All You Need to Know About Reinsurance

What is Reinsurance and where in the Insurance Industry it fits in? Know all about it.

Demystifying Reinsurance

As the name suggests, reinsurance is the insurance of insurances. It is the insurance that an insurance company takes to limit their risk exposure and the amount of loss they could suffer in case of any kind of disaster. 

Reinsurance can help an insurance company to limit the amount of risk that it suffers, thereby indirectly protecting the customers as well. Thus an insurance company shares its risk or passes it on to other insurers by buying an insurance policy from them. This practice makes sure that no insurance company is exposed to ‘too much risk’ at any given point of time. In a typical reinsurance transaction, there are two parties. The insurance company buying the reinsurance policy is called the ceding company or the cedant. The company issuing the reinsurance policy is called the reinsurance agent or simply the reinsurer. The ceding company pays a reinsurance premium to the reinsurer and the latter agrees to pay an agreed portion of the claims made against the ceding company.

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Different types of reinsurance agreements

  • In a Facultative coverage, the protection is available to the insurance company against a specific risk or contract. If the ceding company has multiple risks, then those should be negotiated separately, or else the reinsurer has the right to deny the agreement.
  • Reinsurance treaty is applicable for a particular time and the reinsurance agent covers all the risks of the ceding company that may be liable for a claim during the tenure of the reinsurance treaty.
  • Proportional reinsurance is one where the reinsurer receives a proportion of the premium received by the insurance company and when claims are made, the scope of coverage will be up to that agreed proportion only.
  • In non-proportional reinsurance, the reinsurer’s duty to cover the claim arises only when the loss of the ceding company exceeds a certain limit. This limit may be based on a single risk or an entire business category.
  • Excess-of-loss reinsurance is similar to non-proportional reinsurance, except for the fact that it is specifically used in case of catastrophic events.
  • In risk-attaching reinsurance, the reinsurer agrees to cover the claims that are established during the agreed period. The date of occurrence of the loss is not considered.
  • Loss-occurring coverage, on the other hand, provides coverage to the insurance company for all losses that occur during a particular period.

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Why reinsurance is taken by insurance companies? We look at some of its benefits.

  • The most basic one is for transferring of the risk. It allows insurance companies to pass on risks greater than its size. The policyholder stands to get a higher degree of protection due to reinsurance. 
  • Reinsurance also helps the ceding company to absorb larger losses and reduce the amount of capital required for coverage. 
  • Reinsurance is one of the three things that an insurance company must do when it reaches its loss-absorbing limit. It has to say ‘no’ to new clients, increase its capital or buy reinsurance.
  • By going for reinsurance, the ceding company may end up earning some arbitrage as well. This will happen when they manage to land a reinsurance premium lower than the one that they are charging for the same risk.
  • Insurance companies sometimes prefer the services of reinsurers because of their expertise – be it their knowhow of a particular risk category or their rating ability.

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How does a Reinsurance policy work?

The clientele of reinsurance firms is almost entirely made up of primary insurers from all classes of insurance. And unless a claim affects the reinsurance agreement, the reinsurer's claim department consider day-to-day claims to be the responsibility of the primary insurer only. Reinsurer agrees to indemnify the insurance company and has no obligations against a customer's claim against the ceding company. 

Let's look at some of the scenarios which can be applicable in a reinsurance agreement.

Let’s assume that an insurance policy provides coverage of Rs.1 crore and has a premium of Rs.1 lakh. The insurance company enters into an agreement with the reinsurer for 75% of the coverage. Accordingly, 75% of the premium will be passed on to the reinsurer. The reinsurer may pay a ceding commission to the ceding company to cover the latter’s expenses and acquisition costs. Now, if there is a loss of Rs.50 lakh, the reinsurer will pay 75% of it. This is an example of facultative reinsurance on a pro-rata basis.

In the insurance policy mentioned in the above example, let’s assume that the insurance company also writes an underlying policy of Rs.1 crore. Now if the treaty retention limit per risk is 1.25 crore, the insurance company will have to reinsure the remaining 75 lakh which is beyond its retention. This is not a pro-rata arrangement, instead it is called non-proportional reinsurance, or excess of loss policy - depending on the nature of the risk covered. The premium, in this case, is not a simple proportional pass-on. Various formula guidelines, the underwriter’s risk evaluation, primary rates, market conditions etc. will influence the reinsurance premium.
 
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Reinsurance and the insurance industry

Reinsurance policies enable insurance companies to limit the loss appearing in their balance sheets and help them out with solvency. Thanks to reinsurance policies, insurance companies have been able to honour claims relating to a particular risk through sharing of the risk. Reinsurance has helped insurance companies not only to manage their risks but also to improve their underwriting practices. Reinsurance is equipping the insurance industry to face natural calamities and catastrophes in a better way. If the risk is not spread out enough, insurance companies can go bankrupt in the event of an earthquake or a flood. Reinsurers share this burden and cushion the blow in force majeure conditions.

In India, non-life insurance companies need to reinsure at least 5% of their portfolio with the General Insurance Company of India, the state-owned reinsurer. By ceding 5% of their gross written premium, the insurance company gets insurance against 5% of the risk. This is called obligatory insurance. Insurance companies also have the option of reinsuring beyond a minimum of 5% or opting to reinsure with overseas firms. The extent of reinsurance that an Indian insurance company goes for is also decided by the minimum solvency margin defined by the IRDAI. The IRDAI mandates that the insurer maintains a specified margin of assets over its liabilities. The agency also advices non-life insurance companies to carry out proper due diligence while entering into reinsurance contracts through brokers. Understand the difference between insurance agent and agent broker here. 
 

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