What is Reinsurance: Types, Functions, How it Works, Advantages & More

What is Reinsurance

You must have heard of insurance. But much like assurance and reassurance, there is something known as reinsurance. 

What Is Reinsurance?

A reinsurance, in its most basic sense, is insurance for insurers. It is the process through which insurers minimise the possibility of paying high amounts of money, in case of an insurance claim, by transferring a part of their risk portfolio to other parties. 

But, to understand reinsurance better, let us first look at a more familiar term — Insurance. By definition, insurance means — “an arrangement by which a company or the state undertakes to provide a guarantee of compensation for specified loss, damage, illness, or death in return for payment of a specified premium.” (Oxford Dictionary) 

Hence, in case of an insurance claim, the insurer (ceding party) has to pay the compensation to the claimant, which in most cases is large sums of money. However, to minimise the risk of paying the entire amount by themselves, insurance providers opt for diversifying their risk by sharing it through another party (reinsurer). Which brings us to the question: How does reinsurance work?

How Does Reinsurance Work?

As mentioned earlier, reinsurance is a way for insurance agencies to reduce the risk of paying large amounts of money all by themselves. A reinsurance helps insurers stay afloat by recouping either part or all of the money they’ve paid out to claims. It also lowers the net liability and protects against large or numerous losses in a disaster. Reinsurance also helps ceding companies to expand their underwriting capabilities in terms of quantity along with the risk they may take on. 

Understanding with the help of an example:

Daniel Finance (DF) is a small electronic gadget insurance company with an annual turnover of over Rs. 60,00,000 collected through premiums. Recently, a hefty insurance claim was made to DF, owing to a huge fire in a client’s company building. The claim amount could have almost led the company to insolvency. However, to the company’s benefit, Daniel Finance had already used a part of the premiums received to purchase a reinsurance contract that would pay out part or entire claim (as per the contract) to avoid large losses. Therefore, Daniel Finance could split the claim with the reinsurer and keep the company afloat. 

Though it is important to note that legally, insurers are required to maintain enough reserves to pay all potential claims from all policies issued. Having a reinsurer can be looked at as protective gear, in place to avoid bankruptcy. 

Further, depending on the needs and demands of an insurance company, the contracts with a reinsurer can change. Sometimes, an insurance company might need a risk-sharing of either part of their portfolio, or the entire portfolio. Based on this, there are two types of reinsurers. 

Types of Reinsurances

The two primary forms of reinsurance contracts are — Treaty reinsurance and Facultative reinsurance. Each of these reinsurances caters to different levels of risk subletting. 

Treaty reinsurance

A reinsurance contract that involves an insurance business acquiring insurance from another insurer is known as treaty reinsurance. The cedent is the firm that issues the insurance and transfers all of the risks associated with a specific class of policies to the purchasing company, the reinsurer. 

Treaty reinsurances are contracts based on an understanding of premium sharing. It provides better security for the ceding insurer’s equity and more stability in the case of exceptional or major events. Treaty reinsurance is less transactional, and risks are less likely to be reduced.

Facultative

A primary insurer purchases facultative reinsurance to cover a specific risk (or a group of risks) in the business. This form of contract offers a beneficial edge to the reinsurance business, as it helps in reviewing individual risks. On the other hand, reinsurance provides the insurer with additional protection for its equity and solvency in case of extreme events, 

Facultative reinsurance agreements are considered to be long-term coverage between two parties as compared to treaty reinsurance. 

Depending on the form of agreement between the two parties, the reinsurance — treaty or facultative — can be further divided into two categories. 

Proportional reinsurance

The reinsurer receives a prorated share of all policy premiums sold by the insurer under proportional reinsurance. In the event of a claim, based on a pre-determined proportion, the reinsurer is responsible for a share of the losses. The ceding company is also reimbursed for processing, business acquisition, and writing costs by the reinsurer.

Non-proportional reinsurance

In a non-proportional form of agreement, the reinsurer is liable to pay if the insurer’s losses reach a certain amount, known as the priority or retention limit. As a result, the reinsurer receives no proportional part of the insurer’s premiums or losses. One type of risk or an entire risk category determines the priority or retention limit.

Functions of Reinsurance 

While the main function of any reinsurance company is to reduce the risk associated with the insurance claims. There are a few other functions that a reinsurance company performs. 

Income Smoothing

By absorbing big losses, reinsurance may make an insurance company’s results more predictable. This will very certainly lower the amount of cash required to offer coverage. The risks are spread out, with the reinsurer or reinsurers covering a portion of the insurance company’s losses. Because the cedent’s losses are restricted, income smoothing occurs. This ensures that claim payouts are consistent and that indemnification expenses are kept to a minimum.

Risk Transfer

The risk is transferred from the main insurance company to the reinsurer, which helps the insurance company manage portfolios better. 

Offering Expertise

In the case of a specific risk, the insurance company may desire to use the experience of a reinsurer, or the reinsurer’s ability to determine a suitable premium. In order to safeguard their own interests, the reinsurer will want to apply this knowledge to underwriting. This is particularly true in the field of facultative reinsurance.

Expanding Portfolio

The reinsurer helps insurance companies expanding their portfolio by taking over some part of the risk. This helps both the insurer and the reinsurer.

Assurance Of Claim Settlement

The involvement of a reinsurer also offers an assurance of claim settlement to the policyholders in case of a catastrophic event. 

Objective of Reinsurance

The objective of the reinsurer is very similar to that of any insurance provider. It gives the insurer the surety that no matter what happens, you are insured. 

Following are the objectives of reinsurance

  • Risk is distributed to guarantee that a claim is covered.
  • It gives a high level of underwriting stability during the claim period.
  • Financial obligations that exceed the insurance firm’s capability are outsourced to another company with the necessary resources. As a result, the ceding business is only left with the financial responsibility that it can meet.
  • Profiting from a premium on the net amount.
  • To settle their claims, the real insured individual must work with just one insurance provider.
  • Enhance the risk exposure capacity.

Reinsurance Advantages

Apart from the main risk-bearing advantage. Following are the main advantages of reinsurance. 

  1. Insurance funds protected: In the case of reinsurance, the insurance funds are protected and kept safe in case of any unforeseen claim. It also helps the insurance company manage their funds better.
  • Encourages new underwriters: Having reinsurance encourages insurance companies to have new underwriters. Which further leads to an increase and expansion in business.
  • It provides a limit on the quantum of liabilities: By sharing the risk, the reinsurance also helps in reducing the size and number of liabilities that any insurance company has to bear. Which also helps in bettering the operations of the said insurer.
  • It further increases the goodwill of the main insurer:  A reinsurer helps in building goodwill for the insurance company. The better the claim settlement, the better the business in the future as a rule. 
  • Stability to profits: With the addition of a reinsurer, profit is stable for insurance companies. 

Related Blog: Top 12 Advantages of Reinsurance

What Are Reinsurance Companies?

As discussed earlier, just as there are insurance companies that cater to the individual insurance needs of a person, reinsurance companies help protect the insurance companies from any kind of catastrophic loss. A reinsurance company functions through a procedure known as cession, a primary insurer (the insurance company) transfers policies (insurance obligations) to a reinsurer (the reinsurance company). Cession simply refers to the transfer of a portion of an insurer’s liabilities to a reinsurer.

Following this, just as individuals pay premiums to insurance companies, insurance companies pay insurance premiums to reinsurers. 

Reinsurance companies in India

There are a number of reinsurance companies in India, that offer reinsurance services to insurance providers.

  1. Münchener Rückversicherungs-Gesellschaft Aktiengesellschaft – India Branch (Munich Re- India Branch)
  2. Swiss Reinsurance Company Ltd, India Branch
  3. SCOR SE – India Branch
  4. Hannover Rück SE – India Branch
  5. RGA Life Reinsurance Company of Canada, India Branch
  6. XL Insurance Company SE, India Reinsurance Branch
  7. AXA France Vie – India Reinsurance Branch
  8. Allianz Global Corporate & Specialty SE, India Branch
  9. Lloyd’s India Reinsurance Branch
  10. Markel Services India Private Limited

Is Reinsurance A Good Idea

As we all know, insurance is a very well-known concept. However, reinsurance is not known by many. Reinsurance is a lesser-known component of the insurance sector, and it receives less attention, yet it provides investors with excellent profits and protection. Though the idea behind the two is the same, reinsurance offers protection to not just insurers but also policyholders in a way. Which is essential in the times now. 

With the pandemic causing uncertainty every day, diversified risk management is better than a single holding of portfolios. 

Difference Between Insurance And Reinsurance?

Insurance and reinsurance are important terms used in relation to financial protection. They may seem similar, but the meanings of these two terminologies are different. Insurance and reinsurance are terms used to define the financial protection of a person or company against risk. Both terms allow an individual or a company to transfer their potential loss to other companies in exchange for the payment of bonuses. Both terminologies serve to group probable risk; however, the probable risk is transferred in different ways. Let us understand the difference between insurance and reinsurance in detail.

Insurance can simply be defined as an act that compensates for someone else’s loss. While reinsurance is an act by which an insurance company contracts an insurance policy to protect itself from the risk of loss. 

Difference Between Insurance And Reinsurance Company

Just like the name suggests, an insurance company is a company that provides insurance to single (separately multiple) individuals. The relation is business to customer (B2C). The customer pays a premium to the company for the insurance policy, which can be later claimed to incase of an event causing loss of the insured object. 

In contrast, a reinsurance company is a business to business (B2B). It acts as an insurance provider to an insurance provider. The insurance company pays a premium to the reinsurer based on the contract details. 

Difference Between Reinsurance And Coinsurance

While, by now, you must already know what reinsurance is, coinsurance is an important term that you must know about. Coinsurance refers to the distribution of risk among several insurance companies. It is the participation of one or more companies to share the same risk. 

Difference Between Facultative And Treaty Reinsurance

 Facultative reinsurance is reinsurance for a single risk or a defined risk package that an insurance company shares with another company. Whereas under the treaty reinsurance contract insurance companies may assign all risks to a reinsurance company.

Summary

A reinsurance, in its most basic sense, is insurance for insurers. Like individuals need insurance for health, auto, life etc. Insurance providers need reinsurance to better manage their vast portfolios. A reinsurance contract not only helps insurance providers reduce their risk, but also helps them diversify their portfolio to expand their business. 

Our reinsurance brokers can help you find the right type of reinsurance company that can suit your needs and add leverage to your company. Through our online portal, you can now call or request a quote for the right reinsurance company. 

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