Reinsurance, when utilized correctly with the right type, amount & price, can be a significant enabler for an insurer in many ways.
When done incorrectly, at best it may be suboptimal from a profit perspective, at worst it can lead to the insurer going insolvent.
What is reinsurance?
Put simply, reinsurance is insurance for insurers. The insurer pays a premium to the reinsurer, and the reinsurer takes on a portion of the insurer's risk.
An insurance company is limited by the amount of capital available, the experience and expertise they have and their risk appetite.
These limitations will hinder an insurer from growing their business effectively. Reinsurance provides pathways and strategies to overcome this limitations without compromising their capital and risk appetite.
Reinsurance comes in many shapes and names. To understand what is the best for an insurer, we first have to understand the why.
Why is the insurer seeking for reinsurance?
These could be some of the reasons..
Risk Transfer due to Capital Adequacy
This is the most common and primary reason for reinsurance. Insurers, though well capitalized, have a much smaller capital base than reinsurers. It is critical to ensure that the company will be solvent even in extreme stress scenarios, which are typically represented as VaR99.5 (that is, the insurer should be able to withstand a 1 in 200 scenario).
To have this resilience, there are two solutions.
One, to raise enough money (capital) to fully withstand this shock level. This may not be practical and may not be an efficient use of resources either. Also we need to remember that capital comes at a cost, which needs to be repaid to investors and creditors.
The alternative is to reduce the amount of risk taken by the insurer. There are two ways to do this - either to sell less insurance, which isn't a good solution, or to utilise reinsurance.
(There is a third way, which is to focus on less capital intensive products, but it doesn't eliminate the need for reinsurance).
The reinsurance coverage needs to be calibrated properly so that it achieves the optimal risk reduction that matches the needs of the insurer.
Now, why not transfer all of the risk to the reinsurers? Reinsurance comes at a cost - hence if the insurer were to reinsure everything, they will significantly reduce the amount of profits they make.
Indeed it is possible to reinsure everything, and this is called "fronting". However this may be done for specific portfolios of risks and not for the entire insurance business.
Hence, reinsuring too much is also not desirable, so that the best balance between risk (capital adequacy) and reward (profits) is found.
To insure a new type of coverage or to enter a new market
Reinsurers are typically global MNCs, with vast experience in many countries and many types of insurance risks. Hence they have a vast network of experts to tap on, and a deep collection of data to analyse.
Insurers on the other hand, even large global MNCs don't have the same breadth and depth of expertise and data as reinsurers.
Hence, insurers rely on reinsurers to provide expertise in pricing, product design, underwriting and claims when they want to go into new types of coverages and new markets (countries/regions etc).
In return, the reinsurer takes on a significant portion of the risk, earning the premium.
In these cases, the insurer needs to balance their dependence on reinsurers and consultants. Depending too much on reinsurers could mean that they reinsure more than necessary and lose profits.
Consultants on the other hand cost a fixed amount, that becomes a small proportion of profits with scale.
Getting a consultant with the right domain expertise could be tricky at times, hence the natural dependence on reinsurers.
Alternative financing approach
Financial Reinsurance or FinRe, is a way for insurers to raise funds/capital without involving investors and creditors.
Reinsurers have a very large capital base, and tend to have lower costs of capital.
It can be a win-win situation, for a reinsurer to make this capital available to the insurer, at a fee that makes a profit for the reinsurer, yet is cheaper than what the insurer gets from their capital markets.
FinRe is structured within a type of reinsurance, typically coinsurance (aka full-risk reinsurance), modified coinsurance or some variant of it, and involves some balance sheet transfers of funds. (Which may or may not need actual fund transfers)
These tend to be the most complex and opaque types of reinsurance deals, but are highly prized by both insurers and reinsurers.
In a nutshell
Reinsurance can be a very powerful tool for insurers when deployed correctly. A good amount of time and resources should be spent analysing reinsurance needs and options available before making a decision.
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