The purpose of reinsurance companies is to share risks with insurance companies. This risk-sharing can happen to different degrees. For instance, an insurance company may decide to cede its entire risk to a reinsurance company. On the other hand, the same insurance company could also decide to cede no part of its risk to the reinsurance company. These are both extreme ends of the spectrum.

In general, insurance companies tend to be somewhere in the middle. A percentage of the overall risk is generally transferred to the reinsurance company whereas the balance portion is assumed by the insurance company itself. Deciding how much risk needs to be transferred and how much needs to be retained on the books of the reinsurance company is a complicated task for the ceding insurance company.

The amount of insurance risk assumed by the reinsurance company is called retention. The retention ratio is an important concept in the reinsurance industry since it has an impact on many other aspects of the reinsurance business. In this article, we will have a closer look at what the retention ratio is and why is it important for any reinsurance company.

What is Retention in Reinsurance?

When reinsurance companies assume the risks of their customers i.e. the ceding insurance companies, they tend to look at many factors. Retention is one of the factors which is considered while such risk is being assumed. Retention is the amount of risk that the underlying ceding insurance company has decided to keep on its books.

The retention ratio tells the reinsurance company how confident the ceding insurer is about the quality of its portfolio. For example, if a ceding insurance company is trying to offload its entire risk, then it may be either strapped for capital or may know that the quality of its portfolio is not very good.

How is Retention Ratio Calculated?

There is no standard measure that can calculate the degree of risk which is being transferred from one party to another. It is for this reason that reinsurance companies around the world consider the percentage of premium ceded to be an accurate indicator of the risk ceded and therefore the risk retained. Whether or not this indicator is accurate is a completely different subject that has been widely debated around the world.

The amount of premium received by the insurance company as a result of underwriting various policies is called the gross premium. Out of this total premium, some amount of money is used to pay reinsurance premiums. The balance amount of money that is left after paying the reinsurance premium is called the net premium.

The retention ratio is calculated by dividing the net premium by the gross premium received. The idea is to find out the percentage of the overall premium which the company has decided to keep on its books. This premium is then considered to be an indicator of the overall risk that the insurance company has decided to keep on its books.

Issues With Retention Ratio Calculation

The retention ratio is calculated based on the method explained above. However, there are many experts in the industry who believe that this method is based on some unrealistic assumptions. Some of these assumptions have been listed below.

1. Assumption of Premium Being Proportional to Risk: There is an underlying assumption that if 40% of the premium collected has been passed on to the reinsurer, then 40% of the risk has also been passed on. This may not be the case in reality. This is because there is no linear relationship between risks and premiums. In fact, experts believe that the relationship between premiums and risks is completely non-linear. Therefore, this assumption is deeply flawed. Also, it is a well-documented fact that most insurance companies try to offload maximum risks to the reinsurer while passing on minimum premiums.

2. Assumes Similar Profit Margins: The profit margin is a component of the premium that has been collected. Hence, if we believe that premiums are directly proportional to risk, we are indirectly believing that the profit margins of the insurance and the reinsurance business are the same which is not the case. This information can be verified from the public financial records of insurance as well as reinsurance companies.

3. Assumes Similar Expense Ratios: The insurance premium has a component built in to offset the administrative costs related to the premium collection and providing other services. The proportion of these costs is higher for insurance companies since they have to provide services to a large number of customers. The administrative expense ratio is generally lower for reinsurance companies. However, the retention ratio assumes this ratio to be similar.

4. Economies of Scale: Another important point to consider is that the concept of economies of scale is completely ignored by this assumption. It is a known fact that reinsurance companies charge lower premiums as the scale of business grows. Hence, simply assuming that economies of scale do not exist because of the imagined linear relationship between premium and risk is not prudent on behalf of the reinsurance industry.

The fact of the matter is that the retention ratio is a very important metric in the reinsurance industry. It can be used to make some meaningful conclusions about the risk being transferred. However, it should not be considered to be a measure of the amount of risk which has been transferred between the ceding insurer and the reinsurance company.