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What is a Reinsurance Trust?

Insurance is an important part of the business landscape. Commercial insurance products provide financial protection against loss, helping companies to weather a wide range of claims and to form the foundation of risk management practices. Traditional insurance is not always sufficient; in many cases, companies seek alternative protections like captive insurance to cover unusual or higher-than-expected risks. Even insurance companies themselves seek protection, and they may opt for a practice known as reinsurance. In this guide, we will explore reinsurance, particularly the concept of a reinsurance trust, with the goal of gaining a better understanding of this unique form of business protection.

What is Reinsurance?

In simple terms, reinsurance is a form of insurance carried by insurers to protect against the financial strains imposed by large insurance claims. Sometimes referred to as stop-loss insurance, reinsurance strategies share or transfer certain portions of an insurance portfolio to other parties, usually through some form of agreement. There are two parties involved in reinsurance:

  • The ceding party, or the company/party that chooses to transfer or diversify its insurance portfolio;
  • The reinsurer, or the party that accepts portions of the diversified portfolio in exchange for shares of any insurance premiums.

Reinsurance works by allowing insurers to recover part or all of the amounts paid to insurance claimants, thus reducing the liability on both individual and large or multiple risks. Companies that use reinsurance may also be able to increase their underwriting capabilities.

Structure and Benefits of Reinsurance

There are three major types of reinsurance, each with their own benefits. The three types are:

  • Facultative reinsurance – Protective coverage for insurers for a specific risk or contract.
  • Reinsurance treaties/Reinsurance trusts – Coverage for a specified period of time, contrasting with per-risk or contract-based structures. These treaties may be proportional, or when the reinsurer receives a prorated share of premiums, or non-proportional, where the reinsurer is liable for losses exceeding a pre-determined amount known as a priority or retention limit.
  • Excess-of-loss reinsurance – Similar to non-proportional coverage, this type of reinsurance covers any losses exceeding the insurer’s retention limit. This reinsurance is typically reserved for catastrophic events, including natural disasters, terrorism, or other large-scale claims.

There is one other reinsurance type that bears mention; this is known as a collateralized reinsurance transaction. This type segregates funds from other assets and provides a mechanism for releasing those funds in loss events. The funds remain available even if a particular market were to become insolvent. In addition, collateralized reinsurance transactions often release funds back into a market if no losses are recorded or if the losses are less than limits specified in the reinsurance contract.

Benefits of reinsurance include giving the insurer more financial security, allowing it to withstand financial hardships if a large number of claims or a single large claim were to be made. Reinsurance also improves flexibility, giving insurers the ability to cover exceptional losses with freely-available liquid assets if needed.

A Closer Look at Reinsurance Trusts

Perhaps the most common reinsurance framework is that of the reinsurance treaty or trust. In this model, there is an agreement between three parties: the grantor, such as a captive insurance entity; the trustee, or the entity that holds any transferred assets/premiums; and the beneficiary, or the entity that uses funds in the trust to cover any losses incurred.

In this model, the trustee is the most important party. As the custodian of trust assets, the trustee has several responsibilities, including:

  • Safeguarding deposited assets.
  • Accepting additional deposits of assets as needed.
  • Distributing assets as directed by the grantor or beneficiary.
  • Maintaining negotiability and withdrawal ability of deposited assets.
  • Monitoring assets through routine accounting and review procedures.
  • Arranging for tax return preparations as required.

When selecting a trustee – usually a bank or other financial institution – it is critical that the trustee is both capable of and experienced in the fiduciary duties that will be required of it to perform in this custodial role.

Third-Party Guarantees

In typical reinsurance transactions, the ceding party – such as a captive insurance company — and the reinsurer are responsible for managing their own obligations under the terms of the reinsurance contract. In some cases, however, this may not be enough to provide the level of security one or both parties is comfortable with. In these cases, a third-party guarantee may be desirable.

Third-party guarantees have several benefits in terms of security, including:

  • Better mitigation of credit risks, particularly against default or insolvency risks.
  • Direct right of action on the guarantee that is separate from the reinsurance contract or agreement.
  • Allows for smaller insurance entities to create larger reinsurance programs on a regional or national scale.

As captive insurance options grow for business owners throughout the United States and beyond, the concept of obtaining a reinsurance trust to cover excessive or unusual losses makes more financial sense. These flexible insurance arrangements provide a myriad of benefits and help to secure assets for coverage needs, regardless of risk exposure or catastrophic event.

About Caitlin Morgan Captive Services

Caitlin Morgan Captive Services provides clients with captive insurance solutions supported by years of experience in establishing the successful formation and implementation of a wide range of captives. To learn more about how we can help you, please contact us at (855) 975-4949.