Updated July 15, 2023
Definition of Reinsurance
Reinsurance is a strategy employed by insurance companies wherein the original insurer (the ceding company) obtains insurance coverage from another insurer (the reinsurer). The primary purpose is to minimize the potential impact of large claims, thereby safeguarding the financial stability of the ceding company in the event of significant risk events during the claims period.
- Before understanding reinsurance, one should understand the meaning of insurance. Insurance means the insurance company provides an assurance of compensation to the insured person in case of loss or damage or death, or any other disastrous event happening to the insured person & against such assurance. The insured persons pay the premium.
- If the insurance company feels that the event will occur in the claim period & the insurance company will have to bear the full amount of the claim (high quantum enough to wipe the entire reserves of the insurance company). So as to avoid such a situation, the insurance company, in turn takes insurance from a big insurance company (obviously which has the capacity to fulfill the claim) to compensate in case of the occurrence of the event.
- In the insurance sector, such reinsurances are common, so do not pass on the insurance business to the competitors.
- The Company taking such insurance is called a “ceding company,” & the company which provides assurance is called a “reinsurer”.
Objectives of Reinsurance
- Distribution of risk to ensure the coverage of a claim.
- It provides great stability for underwriting during the period of the claim.
- The insurance company outsources the financial obligation beyond its capacity to another company with such capacity, leaving the ceding company with only the financial obligation it can fulfill.
- Earning premium on the net amount.
- The insured person must coordinate with only one insurance company to satisfy their claims.
- Another objective is to increase the capacity of risk exposure.
How Does it Work?
- The insured person enquires with the ceding company (i.e. the main insurer) for an insurance policy specifying all the information. The main insurer informs the insured person about the claim amount & insurance premium to be paid, along with the frequency of payment required. Thus, the main company assumes the risk involved in the policy.
- Once the main insurer enters into the main insurance contract, it agrees with another insurance company (referred to as a reinsurer) to assume a portion of the risk, along with a proportionate premium. If the parties enter into the agreement, it is called “reinsurance.”
- The respective insurance companies profit from the premium amount paid in case no such event occurs during the period of insurance.
- However, in case the event occurs, the main insurer will pay the entire claim amount & will get the proportionate amount reimbursed from the reinsurer.
Example of Reinsurance
ABC Inc has a hub of factories all over the country. It carries the risk of damage to the factories due to any act beyond their control. It wishes to take insurance from insurance company A. Company A assumes the risk & receives a premium of $ 5 crores. Company A considers the proposal to be riskier & hence already entered with Company B for 60% reinsurance. Now, Company A will pay Company B $ 3 crores for the reinsurance risk assumption in such a case. After a few years, if the risk triggers, Company A will first recover the 60% claim amount from Company B.
Types of Reinsurance
1. Treaty Reinsurance
- This type of reinsurance covers the insurance based on the nature of the policy. This means that all policies of similar nature are covered, even though someone may not specifically refer to a policy.
- This type of reinsurance specifies the qualification criteria. If such a criterion is met, all such policies get reinsured automatically. The Treaty reinsurance is further divided into two sub-categories, namely, pro-rata reinsurance & excess of loss reinsurance.
- Pro-rata reinsurance (also known as quota share) means the proportional risk assumed by the reinsurer. In respect of such proportion, the reinsurer assumes the proportional risk.
- Excess of loss reinsurance protects losses above a certain predetermined level. If we protect a single event, we refer to this type as “per occurrence” reinsurance. If we protect all losses that may occur during a specified period, we call it “aggregate” reinsurance. In the case of protection for individual-specific risk classes, we refer to this type as “per risk” reinsurance.
2. Facultative Reinsurance
- In this type of reinsurance, the reinsurer takes reinsurance for specific types of risk rather than reinsuring the entire policy.
- However, such a type of reinsurance demands a due diligence process in case of the occurrence of any claim.
- Thus, such reinsurance is always subjective.
Reasons for Reinsurance
- Premiums are known in an insurance contract, but the claim amount is uncertain.
- It helps reduce the insurance company’s liability and improves its financial position by strengthening its balance sheet.
- By transferring a portion of the risk to a more capable insurer, reinsurance allows the main insurer to manage its capital and avoid significant losses when claims become payable.
- Involving another insurance company through reinsurance allows the main insurer to charge higher premiums, as it shares the risk and reduces the financial burden.
- Some states have strict regulations on the number of policies issued for certain risk categories. When approaching the risk threshold, insurance companies may choose to transfer the excess risk, creating room for issuing more policies.
Functions of Reinsurance
- It helps the main insurer to grow or multiply in terms of the volume of premiums.
- Protects the main insurer from catastrophes occurring.
- Increases the capacity to assume more risks & to issue more policies.
- Provides great stability to the profits of the insurance business.
- Distribution of risk to big players.
- Assurance of claim settlement from big players.
- One of the main advantages is the diversification of assurance risk.
- The insurance funds are protected.
- It further encourages new underwriters.
- Reduces the number of deals that normally happens with co-insurance.
- Provides a limit on the quantum of liabilities.
- It further increases the goodwill of the main insurer.
- Thus, it boosts the insurance business.
- It provides stability to profits by reducing deviations.
- One of the main disadvantages is the sharing of premiums.
- Reduction of profits.
- More cost to the insured person
- Length process of settlement of claims.
- Reduction in the growth rate of profits.
Every person on this globe carries a certain form of risk. Everyone wants to get insured. Then why not the insurance company want to get protected? It works on the said principle. However, one should note that reinsurance accelerates the risk-taking capacity of the insurance company.
This is a guide to Reinsurance. Here we discuss the introduction and how does reinsurance work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –