REINSURANCE – What is it? [Complete Guide-2019]

What Is Reinsurance?

Reinsurance is a risk-reducing tactic where insurance companies of different fields purchase insurance policies together to cut down their own loss when a case of disaster happens. This is better worded as “insurance for insurance companies” by the Reinsurance Association of America. The point of this is so that no particular insurance company faces a huge loss or has too much exposure when a disaster strikes.

What is Reinsurance
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How did Reinsurance begin?

The beginnings of reinsurance can be traced as far back as the 14th century, as stated by the Reinsurance Association of America. It was used as insurance for fire and marine. And the rest, as they say, is history, as they have covered almost every aspect of the new insurance market.

How Reinsurance Works

An individual insurance company can gain clients, by spreading the risk factor. They can take in companies which would have a huge burden on them, being a single insurance company, when a disaster comes their way, and they cannot handle the risk alone. When reinsurance is taken into account, the companies who paid for the premium, those shares are usually shared among all the companies of the insurance that were involved.

If only one company rakes the entire risk on its shoulders, then the cost of their bankruptcy would be too much for them to handle and it would financially ruin them. The company’s insurance would not be enough to cover them for the loss that the original company suffered that paid for the premium for insurance.

For instance, let’s take in an incident for consideration – a massive storm in the state of Odisha that has caused immense damage and will cost lots of money to set everything right. If one company had taken the job to provide insurances to all homeowners, then the chances of the company being able to cover for their losses would be highly unlikely. So, instead of one company taking the risk, multiple companies come together, so that the cost of the risk is spread out among other insurance companies.

Reasons why Reinsurance is purchased

There are four primary reasons why reinsurance is bought by insurers. To cut down on the liability for a specific risk to not face too much damage, to even out the loss experienced by a company, to protect themselves and the insured companies against risk, disasters and catastrophes, and the last reason is to increase their capacity. Reinsurance can help a company by keeping these factors in mind –

Arbitrage–The extra profits that the companies gain by buying insurance from elsewhere in paying less than those of the premium that the company get from the policyholders, those funds can be used to help save whatever has been damaged in the disaster.

Risk Transfer– The risk factor greatly reduces as the company shares it with other companies. And also, this sharing helps to free up additional capital.

Expertise– The experience and knowledge of a fellow insurer can help the company get premium.

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Anum Yoon is the founder and editor of Current on Currency. She loves all things personal finance, which is why you'll find her work all over the PF blogosphere.