Introduction

Insurance companies exist to fulfil their primary purpose: paying claims. To ensure their ability to meet these obligations, they must maintain a certain level of funds in reserve. Although it involves complex calculations, the basic principle is simple: insurers make predictions regarding the funds necessary to cover their customers' claims in the coming months.

When these predictions hold true, insurers operate smoothly by collecting premiums, settling claims, and allocating a portion for reserves and operational expenses. However, what happens when their predictions prove inaccurate?

The occurrence of major loss events, such as floods or wildfires, can result in billions of dollars in damages. Even if the burden is shared among multiple insurers, it remains a substantial financial burden. Insurance companies cannot feasibly keep hundreds of millions of dollars idling in bank accounts, awaiting natural disasters. Such an approach would require charging unaffordable premiums to their customers.

This is where reinsurance plays a crucial role.

What is Reinsurance?

In straightforward terms, reinsurance can be described as an insurance policy acquired by insurance companies. Its purpose is to safeguard the interests of these insurers and maintain their financial stability, particularly in situations where numerous significant claims may arise, such as in the aftermath of a natural disaster. By securing reinsurance, insurance companies ensure their solvency and ability to fulfil their obligations, even in challenging circumstances.

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What is the Purpose of Reinsurance?

The primary objective of reinsurance policies is to minimise potential losses for insurance companies and provide them with sufficient time to recover from any financial setbacks. When insurance companies choose to enter into reinsurance contracts, they effectively transfer a portion of the risks associated with their policies to another company. This risk transfer mechanism not only helps in mitigating potential losses but also provides insurance companies with a buffer to restore their financial stability.

Ceding company V/S Accepting Company


Insurance companies that choose to transfer their risk to other entities are commonly referred to as direct writers or ceding companies. On the other hand, the entities providing reinsurance policies are known as accepting companies, reinsurance agents, or simply reinsurers.

It is worth noting that not all insurance companies engage in reinsurance activities due to the substantial capital requirements involved, which exceed those of a typical insurance company. In the realm of reinsurance in India, notable participants include prominent entities like Lloyds of London and LIC (Life Insurance Corporation of India).

What are the Different Types of Reinsurance Agreements?

  • Facultative Reinsurance: Under this type of coverage, an insurance company seeks protection against a specific risk or contract. If the ceding company has multiple risks, each one must be negotiated separately, as the reinsurer has the right to reject any particular agreement.
  • Reinsurance Treaty: A reinsurance treaty is valid for a specified duration, and during this period, the reinsurance agent covers all the risks of the ceding company that may give rise to a claim. The treaty provides comprehensive coverage for the agreed-upon tenure.
  • Proportional Reinsurance: In proportional reinsurance, the reinsurer receives a portion of the premium collected by the insurance company. When claims are filed, the coverage extends up to the agreed proportion only.
  • Non-Proportional Reinsurance: In non-proportional reinsurance, the reinsurer's responsibility to cover a claim arises only when the loss incurred by the ceding company exceeds a predetermined limit. This limit can be based on a single risk or an entire category of business.
  • Excess-of-Loss Reinsurance: Similar to non-proportional reinsurance, excess-of-loss reinsurance comes into play specifically in the event of catastrophic occurrences. The reinsurer assumes responsibility for covering losses that surpass a predefined threshold.
  • Risk-Attaching Reinsurance: Under this arrangement, the reinsurer agrees to cover claims established during the agreed period, regardless of when the loss occurred.
  • Loss-Occurring Coverage: This type of reinsurance provides coverage to the insurance company for all losses that arise during a specified period.

It's important to note that these reinsurance agreements offer different levels of protection and coverage based on the specific terms and conditions outlined in the contracts.

What are the Different Types of Reinsurance Premiums?


There are two primary types of premiums that can be paid for reinsurance, as outlined below:

  1. Direct Premium or Original Premium: This premium is determined based on the percentage of risk transferred by the ceding company to the reinsurer. For example, if an insurance company wishes to transfer 40% of its risk to a reinsurer, the reinsurer will receive 40% of the premiums collected by the ceding company.
  2. Revised Risk Premiums: In this type of premium, the amount is not dependent on the premiums received by the ceding company. Instead, the reinsurer independently quotes a premium based on the level of risk coverage provided by the reinsurer.

Why do Insurance Companies Opt for Reinsurance?

Let's explore some of the benefits associated with reinsurance:

  1. Risk Transfer: Reinsurance enables insurance companies to transfer risks that exceed their capacity. By doing so, policyholders gain a higher level of protection due to the additional coverage provided through reinsurance.
  2. Absorption of Larger Losses: Reinsurance assists ceding companies in absorbing significant losses and reducing the amount of capital required for coverage. This allows insurance companies to manage unexpected or catastrophic events without jeopardising their financial stability.
  3. Loss-Absorbing Limit: Reinsurance is one of the three options available to insurance companies when they reach their loss-absorbing limit. They can either decline new clients, increase their capital, or opt for reinsurance to maintain their risk capacity.
  4. Arbitrage Opportunities: Ceding companies may benefit from arbitrage by obtaining reinsurance premiums lower than the premiums they charge for the same risk. This can contribute to increased profitability for the ceding company.
  5. Access to Expertise: Insurance companies often rely on reinsurance providers for their expertise, whether it's their in-depth knowledge of specific risk categories or their ability to assess and rate risks accurately.

Reinsurance serves as a strategic tool for insurance companies, offering them risk management solutions, financial stability, and the ability to provide enhanced protection to policyholders.

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How does Reinsurance Work?


Reinsurance has been a long-standing practice in the insurance industry and is extensively utilised across all sectors today. Its primary purpose is to distribute risk among multiple insurance providers and minimise losses during exceptional situations.

For instance, imagine a natural disaster striking a region where a single insurance company holds the majority of home insurance policies. If thousands of homes are destroyed or damaged, the company would face significant challenges in covering all the resulting claims.

However, through reinsurance, the insurance provider can access resources from other insurers to handle the losses, thereby avoiding insolvency. This arrangement not only safeguards the insurance companies themselves but also ensures that their clients receive the coverage they require.

Moreover, reinsurance allows insurance companies to expand their coverage capacity. By mitigating losses when claims are made, insurers can confidently accommodate clients seeking larger policy coverage. This capability is particularly valuable as it enables insurance companies to serve a larger clientele without the need for substantial increases in their capital reserves.

How does reinsurance affect your life insurance application?

While reinsurance agreements between insurance companies typically don't have a direct impact on individual insurance applications, they do influence the insurance market, which can indirectly affect application outcomes.

The primary impact of reinsurance on insurance applicants relates to its role in stabilising the insurance market by mitigating risk. Through risk distribution, reinsurance allows insurance companies to take on more policies without the need for significant increases in capital. This positions insurance providers to better accommodate higher-risk applications, ultimately improving the chances of coverage for insurance applicants.

Reinsurance also plays a part in determining premium rates. Reinsurance companies closely monitor global trends such as climate change and mortality data, as these factors can lead to increased claims. Based on these risks, reinsurance companies adjust costs accordingly, which then affects policy rates for consumers.

In some cases, when an insurance provider works with a reinsurer on a facultative basis, the processing time for an insurance application may be longer. Reinsurers have their own underwriting processes for each insurance policy, which can extend the application processing period. Additionally, since reinsurers have the option to assume only a portion of the risk, the ceding insurance company may need to seek additional reinsurers, further prolonging the processing time.

For example, if you apply for a life insurance policy and have pre-existing health conditions, your primary insurance provider may need to consult their reinsurer to assess the risk involved in insuring you. Consequently, your application may be approved, approved with a rating, or approved with exclusions based on the decision reached by the reinsurer regarding the risk associated with your pre-existing condition.

List of Major Reinsurance Companies Operating in India

The following is a compilation of prominent reinsurance companies that operate in India:

  • Lloyd's India
  • XL Insurance Company SE India
  • Hannover Ruck SE - India Branch
  • General Insurance Corporation of India
  • AXA France Vie - India Reinsurance Branch
  • Swiss Reinsurance Company Limited, India Branch
  • Munich RE - India Branch
  • SCOR SE - India Branch

Please note that these companies play a significant role in the Indian insurance industry.

The growth and development of reinsurance in India

  • Pre-nationalization: Before nationalisation, general insurance companies formed the India Insurance Corporation in 1956, which started obtaining voluntary quota share sessions from various member companies. In 1967, the Government mandated re-insurers to cede a minimum percentage of insurance premiums to the Reinsurance Corporation.
  • Post-nationalization: In 1972, the General Insurance Corporation of India (GIC) was established as a government-owned company. GIC held a monopoly in the Indian insurance market, acquiring 60% of premiums from Indian insurance companies and the remaining 40% from other countries.
  • Post-liberalization: Following the liberalisation of the reinsurance industry, the Insurance Regulatory and Development Authority of India (IRDAI) was authorised to regulate and control the Indian insurance business. Four subsidiaries were established: The New India Assurance Company Limited, National Insurance Company Limited, United India Insurance Company Limited, and Oriental Insurance Company Limited.
  • Recent changes: The General Insurance Business Nationalisation Amendment Act, 2002, came into force in 2003, ending GIC's supervisory role over the subsidiary companies. The ownership of the subsidiary companies was vested with the Government of India, making General Insurance Corporation of India the sole domestic reinsurance company.

These phases mark the progression and evolution of the reinsurance industry in India

Commonly used reinsurance terms

  • Risk transfer: Risk transfer occurs when an insurance company pays a reinsurance company to handle losses that exceed a certain threshold, effectively transferring the risk to the reinsurer.
  • Cedent: The cedent, also known as the ceding company, is the insurance company that transfers its risk to the reinsurance company.
  • Arbitrage: In reinsurance, arbitrage refers to the motivation for an insurance company to purchase reinsurance at a lower cost than the premium charged to the insured for the underlying risk.
  • Capital management: Reinsurance serves as a tool for capital management as insurance companies seek ways to manage risks and optimise profitability.
  • Solvency margins: Solvency margins indicate an insurance company's ability to meet unexpected costs. Reinsurance provides a layer of security, ensuring that insurance companies have the capital to honour catastrophic claim payouts without facing insolvency.
  • Expertise: Reinsurance companies often offer specialised expertise to insurance companies. This includes setting appropriate premiums for specific risks and providing guidance on risk management.
  • Retention: Retention refers to the maximum amount of risk held by the primary insurance company. When a loss exceeds the company's retention limit, it is passed on to the reinsurance company.

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Conclusion

In conclusion, reinsurance plays a vital role in the insurance industry by providing risk management solutions and enhancing the financial stability of insurance companies. By transferring risks to reinsurers, known as cedents, insurance companies can protect themselves from large losses and ensure they have the necessary capital to honour claims. Reinsurance enables insurers to optimise their profitability, manage solvency margins, and tap into specialised expertise. With a clear understanding of reinsurance and its terms like risk transfer, capital management, and retention, both insurance companies and policyholders can benefit from a more secure and resilient insurance market.