Reinsurance, insurance for insurers, helps insurance companies to reduce the obligation of paying large claim amounts via some agreement of transferring risks to other insurance companies. The party that transfers or shares risk portfolios is the ceding party and accepts the obligation of sharing risks against a proportionate share of premiums is the reinsurer. Further, the article explains the advantages of reinsurance.
For example, there are two insurance companies X and Y. Rakesh, a policyholder, has taken life insurance from company Y worth ₹20,00,000. Moreover, he pays a monthly premium of ₹20,000. The principle of indemnity is not applicable in the case of life insurance because one cannot assess the value of human life in monetary terms. Therefore, the insurer needs to pay the entire sum assured (₹20,00,000) on the maturity of the policy or the death of the policyholder, whichever is earlier.
Maturity of policy or the death of a person is inevitable. Hence, the insurance company is under the obligation to pay the claim amount. However, company Y wishes to reduce its risk arising in future. Hence, it enters into a reinsurance contract with company X in the ratio of 1:1. Company Y retains ₹10,00,000 and reinsures the remaining ₹10,00,000 with company X. Similarly, the monthly premiums also get divided equally in the ratio of 1:1 between the two insurers. Y collects ₹20,000 from the policyholder (Rakesh) and forwards ₹10,000 to X. There is no role of the policyholder in reinsurance.
On maturity or death of the policyholder (Rakesh), company Y will collect ₹10,00,000 from X and contribute ₹10,00,000 of its own. Lastly, Y pays ₹20,00,000 to Rakesh or the beneficiary.
Reinsurance in India
From 1950 onwards, India saw rapid development in the insurance business. It was due to large scale economic development.
The growing business increased the requirement for reinsurance protection, especially in the foreign markets. Moreover, the government had to conserve foreign reserves. Hence, they initiated reinsurance operations accordingly. Let’s learn about the reinsurance advantages.
Advantages of Reinsurance
Reinsurance helps in accepting risks of complex nature, high value and concentration. Moreover, it helps to accept policy amounts beyond the financial capacity of the insurer and handle large losses together.
High-value insurance policies of property, persons, etc., can lead to huge losses for the insurance company. A single claim or series of claims of a large magnitude can lead to a huge cash outflow from the insurance company in form of a claim amount. Besides the individual risks, one event can lead to various risks. For instance, in case of an earthquake, flood, etc., a large number of policyholders will altogether claim property damages. Therefore, the insurer will have to pay many claims at one time. However, reinsurance avoids such nasty surprises and protects the financial stability of the company.
Stabilization of claims ratio
The fundamental of insurance is the spreading of risks. It means to pool risks from more than one source. The insurance companies try to distribute risks and losses of a few people among a large number of people. For example, an insurance company has 10,000 policyholders all over India. 100 policyholders living in Pune die because of a flood. It won’t affect the financial stability of the insurance company to a huge extent. The selling of insurance to varied locations and a large number of policyholders helps to reduce the burden of losses.
However, events like unexpected weather conditions, inadequate risk spreading, new technology, and social and economic changes like pandemics, terrorism, etc., can bring major fluctuations in claim ratios. In such cases, if there is no reinsurance, the insurance companies will ultimately increase the premium rates, as the premium to claim ratio gets affected. Therefore, reinsurance absorbs such fluctuations and helps them maintain financial stability.
Accumulation of claims under various classes
Many single events can lead to the accumulation of losses, affecting different branches of insurance. For instance, an earthquake in the eastern part of the country can impact huge areas. Hence, claims could arise from various insurance policies like fire, property, etc. Such events would affect the solvency of the insurance company. However, insurers can avoid huge losses if they have reinsurance.
Spread of Risks
The basic principle of insurance is to spread risks across any business class and geographical boundaries. Therefore, foreign insurance companies also become a part of the reinsurance business. Hence, reinsurance helps to spread risks within and outside the geographical boundaries of the country and across any business class.
Protection of solvency margins
In some countries, the government limits the net premium income of the insurance companies with respect to capital and reserves. It helps insurers pay sufficient dividends to the policyholders and retain reasonable profits to support the increasing assumption of risks. However, non-compliance to the ratios leads to government intervention. Therefore, reinsurance ensures the long-term profitability of the insurance company and compliance with solvency norms.
- Firstly, reinsurance helps to underwrite unusual risks and proposals.
- Secondly, reinsurance helps in sharing expertise on various aspects like technical, actuarial, underwriting, reserving, handling of claims, etc.
- Thirdly, reinsurance helps insurers to take up new risks arising from economic and social changes, scientific development changes, etc.
- Lastly, reinsurance acts as a catalyst between the ceding party and the reinsurers. It helps in communicating and sharing new forms of insurance, international experience, and technical suggestions.
To sum up, reinsurance has many advantages. Firstly, reinsurance helps to accept untested and new risks. Secondly, reinsurance increases the capacity of the insurer though he needs to restrict risk exposure to the level of resources available. The ceding party can transfer the risk that it cannot bear to the reinsurer due to financial constraints. Thirdly, it helps to spread and distribute the incidence of loss. Further, it helps stabilize net premiums and losses over a short period. It also helps the insurance company increase operating profits yearly as the reinsurer accepts part of larger and catastrophe risks. Lastly, it helps to control the accumulation of losses arising out of single and different lines of business.