Definition of Reinsurance
Reinsurance is a very famous tool that implies the insurance taken by an insurance company (i.e. the ceding company) from another insurance company (i.e. the reinsurer company) so as to reduce the risk of big claims which in effect protects the ceding company from insolvency in case of risk triggers during the claim 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 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 “ceding company” & the company which provides assurance is called “reinsurer”.
Objectives of Reinsurance
- Distribution of risk to ensure the coverage of a claim.
- It provides a great level of stability for underwriting in the period of the claim.
- The financial obligation out of the capacity of the insurance company is outsourced to another company having such capacity. Thus, the ceding company is left with only the financial obligation which it can fulfill.
- Earning premium on the net amount.
- The actual insured person has to 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 insurance contract is entered into, the main insurer makes an agreement with another insurance company (called as reinsurer) to assume a part of the risk along with a proportionate premium. If the agreement is entered into, the agreement is called “reinsurance”.
- In case no such event occurs during the period of insurance, the premium amount paid is a profit of the respective insurance companies.
- 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
Say, 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. In such a case, Company A will pay Company B $ 3 crores for the reinsurance risk assumption. After a few years, in case the risk triggers, Company A will first recover 60% claim amount from Company B.
Types of Reinsurance
Reinsurance can be divided into two categories.
1. Treaty Reinsurance
- This type of reinsurance covers the insurance on the basis of the nature of the policy. This means no exact specific policy is covered. But all such policies falling within the same nature are covered.
- This type of reinsurance specifies the qualification criteria. In case, the such 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 is where the losses are protected above a certain predetermined level. In case the protection is for the occurrence of a single event, such type is called as “per occurrence” type of reinsurance. In case the protection is for all losses which may occur during the specified period, such type is called an “aggregate” type of reinsurance. In such the protection is for individual specific risk classes, such type is called as “per risk” type of reinsurance.
2. Facultative Reinsurance
- In such type of reinsurance, the reinsurance is taken for specific types of risk rather than reinsuring for the entire policy as a whole.
- 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
- In an insurance contract, the amount of the premium is known but the amount of the claim is unknown at the time of entering into the contract. Thus, in case the actual event occurs, the insurance company is liable to pay the claim amount & such payment may exceed all the premiums received to date. Thus, reinsurance contracts are taken in order to have an upper limit on the quantum of loss that would be suffered in case the event actually happens.
- This reinsurance reduces the proportionate liability of the insurance company from its balance sheet & thus, it leads to restructuring or strengthening of the balance sheet.
- Due to reinsurance, a proportionate risk is transferred to a more capable insurer.
- It provides the main insurer a chance to manage the capital by avoiding losses in case the claim becomes payable.
- Since another insurance company is also involved, it can take up a higher insurance premium.
- Laws of some states may provide restrictions on the number of policies to be issued for a specific risk category. Insurance regulations are said to be very strict in terms of compliance with the law. Thus, the insurance company offers to transfer the risk in case they are about to cross the threshold of risk. Such transfer opens space for more policies to be issued.
Functions of Reinsurance
Some of the key functions of reinsurance are discussed below:
- It helps the main insurer to grow or multiply in terms of the volume of premiums.
- It protects the main insurer from catastrophes occurring.
- It increases the capacity to assume more risks & to issue more policies.
- It provides great stability to the profits of the insurance business.
- Distribution of risk to big players.
- Assurance of claim settlement from big players.
Following are the advantages given below:
- One of the main advantages is the diversification of assurance risk.
- The insurance funds are protected.
- It further encourages new underwriters.
- It reduces the number of deals that normally happens with co-insurance.
- It 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.
Following are the disadvantages are given below:
- 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? Reinsurance 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 –