Definition of financial reinsurance

transaction of reinsurance under which there is a limit on the total liability of the reinsurer and future investment income is a recognized component of the underwriting process. This financial instrument incorporates the time value of money into the ceding process such that the CEDENT can reinsure its liabilities at a premium rate less than the true rate for the liabilities transferred (difference in the two rates to be made up by the investment income generated during the years the reinsurance contract remains in force). Financial reinsurance can be used effectively in several situations:

1. surplus relief( quota share reinsurance)- ceding companytransfers a percentage of its book of business to the reinsurer (the reinsurer will limit its total liability under any one contract).
2. portfolio transfers-ceding company transfers reserves on known losses to the reinsurer in exchange for premiums equal to the present value of the future claims experience.
3. retrospective aggregates-ceding company transfers reserves on known losses as well as Incurred But Not Reported losses (IBNR).
4. prospective aggregates-ceding company pays a premium on a prospective rating basis to the reinsurer. In exchange, the reinsurer is obligated to pay future losses incurred by the cedent. If these future losses are less than expected, the cedent will receive the underwriting gain. Any gains from investments and fees will be retained by the reinsurer. Through this mechanism, in essence, the cedent gains current capacity for writing additional business by borrowing against income to be received in the future.
5. catastrophe protection-coverage against shock losses is provided by spreading the payment of such losses over several years.