In the previous article, we have already studied what retention is and why it is important for many insurances as well as reinsurance companies. We are now also aware of the fact that some insurance companies tend to retain more risks on their balance sheet whereas there are others who pass on more risks from their balance sheet. The decision to hold on to risk or to pass it on to a reinsurer is not arbitrary. Instead, it is the result of a careful decision made after considering many factors.
In this article, we will have a closer look at some of the factors which influence the retention decision.
- Size of the Insurance Company: The size of the insurance company is a very important factor when it comes to retention ratios. Large insurance companies which have businesses spread across multiple geographies have a large portfolio. These companies are also known to be flush with capital.
Also, there are many investors willing to provide capital to these companies if they want to underwrite more business. Such companies tend to use reinsurance only as a means of transfer of risk and not as a tool to unlock capital. Hence it can be said that larger insurance companies have a higher retention ratio as compared to smaller insurance companies.
- Size of the Portfolio: Along with the size of the insurance company, the size of the insurance portfolio is also considered to be very important. For instance, it is possible that a very large life insurance company has a small motor insurance portfolio. The problem with small portfolios is that the risk does not get properly diversified.
It is a well-established fact in the insurance business that larger portfolios have a lower probability of loss as compared to smaller portfolios. It is for this reason that when insurance companies have a smaller portfolio, they cede their premiums to reinsurance companies so that the smaller portfolio can be merged into a larger portfolio.
- Diversification Within the Insurance Company: Insurance companies tend to have their own internal metrics and risk models. These models tend to be quite accurate and can make a reasonable prediction about the quantum of loss that is likely to be faced.
It is a known fact that diversification within the portfolio tends to lower losses. This diversification could be in terms of different lines of business or it could also be in terms of geography.
Insurance companies that have a well-diversified portfolio of risks tend to retain a higher percentage of risks on their balance sheet. On the other hand, insurance companies whose portfolio is not as well diversified tend to cede more risks to different reinsurance players.
- Availability of Additional Business to Underwrite: When insurance companies have an additional business that they want to underwrite, they tend to unlock their capital by reducing their retention rates and then increasing their overall capability to underwrite more risks. In such scenarios, insurance companies tend to cede more business to reinsurance companies.
On the other hand, if an insurance company feels that the primary market is saturated and that more underlying business cannot be obtained, then they are likely to retain more risk on its balance sheet. Insurance companies want to unlock capital only if they have an alternate use for the same.
- Continuity: The reinsurance business model is built on the premise of repeat business. More and more companies expect repeat business from their customers. At the same time, insurance companies also try to provide a stable base to the reinsurance companies. Any revision in the volumes of business takes place slowly. Usually, such revisions are upwards i.e. the insurance company decides to give more business to the reinsurance company.
Hence, continuity is a big factor when it comes to retention rates. Based on the existing trend, it can be assumed that insurance companies tend to keep their retention rate fairly stable unless some drastic changes are being made to their business model.
- Regulatory Limits: It is also important to understand that in many parts of the world, the decision about how much risk an insurance company wants to retain is not made only by the insurance company.
In many parts of the world, there are regulatory agencies that provide guidelines regarding the minimum as well as the maximum amount of reinsurance cover that an insurance company can undertake. This is done to make sure that the risks insured by the company do not face a credit default. Hence, regulators also have a significant influence over the retention ratio.
- Reinsurance Premiums: Last but not the least, the priciness of reinsurance premiums also helps in deciding the reinsurance rate. When there is a shortage of reinsurance supply, the premium rates tend to go up. In such a scenario, many companies find it effective to simply hold on to the risks on their balance sheets. However, when the premium rates are low because of excess supply, these same companies tend to cede most of the risks to reinsurance companies.
The bottom line is that a retention ratio is a complex number that is influenced by many different factors. Reinsurance companies need to understand all these factors in order to be able to make an educated guess about what the retention rate will be in the future.
View All Articles