What is Reinsurance? – Its Types and Functions

To secure a future, insurance is the ultimate answer that relieves financial burden in the case of unforeseen circumstances. Just like others, even insurance companies are prone to unexpected situations.

To keep them prepared for the future they insure themselves too. But, have you ever wondered how they do this? It’s through Reinsurance. What is Reinsurance, you ask? Here is the answer:

Reinsurance Meaning

In simple terms, Reinsurance refers to the insurance policy that is purchased by insurance companies to secure their interest and to make sure that they remain solvent. Solvency becomes an issue during extreme scenarios that results in major claims, like a natural disaster.

This is when Reinsurance helps the company to provide assistance even during extreme conditions. The main motive of the policy is to ensure that the insurance company incurs minimal losses and also grant it substantial time to recover from the losses.

For you to understand better, here is an example: In 1992, Florida was struck by Hurricane Andrew that caused damage of $15.5 billion. During this period, nearly seven insurance companies became insolvent as they were not able to pay the claim amount that resulted because of the disaster. To avoid this, being insured is not an option for insurance companies but more of a necessity.

Types of Reinsurance

There are mainly two types of reinsurance, they are as follows:

1.) Reinsurance treaty

When an insurance company enters into a reinsurance contract, it is known as treaty insurance. In a treaty contract, the reinsurer agrees to all specific risks pertaining to the ‘insured insurance company’. Usually, in such a contract, the company providing reinsurance tends to agree to all the kinds of risks mentioned. There are two types of treaty contract:

• Quota Share or Quota: In such a contract, the ceding company, keeps a certain percentage of risk to itself while the rest is transferred to the reinsurer. The percentage is fixed and mentioned in the contract.
• Surplus Insurance: Three factors that are considered here are: The percentage of risk that will be transferred; The utmost cover that the reinsurance company is willing to accept; The maximum loss factor.

2.) Facultative reinsurance

In Facultative Reinsurance, a single risk is covered. This allows the reinsurer the freedom to evaluate individual risk and proceed accordingly. The risk to be taken up is determined on the basis of the reinsuring company’s structure of profit. A facultative certificate is created in such agreements that mention the specific risk that is accepted by the reinsurer.

Functions of Reinsurance

There are several functions of Reinsurance that help a company in a plethora of ways. They are as follows:

1. Transfer of risk: The specific risk of a company can be shared with multiple other companies.
2. Capital management: By transferring or sharing the risk, companies can avoid huge losses.
3. Arbitrage: Profits can be obtained additionally by securing insurance which holds a lower premium than the amount that is collected from the customers by the company.
4. Expertise: A company can receive a high rating and premium by exerting the other insurer.