Reasons for Reinsuring

Reasons for reinsruance

You may ask – Why reinsure? Is my risk reinsured? Should I care? How does reinsurance benefit the insurer?

One of the best ways of handling risk is to spread the risk. So reinsurance by definition is insuring the insurance companies thus helping the insurer in risk spreading. This is done by taking to carry a certain percentage of that risk. This is a commercial service. So the reinsurance contract which is called reinsurance treaty contains reinsurance commission as well as detailed reinsurance terms.

The role of the reinsurer is same as the one of the insurer. When claims happen the reinsurers need to reimburse the part of the risk which they are carrying.

Insurance companies must spread their risk so as to remain financially strong. Reinsurance helps them to meet their obligations under any circumstances. Insurers reinsure for one or a combination of the following specific reasons:

To increase the insurer’s capacity to write business

Often insurance companies can not carry as much risk as they can sell. This can happen even to the biggest insurance companies but especially to the newly formed. So that they meet the insurance regulation for solvency they have to re-sell the risk and sign reinsurance treaties with reinsurers.

To maintain a proper reserve/liability balance

Under the terms of the Insurance Acts all insurers are required to maintain reserves for unearned premiums and outstanding losses. The reserves are in the form of investments. An insurer can experiences a large increase in underwriting volume with a resultant increase in premiums and losses. This can result that the insurer is without sufficient assets to meet the new reserve requirements. If insurer continues to sell without appropriate reserves the insurer could have its license to do business suspended.

One solution is for the insurer to reinsure a greater portion of new business. This will decrease its reserve requirements by transferring the liability to the reinsurer. Another alternative is to inject fresh capital into the business. The worst possible legal scenario is to cut off new business until the correct balance is achieved

To reduce the effect of a catastrophic loss

Reinsurance of natural disasters is very important aspect which helps local insurers a lot. Usually insurers work in certain geography – a city or a state. It can happen that big insurance companies have good brokers in some state and sell much more there.  When natural disasters hit this region the insurers which have better reinsurance process flow will be better prepared.

Every insurer is prepared to accept ordinary losses as a course of its business. Still in real life events like tornadoes, earthquakes, hailstorms, airline or marine disasters, and fires that can get out of control. They can destroy whole city blocks may seriously strain its financial resources of an insurer. Reinsurance on a catastrophe basis is available for such eventualities. This is an effective way of spreading risk among as many people as possible.

Actuarial mathematicians are preparing claims models every year for risks which are more predictable. For them a process of reinsurance optimization can be done. Such software solutions for optimal reinsurance help a lot with third party motor liability etc.

Since natural catastrophes do not follow a pattern it is more difficult to predict and to optimize the claims distribution. So it is a good practice to use XL treaties for CAT risks.

To provide stability in a fluctuating market

Reinsurance will not prevent underwriting losses, nor claims inspection costs. Still the reinsurance can smooth out the effect on the insurer’s results in any given year. Insurers plan and determine ahead of time how much they are prepared to pay out in losses under the worst possible loss scenario.

To enable an insurer to cease operations

This is the least risk related reason for reinsurance. It can happen and has happened in the past that an insurer wishes to withdraw from certain market. Maybe just for a segment. The reasons might be strategic and totally unrelated with bankruptcy.

To leave a market or market segment the insurance company must serve all business until it is run off. Also all the outstanding claims have to be settled. This could be a long-term and expensive process. An alternative solution is to reinsure the outstanding portfolio of business with another insurer. This is not reinsurance in the strict sense. This reason is merely a transfer of risk from one carrier to another

Source: C11 – Principles and Practices of Insurance

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