How Reinsurance Premiums are Calculated?

The pricing of reinsurance policies i.e. the calculation of reinsurance premiums is a very complicated topic. The process is quite detailed and involves deep statistical analysis of huge volumes of data. The quality and quantity of this statistical data are very important for the reinsurers to ensure that they have determined the correct premium.

Incomplete or incorrect information could lead to wrong pricing, the effects of which can be disastrous. Under-pricing would cause the insurer to pay out more money in the form of claims than they receive in the form of premiums. At the same time, overpricing would make the reinsurance cover too expensive and result in the reinsurer becoming competitive.

In this article, we will have a look at some of the basic details which are taken into account while determining reinsurance premiums.

Reinsurance For Different Types of Treaties

Firstly, it is important to note that the pricing of reinsurance policies is heavily dependent upon the type of policy. This is because the type of policy determines the quantum of money which will have to be paid out. For example, when proportional reinsurance treaties are signed, the reinsurer agrees to pay a fixed proportion of the losses incurred by the insurer. As such, the insurer pays a ceding commission to the reinsurer which is almost equal to that proportion.

For instance, if a reinsurer is agreeing to pay out 20% of the total losses, they will receive about 20% of the premiums collected. On the other hand, reinsurance treaties which are based on the excess of loss method are quite difficult to price. This is because the reinsurer has to take into account the probability of a loss arising when payouts go beyond a certain predefined level.

Which Factors are Considered While Deciding Insurance Premiums?

Reinsurance companies need to take into account a wide variety of factors before they decide on reinsurance premiums. Details regarding some of the factors have been mentioned below:

1. Frequency and Severity: Reinsurance companies need to ensure that they are cash flow positive. This means that the amount of money they take in must be greater than the one that they have to pay out in the form of claims. This means that reinsurance companies need to figure out with relative accuracy the amount of money that they will have to pay out. This is generally done by predicting the frequency and severity of the claims which are likely to arise.

   Statistical models are used to determine this base premium that must be charged. This needs to be adjusted for a lot of other factors before the final premium which needs to be paid by the ceding insurer is arrived at.

2. Market Conditions: The reinsurance market undergoes market cycles. This means that the available capacity as well as the demand for that available capacity fluctuates quite frequently.

   When a natural disaster has taken place, most reinsurance companies will not have the excess capacity as they will be paying out claims. If a reinsurance company is able to underwrite more business during such a difficult market, they are likely to charge a premium for the same. This also needs to be taken into account while considering reinsurance.

3. Inflation: Inflation is an economic reality in today’s world. The reinsurance business is not immune to inflation in any way. Hence, a prudent reinsurer would like to estimate inflation as closely as possible and then include this estimate as a part of their pricing.

   The amount of reinsurance premiums collected and even the profitability of the reinsurer is highly dependent upon the inflation rate which is used in the calculation. Many reinsurance companies have built indexation clauses into their contracts to help them price the policies better. Details about indexation clauses have been mentioned in other articles.

4. The volume of Business: Just like all other businesses, reinsurance companies have to spend a lot of money marketing their services. Hence, there is a huge cost to acquiring a customer.

   Once the customer has been acquired, the reinsurance company incentivizes them to transfer all their business to the reinsurer. This is done by providing discounts that keep on increasing based on the volume of business that is being given by the ceding insurer to the reinsurer. The concept of economies of scale is as applicable in the reinsurance business as it is in any other business.

5. Claims Experience: It is common for ceding insurers to want a hassle-free claim process when they face a loss. Also, since they themselves have claim processes in place, they are better aware of how to evaluate these processes for effectiveness.

   Ceding insurance companies are willing to pay a small premium for a smooth functioning claims process. Hence, a reinsurer with a faster and more efficient process will be able to charge more.

6. Soft Factors: Last but not the least, there are many soft factors that need to be taken into account. For instance, the reinsurer has to take into account the underwriting standards of the ceding insurer. If they have poor underwriting policies and are not able to price policies correctly, then the losses are likely to spill over to the reinsurance company as well. There are other such factors as well which need to be considered while arriving at a reinsurance premium.

The bottom line is that the calculation of reinsurance premiums is a complicated activity wherein a lot of factors need to be taken into account and they must be converted into a mathematical equation so that they are factored in during the pricing process.