Have you ever wondered how an insurance company will manage to pay its claims from customers if there is a major calamity wherein all are affected?
Just like how we insure our lives or property from unforeseen circumstances, insurance companies also insurance themselves to aid large payments that might be required to pay many customers at once.
Definition of Reinsurance
When one insurance company purchases an insurance policy from another company (reinsurer) to limit its losses, it is called reinsurance.
The reinsurer is its last resort to pay the claims made by customers if the premium collected is not sufficient to pay them off.
This will also protect the insurance company from becoming solvent.
Why is Reinsurance done?
The main reason is risk management. The insurance business is run on the probability that only a fraction of their policies issued will be claimed at a time. Due to this assumption, the total sum that is assured to all insurers is much greater than the net worth of the company.
Premiums collected is expected to help the company to pay off insurance claimed (assuming these will be limited) after providing for all losses.
But, in a bad year, if due to unpredictable occurrence of events resulting in a large number of claims, these cannot be covered just by premiums collected. This will put the company at the risk of insolvency. The company's net worth would be wiped off in an attempt to pay all its customers.
In short, reinsurance is an insurance policy for insurance companies.
Other reasons could include, to earn an additional income in case the premium collected by the insurer is more than what it pays to the reinsurer.
Reinsurance also has tax benefits for the company. It can also benefit from the reinsurer's expertise in the business of insurance, like in setting the proper rating and premium.
How does Reinsurance work?
The insurance company will pay premiums to the reinsurance company. The reinsurer will pay claims to some of the insured's customers when it cannot do so on its own.
The reinsurer can be a company that is exclusively in the business of reinsurance or it can be another insurance company where the companies are willing to share the risk with each other.
Types of Reinsurance
It means that each insurance policy is negotiated separately or the coverage is provided for a defined class of risks. These are usually purchased for policies that have very high insurable value and the insurance company does not hold the capacity to provide it on its own.
Here a pre-negotiated agreement is made between the insurance company and reinsurer. In this, a specified share of policies is covered that fall under a specified class. This is more of an obligatory insurance opted by the company.