"Reinsurance is defined as insurance for the insurer"
It is a kind of an arrangement where the reinsurer bears a part or a portion of risk covered under a policy issued by the insurance company.
One of the world's leading Reinsurance companies, Swiss Re defines that "Reinsurance is the transfer of part of the risks that a direct insurer assumes by way of an insurance contract on behalf of an insured, to a second insurance carrier, the reinsurer, who has no direct contractual relationship with the insured."
The insurance company pays a part of the premium to the reinsurer in return for risk-sharing, i.e., the reinsurer will then pay a part of the claim made, the amount to be paid by the reinsurer being determined by the type of reinsurance arrangement it involves into.
The main purpose that the concept of reinsurance serves is to mitigate the risk for the insurer. The insurer insulates itself from the risk of larger claims increasing its ability to withstand in case of unusual events. Also, by taking out reinsurance, the insurance companies' losses are limited, arising income smoothing and caps costs.
The companies which seek reinsurance are known as ceding companies.
An insurance company still needs to maintain sufficient reserves, even after being into reinsurance arrangements.
Reason of need for reinsurance
To transfer the Risk: Reinsurance allows the ceding insurance company to take risks that are greater than its capital size. As an example, if the XYZ insurance company's maximum risk-bearing capacity is $100M, but if the company gets a proposal of a $150M policy then if the XYZ insurance company rejects the policy it could be a wrong decision for the company's growth and reputation. Reinsurance allows transferring the portion of the risk.
To make Income smoother: If the company has larger losses portfolios in the sheets, it may cause an unexpected huge loss. By Reinsurance, the company can absorb larger losses.
To diversify the portfolio: The insurance company can manage its portfolio by taking Reinsurance. This means that investors should not worry about their money and returns. By taking Reinsurance, the insurance company can manage its pre-defined portfolio of risk in case of larger policies.
Types of Reinsurance:
Facultative versus treaty reinsurance
Facultative Reinsurance: This is the type of reinsurance, in which the insurer can freely choose the individual risks he wants to offer to a reinsurer.
Treaty Reinsurance: In the Treaty Reinsurance, an entire portfolio of an insurer got reinsured (Automatic Reinsurance).
Proportional versus non-proportional reinsurance
Proportional Reinsurance: Direct Insurer and Reinsurer divide the premiums and losses between them at a predefined ratio.
Non-Proportional Reinsurance: In this type of Reinsurance, the reinsurer defines a tranche of the risk. i.e, If the XYZ insurance company takes a Non-Proportional Reinsurance in which the company bears the loss till $5M, but if the loss exceeds $5M then the exceeded amount will be bear by the Reinsurer.
Scenario 1: If the policyholder reported a claim of $3M, then XYZ will settle the full loss.
Scenario 2: If the policyholder reported a claim of $7M, then XYZ has to give $5M and the excess amount ($2M) will be settled by the Reinsurer.
Written by: Kritika Khandelwal
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Contributor: Kalpesh Agrawal (Actuarial Intern - IIB)
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