Basics of Reinsurance Pricing

Like primary insurance, reinsurance is a mechanism for spreading risk. A reinsurer takes some portion of the risk assumed by the primary insurer (or other reinsurer) for premium charged. Most of the basic concepts for pricing this assumption of risk are the same as those underlying ratemaking for other types of insurance. This study note will assume a knowledge of basic ratemaking concepts on the part of the reader. A major difference between reinsurance and primary insurance is that a reinsurance program is generally tailored more closely to the buyer; there is no such thing as the “average” reinsured or the “average” reinsurance price. Each contract must be individually priced to meet the particular needs and risk level of the reinsured. This leads to what might be called the pricing paradox: If you can precisely price a given contract, the ceding company will not want to buy it. That is to say, if the historical experience is stable enough to provide data to make a precise expected loss estimate, then the reinsured would be willing to retain that risk. As such, the “basic” pricing tools are usually only a starting point in determining an adequate premium. The Actuary earns his or her money by knowing when the assumptions in these tools are not met and how to supplement the results with additional adjustments and judgement. For the different types of reinsurance outlined in this study note, the basic pricing tools will be introduced in Section A, and criticisms and advanced topics will be introduced in Section B. Section A will include the methods generally accepted and standard throughout the industry. Section B will include areas which require the Actuary’s expertise but have not been solved to universal agreement. This study note will focus on domestic treaty covers. Pricing for facultative covers or international (non-U.S.) treaties will not be addressed explicitly, but may be viewed as variations on the same themes. Differences exist in accounting, loss sensitive features and the amount of judgement needed, but the underlying theory does not change. Finally, this study note will give numerical examples where needed. The numbers used are meant to illustrate the pricing techniques with realistic amounts, but in no way should be taken as recommendations for actual factors.