Have you ever found yourself pondering how insurance company CEOs sleep at night knowing they have billions upon billions of dollars in property insurance values exposed to catastrophic losses at any given time? Ponder no more!

At Holmes Murphy, we and our clients operate every day in the “primary” commercial insurance market. We work with our clients to secure property limits often in the tens and hundreds of millions, or even billions, of dollars. More broadly, if you stand in the middle of any town or city and look around, or gaze down from your airplane window at the cities and towns below, every man-made structure you see is almost certainly insured. And as we all know, every so often, catastrophe strikes.

So, how do insurance companies manage this massive exposure? How do they continue writing business, even in “disaster-prone” areas? Like the structures you see in your city or town, or below you from the airplane window, those insurance companies too are almost certainly insured.

Transferring Risk With Reinsurance

Insurance companies can reinsure potential losses for nearly all lines of business including property, general liability, auto liability, etc. Because it is probably the most tangible and quantifiable example, I’m going to focus on two specific types of property reinsurance: treaty and facultative.

In both cases, the insurance company (cedent) cedes risk to the reinsurance company (reinsurer). The reinsurer agrees to assume that risk in exchange for a premium in the same way our clients transfer risk to insurance companies for a premium.

Treaty Reinsurnace

A reinsurance treaty is generally an annual contract between the cedent and the reinsurer where the reinsurer assumes a certain amount of the cedent’s risk on a book of business basis. The cedent and reinsurer agree to a set of guidelines within which the cedent will write policies for its customers, and the reinsurer will cover either a proportion of every loss on a percentage basis or will reimburse the cedent for losses above a certain threshold on an excess basis.

In a treaty arrangement, the reinsurer does not need to see every single transaction the cedent engages in; the cedent just needs to stay within the agreed upon underwriting parameters in the contract. This could mean capping limits for flood or earthquake at a certain amount, not writing a particular class of business (i.e. fireworks manufacturers), etc. The cedent’s book of business is typically subject to audit by the treaty reinsurer to confirm it is abiding by the treaty.

Facultative Reinsurance

Facultative reinsurance applies to individual risks, as opposed to a whole book of business, where the insurance company can decide to cede a portion of its risk to a reinsurer at the policyholder level. For instance, say a policyholder has $100M of values exposed in a wildfire zone across 10 locations (each valued at $10M). The insurance company is willing to accept the risk of a fire destroying four locations totaling $40M but would not be comfortable paying a loss greater than $40M. The insurance company can cede the remaining risk to a reinsurance company by purchasing facultative reinsurance in the amount of $60M, excess of the $40M of risk it retains, specific to the peril of wildfire for this individual policy holder.

To get even more granular, the insurance company can buy reinsurance on an individual location (called “spot fac”) when it wishes to cap its exposure for a particular building or campus. In a facultative reinsurance arrangement, the cedent often passes most or all its costs for purchasing reinsurance down to the policyholder in the form of additional premium.

Reinsurance Market Recovery

Reinsurance is a significant operating cost for insurance companies. Over the last several years the increased frequency and magnitude of catastrophic events, financial market volatility, inflation, and increased cost of capital have combined to make the property reinsurance market particularly challenging.

In 2022 and 2023, reinsurance costs for many carriers were increasing to the tune of 50% or, in some cases, even 100% annually. As a result, insurance companies were forced to either pay more for reinsurance or purchase less of it and retain the exposure themselves. With treaties operating behind the scenes on almost every policy an insurer writes, plus additional spend for facultative purchases, reinsurance has been a major factor in the perpetuation and continuation of the hardening insurance market.

Thankfully in 2024, we have begun to see far greater stabilization in the reinsurance market. In some cases, these costs are coming down. We are starting to see this stabilization trickle down into the primary insurance market as conditions are starting to improve. With a little luck in the weather department, this stabilization should continue so that policyholders fatigued by six years of rate hikes will finally get some relief.

Our Experts Protect Your Business

Anyone who runs a business or works in insurance knows risk management is one of the many keys to success, but knowing how to do it well can be intimidating. That’s where the experts at Holmes Murphy can help. We understand your organization’s unique needs and can design a plan that protects what matters most.

If you’re ready to chat about reinsurance or have questions about anything else in the world of Property Casualty, reach out today and let’s get started!