and covers all claims to that level. The reinsurer then covers the remainder of the claim payment up to a predetermined limit. Premiums and claims are not shared proportionally.

In facultative reinsurance, the primary insurer identifies which risks it wants to cover and which risks are ceded to the reinsurer. This type of reinsurance is less common because each policy is offered and considered on an individual risk basis. Facultative reinsurance normally is purchased by insurance companies for individual risks not covered by their reinsurance treaties, for amounts in excess of the monetary limits of their reinsurance treaties, and for unusual risks. Each facultative policy issued delineates the terms of each risk that is reinsured.

Reinsurance and medical liability
Reinsurance cost is a significant portion of each physician’s medical liability premium. Although the exact percentage of the cost of reinsurance compared to the total premium varies by state and specialty, reinsurance costs can exceed 50 percent of the premium. Because reinsurance covers losses above a specified threshold, the size of a medical liability judgment can have a major impact on premiums. The publicity that attends the largest jury verdicts can result in price shocks, leading insurance actuaries to make worst-case projections.

Securing reinsurance is a key factor in the success of all medical liability insurance companies, especially those that self-insure or use risk retention groups. To secure reinsurance coverage, a personal visit to the headquarters of the medical liability reinsurance company is required. Prior to the visit, the insurer must submit a listing of medical liability losses, a description of the medical liability market in the service areas, and a business plan. Reinsurance syndicates control billions of dollars and carefully select where to invest their funds.

Reinsurance plays a critical role in the stabilization of the insurance market. Although catastrophic losses and declining investment income have contributed to rising rates, medical liability losses have been a primary driver of increasing medical liability reinsurance premiums, which are passed along to the physician in higher medical liability premiums. Stabilizing the medical liability environment would result in decreased reinsurance costs and help lower individual premiums as well.

Thomas B. Fleeter, MD, is a member of the AAOS Medical Liability Committee. He can be reached at bonedock@comcast.net

Editor’s Note: Articles labeled Orthopaedic Risk Manager are presented by the Medical Liability Committee under the direction of contributing editor S. Jay Jayasankar, MD. Articles are provided for general information and are not legal advice; for legal advice, consult a qualified professional.

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