What is Modified Coinsurance and How it Works

A reinsurance contract is essentially a contract between a ceding insurance company as well as a reinsurance company. Under plain vanilla reinsurance contracts, the premiums, as well as risks, are transferred proportionately from the ceding insurer to the reinsurance company.

In some cases, this arrangement is not acceptable to one or both of the parties. In such cases, a modified coinsurance agreement is made wherein the premiums received as well as the reserves stay on the balance sheet of the ceding insurance company. This arrangement is known as a modified coinsurance agreement.

In this article, we will explain what a modified coinsurance is as well as the various implications of entering into a modified coinsurance agreement.

What is Modified Coinsurance?

During reinsurance, the ceding insurance company generally provides a percentage of the insurance premium to the reinsurance company. The reinsurance company then uses this money to buy a portfolio of assets such as stocks, bonds, etc to generate income from the premium amount received.

At the same time, a certain amount of money has to be set aside from the premium received. This amount of money is based on the statistical probability of a loss event taking place. However, both the investments and reserves are maintained on the books of the reinsurer in the event of plain vanilla reinsurance.

Now, when it comes to modified coinsurance, the reinsurance company does not keep the assets as well as reserves related to reinsurance premiums on its books. Instead, it asks the ceding insurance company to do so on its behalf.

The decisions related to the purchase of assets are taken by the reinsurance company. However, they are executed by the ceding insurance company. Hence, the ceding insurance company does not actually pay out the premiums i.e. there is no negative cash flow. Instead, they just internally transfer the money to an account that has been earmarked for future payments to the reinsurance company.

How Does Modified Coinsurance Work?

A modified insurance contract is quite similar to a traditional reinsurance contract. However, there are some key differences. The first similarity is that just like a traditional reinsurance contract, the reinsurance company is providing the ceding insurance company with coverage against certain unforeseen events.

However, in the case of modified coinsurance, the ceding insurance company does not pay the premium to the reinsurance company. Instead, it buys certain assets on behalf of the reinsurance company. These assets are generally purchased in consultation with the reinsurance company. However, it needs to be understood that even though these assets are held on the books of the ceding insurance company, their liability belongs to the reinsurance company.

The ceding insurance company holds these assets on its own books and also creates a reserve to offset possible payments that may arise in the future.

Now, the value of these assets may change periodically. The values may go up or down. The difference in the values accrues on the balance sheet of the ceding insurance company. However, in the end, it needs to be passed on to the reinsurance company. This can be done by using a modification adjustment. This means that the investment value is periodically adjusted. If the adjustment value is positive, then the ceding insurance company pays the reinsurance company.

However, if the value is negative, then the reinsurance company pays the ceding insurance company. It is important to note that the calculation of modification adjustment can be complicated. This is because a modification adjustment can have several components i.e. the change in investment value and the annual premium. Also, the composition of this modification adjustment may be impacted by several statutory factors.

Tax Implications of Modified Coinsurance

Modified coinsurance seems like a needlessly complicated strategy. However, it is generally deployed for tax reasons. Reinsurance companies obtain huge tax benefits by deploying this strategy. It is for this reason that the tax implications must also be understood.

It is important to understand that not all income generated by reinsurance companies is taxed at the same rate. The premium income generated by the reinsurance companies is generally taxed at a much lower rate as compared to the investment income generated by them. This is the case in almost all the countries of the world. Hence, if reinsurance companies can find a legal way to convert their investment income into premium income, they stand to save a lot in the form of taxes.

Modified coinsurance is a legal way to convert investment income to premium income. Reinsurance companies keep the investments on the books of the ceding insurer and access the gains via a modified coinsurance premium. This means that the annual premium is paid as well as the gains and losses are all considered to be premium income.

In some parts of the world, tax agencies do not condone the use of modified coinsurance. They do not prohibit the use of modified coinsurance. Instead, they have set up rules and regulations which govern how different incomes will be treated for tax purposes. This has been done with the intention of negative tax advantage which can be obtained by using the modified coinsurance strategy.

To sum it up, modified coinsurance is a moderately complicated strategy that is used in the reinsurance industry. The main purpose of using this strategy is to reduce the possible taxation which the reinsurance company may have to pay. This strategy is not widely used across the world.