Reinsurance Explained: What It is, Concept, and Types
Reinsurance is an arrangement wherein an insurer (aka ceding company) opts for insurance from a reinsurance company to minimize potential losses tied to insurance issued by the former. Simply put, reinsurance provides a predetermined threshold of protection to insurance issued by the insurers. From home insurance to auto insurance, reinsurance covers a wide array of offerings, enabling insurers to operate seamlessly without wondering about imminent financial loss.
Reinsurance companies can render insurance to seeding companies facilitating one or more type of insurance. Just like insurance companies, reinsurance firms also fall under the IRDAI ambit, complying with specific guidelines concerning registration, management, policy issuance, claim settlement, etc. Let’s understand more about how these entities operate and what legal implications they attract.
Why Do Insurance Companies Need Reinsurance?
Sometimes insurance companies struggle to render required coverage against the policies. From financial crunches to unforeseen circumstances, there could be a number of reasons why that happened. The only viable solution to this pressing issue is a supply of supplementary or backup funds, primarily provided by the reinsurer against a treaty or a legal contract.
For example, if an insurance company fails to render a sum of 90 lakh rupees as a coverage amount for an insured property, the reinsurance company may intervene and pay a mutually agreed amount, be it 20, 30, or 50%, relieving the insurer from the extra burden. In a nutshell, reinsurer enables the ceding company to transfer financial risks to maintain solvency.
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Underlining the Types of Reinsurance
Reinsurance is broadly classified into four parts, namely:
Treaty
The treaty is a time-based arrangement wherein reinsurance companies agree to pay a certain coverage amount for a fixed timeline, let’s say a year or so, against losses due to major events. The reinsurance companies consider the predefined class of risks before figuring out how much they will pay and the tenure they will serve. The class of risks is formulated by a number of factors, including the premium involved, coverage threshold, etc. The amount might be dispensed based on the mutually agreed proportion.
Facultative
Under this arrangement, reinsurance provides a mutually agreed coverage amount to insurers against the specified risk. Unlike a treaty, the facultative is not a time-based arrangement, providing insurers flexibility to mitigate specified risks having a high potential of occurrence. Again, reinsurance has all the right to deny or agree to the reinsurance proposal.
Proportional
Under this arrangement, the insurer pays a prorated share of all policy premiums to the reinsurance company, based on which coverage amount to be paid by either party shall be evaluated. For example, the reinsurer may admit to accepting 30% of the premium for a policy offering 10 lakh of coverage to the insured. In case of a mishap when the insured applies for the claim, the insurer shall pay 70% of the coverage amount i.e. 7 lakhs rupees.
Likewise, the insurer shall pay the rest of the amount i.e. 3 lakhs rupees. This arrangement ensures risk diversification, enabling insurers to maintain solvency in testing time. If required, the reinsurer also compensates for expenses encountered by insurers for processing, business acquisition, and writing policies.
Non-proportional reinsurance
Non-proportional enables insurers to transfer coverage risk to the reinsurer once the loss surpasses a certain threshold, broadly known as priority or retention limit. Unlike proportional reinsurance, this arrangement does not allow for premium or loss bifurcation. The priority or retention limit is formulated based on the specified or entire risk category.
FAQs
- What is reinsurance in simple terms?
Reinsurance is when an insurance company gets insurance for itself from another company to reduce the risk of large financial losses. - Why do insurance companies need reinsurance?
Reinsurance helps insurance companies manage financial risks by providing backup funds or coverage when claim payouts exceed their capacity. - What are the main types of reinsurance?
The main types of reinsurance include Treaty, Facultative, Proportional, and Non-proportional, each with unique coverage arrangements. - How does proportional reinsurance work?
In proportional reinsurance, the insurer and reinsurer share premiums and claims in a predetermined ratio, diversifying financial risks. - What is the role of non-proportional reinsurance?
Non-proportional reinsurance steps in when losses exceed a certain threshold, helping insurers manage high-value claims without splitting premiums.
Conclusion
Having a reinsurance partner is a legitimate way of offsetting potential losses triggered by the policies. From empowering insurers to ensure operational continuity to maintaining solvency, reinsurance companies can offer several benefits to insurers that can significantly influence the insurer’s performance and lifespan. While having reinsurance is paramount, insurers must not forget to evaluate the risk threshold as it may also require underwriting policies.
Also Read: Know Everything About an Insurance Broker Registration
