The Basics of Reinsurance

Insurance is a tool which helps individuals protect themselves and diversify their risks. The concept of insurance is based on the fact that the risks will only affect certain individuals during a given period of time. Hence, if money is pooled by all individuals and paid out to a few, the risk can be mitigated. The problem is that in case of catastrophe events, the risks may affect all individuals within a certain area. Therefore, all individuals will claim and ask for reimbursement from their insurance company. Such a situation is likely to bankrupt the insurance company. If the company becomes bankrupt, some policyholders may not receive their claim. This will break their trust in the concept of insurance. To prevent this from happening, reinsurance is used.

Reinsurance can be thought of as an insurance policy for insurance companies. All insurance companies generally enter into reinsurance contracts with other insurance companies. As a result, they can themselves claim all or part of the losses that they face while paying claims to the customers. Reinsurance is an important pillar which brings stability to the field of insurance.

There are many types of reinsurance contracts that happen between insurance companies and reinsurance companies. Some of the important ones have been listed in the article below:

Risk Based Coverage

In this type of contract, the reinsurer only provides cover for certain pre-specified people, events or risks. For instance, if an insurance company wants to offload some risk related to floods it will have to draw a very specific contract with the reinsurer. Under this contract, the reinsurer will not cover damages that happen because of other causes such as earthquakes or fires. Hence, if an insurer wants to offload several different risks, they will have to draw up several different contracts with the reinsurance company. These contracts are cheap from the point of view of the insurance company. However, they are not very stable since the reinsurance company can choose to not renew the contract once the term ends.

Time Based Coverage

A time based reinsurance cover is like a general contract between the insurance company and the reinsurer. This is why it is also known as the reinsurance treaty. As per the provisions of this contract, a reinsurance company is legally bound to reimburse all or part of the losses incurred within a specific period of time. The underlying cause or the specific risk is immaterial. For instance, the reinsurance company will have to make good the loss regardless of whether it was caused by a flood or an earthquake. These types of contracts are more expensive as compared to risk based coverage.

Proportional Coverage

A proportional coverage contract is a type of contract which ensures that the insurance company and the reinsurance company work as partners. As per the terms of this contract, an insurance company has to pay a part of its premium received to the reinsurance company. For instance, if an insurance company collects $100 as premium, it may have to pay $40 to a reinsurance company.

In return, the reinsurance company promises to cover 40% of the claims that will be made upon the insurer. For instance, if the insurance company has to pay claims worth $80, then the reinsurance company will have to cough up 40% i.e. $32 while the balance will be paid by the insurance company.

It needs to be noted that the reinsurance company also has to pay an upfront commission to the insurance company. This commission is called the ceding commission. These costs are meant to cover underwriting and customer acquisition costs. This commission is also paid in the same proportion.

Simply put, the insurance company and the reinsurance company become 60% and 40% partners (in this case) respectively. Their assets are not merged but they are responsible for the claims and premiums in the said proportion.

Non Proportional Coverage

Many insurance companies do not want to have a full-fledged partnership with a reinsurance company. Instead, they just want to be covered in the event of a catastrophe. In such cases, they draw up non proportional coverage contracts. Under this contract, an insurance company pays a small fee to the reinsurance company to cover the losses if they go above a certain amount.

For instance, an insurance company may want to be covered it the total claims paid by it exceed $100 million per year. In such cases, the first $100 million in claims will be paid by the insurance company. Once, the limit is exhausted, any claims that are paid by the insurance company will be reimbursed by the reinsurance company.

There are several other types of reinsurance policies apart from the ones that are mentioned above. In some types of contracts, the date when the claim is made is vital. Whereas in many other types of contracts, the date when the loss is incurred is considered to be important.

The bottom line is that reinsurance is an efficient system which allows insurers to fulfil their commitments. Hence, if there is a big earthquake in Thailand and all of Thailand makes a claim, the insurers will still be able to pay out because they have reinsured themselves with companies that operate in other parts of the world where a catastrophe has not occurred.