REINSURANCE —MEANING, TYPES, IMPORTANCE AND RETROCESSION

Reinsurance is an arrangement in which an insurance company, known as the primary or ceding company, transfers a portion of its liability with another insurance company, known as the reinsurer. 

It is a contract in which the insurance company that originally underwritten an insurance policy transfers part or all of the potential risks associated with the coverage to another insurer.

Reinsurance is the ceding of all or part of insurance originally written by one insurer to another insurer.

The insurance company that initially writes the insurance is called the ceding company, cedent or primary insurer while the reinsurer( or assuming insurer) is the insurer that accepts part or all of the insurance from the ceding company.

The retention limit (or the net retention) is the amount of insurance retained by the ceding company for its account while the amount of insurance ceded to the reinsurer is called a cession.

Reinsurance

Reinsurance is essentially insurance for insurance companies. 

It is a form of insurance whereby an insurance company purchases insurance from another company to protect itself from the risk of large claims.

Reinsurance is a transaction that only takes place between insurance companies. It has nothing to do with private individuals.

Insurance firms use reinsurance to transfer risk to other parties, thereby reducing the chances of having to pay a large number of claims in the future.

Under a reinsurance contract, an insurer is indemnified against losses occurring on its insurance policies covered by the reinsurance contract.

Types of reinsurance

1. Facultative reinsurance: This is an agreement between the ceding company and the reinsurance company which covers a specific risk of the ceding company.

It's a method of risk reinsurance where risks are reinsured on an individual basis.

That is, a reinsurance policy is negotiated separately for each insurance policy that is reinsured.

That is, for each reinsured insurance policy, a reinsurance policy is negotiated separately.

Facultative reinsurance is usually written to cover specific risks, often an individual insurance policy.

Facultative reinsurance necessitates the creation of a new contract for new risk.

As a result, facultative reinsurance adds to the ceding company's uncertainty by requiring contract terms to be negotiated separated for each policy.

Facultative reinsurance also involves higher administrative costs as each risk is individually underwritten and administered.

2. Treaty reinsurance: This is an agreement between the ceding company and the reinsurance company that covers the ceding company's entire books of a specific business type.

Treaty reinsurance covers a large number of risks, usually all of an insurer's policies in a particular area that meets specified criteria

It is a reinsurance contract between the ceding company and the reinsurer in which the reinsurer covers a specified share of all the ceding company's insurance policies that comes under the scope of the contract.

Treaty reinsurance has the advantage of involving lower administrative costs as one insurance contract, applies to numerous policies.

Also, unlike facultative reinsurance which generates uncertainty for the ceding company, treaty reinsurance is, to a large extent, certain as the terms of the contract are known beforehand,

One important difference between facultative reinsurance and treaty reinsurance is that the former is usually arranged after the underlying policy has been written whereas the latter is usually written before the underlying policy has been written.

Advantages of reinsurance

1. Provides financial stability: Prudence requires an insurance company to manage and regulate its affairs in such a way that large losses do not endanger its financial stability.

Large losses can arise on high-value insurances of property/persons/profits. 

Similarly, a single event can produce a claim or series of claims of very high magnitude through accumulation.

In such cases, reinsurance provides financial stability to insurers by paying the reinsured portion of the loss.

In the absence of reinsurance, a single insurer would have been responsible for the entire loss.

2. Increases the capacity of the primary insurer to underwrite new risks: Reinsurance allows the primary insurer can transfer some of its risk exposure.

This transfer of risk allows the primary insurer to keep writing new policies as long as it can find someone to provide the required reinsurance.

3. Protect against catastrophes: Floods, hurricanes, and earthquakes are just a few instances of catastrophe risks that can't be covered by a single insurer.

If these risks are to be insured, they must be diversified (or spread) between numerous parties.

Catastrophes would force many primary insurers to become financially insolvent or impaired if they didn't have reinsurance.

The reinsurance market allows catastrophic risks to be diversified and, as a result, insurance can be created to cover catastrophic exposures.

As a result of the reinsurance market's ability to diversify catastrophic risks, insurance can be created to cover catastrophic exposures.

This is because when more parties are engaging in risk-sharing, there is more financial capital available to cover any losses that may occur.

To illustrate, consider an insurance company that sells insurance to a large number of households in a community.

If a natural disaster like a flood strikes the community, then the insurance company will be forced to pay a large number of claims at the same time, potentially bankrupting the company.

To avoid this kind of scenario, the insurance company may enter into a contract with another insurance company (reinsurer) to limit the size of claims it would pay.

4. The insurer gains from the reinsurer: When there is a reinsurer, the insurer also benefits.

The reinsurer may help the insurer with rating, underwriting, reserving, claims management and other aspects relating to the prudent writing of the direct business.

5. Assists in the absorption of new exposures: Reinsurance helps the insurer absorb newer risk exposures that may arise as a result of economic changes, changes in insurance methods, social changes, changes resulting from scientific development, and so on.

6. Protect solvency margin: A well-planned reinsurance program can ensure long-term profitability while also adhering to solvency requirements.

7. Income smoothening: By absorbing large losses, reinsurance can make an insurance company's income more predictable.

This is likely to lower the amount of capital required to provide coverage.

The risks are spread, with a portion of the cedent losses absorbed by the reinsurer(s).

Because the cedent losses are restricted, income smoothing occurs.

The income smoothing ensures that claim payouts are consistent and that indemnification expenses are kept to a minimum.

8. Arbitrage: In most cases, reinsurance allows the ceding company to purchase reinsurance coverage at a lower cost than the insured pays for the underlying risk.

9. Boost and expands insurance business: Reinsurance ensures that insurance company can accept a large number of risk knowing fully well that the total risk will be distributed among reinsurers.

Indeed, the presence of a reinsurance contract enables the primary insurer to consider an unusual proposal that he would not have underwritten if there was no reinsurance.

This boosts the insurance business and helps the insurance company expand its operation.

Related post

Retrocession

Related to reinsurance is retrocession, which is an arrangement whereby a reinsurer transfers risk that it has reinsured to another reinsurer

It is a situation where one reinsurance company transfer all or part of a risk to another reinsurance company known as the retrocessionaire.

Retrocession can be illustrated thus: Insurance Company A, reinsure insurance with Insurance Company B, who then reinsures the same with Insurance Company C.

In this case, Insurance company A is the ceding company, insurance company B is the reinsurer and insurance company C is the retrocessionaire.

Under a retrocession agreement, a reinsurance company transfer risk to another reinsurer for the same reasons that the primary insurance company buys reinsurance.

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Reinsurance is a contract between______


the insurer and the insured
The insured and the underwriter
The reinsurer and retrocessionnaire
insurer and reinsurer

see explanation

Reinsurance is a contract whereby an insurer transfer risk associated with it's policies to another insurance company known as the reinsurer.

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