Objectives of Reinsurance
Almost all insurance companies have a reinsurance program. The ultimate goal of that program is to reduce their exposure to loss by passing part of the risk of loss to a reinsurer or a group of reinsurers. In the United States, insurance is regulated at the state level; which only allows insurers to issue policies with a maximum limit of 10% of their surplus (net worth) unless those policies are reinsured. In other jurisdictions, allowance is typically made for reinsurance when determining statutorily required solvency margins.
(a) Risk transfer
With reinsurance, the insurer can issue policies with higher limits than would otherwise be allowed, thus being able to take on more risk because some of that risk is now transferred to the reinsures. The reason for this is the number of insurers that have suffered significant losses and become financially impaired. Over the years there has been a tendency for reinsurance to become a science rather than an art; thus reinsurers have become much more reliant on actuarial models and on a tight review of the companies they are willing to reinsure. They review their financials closely, examine the experience of the proposed business to be reinsured, review the underwriters that will write that business, review their rates, and much more.
(b) Income smoothing
Reinsurance can make an insurance company’s results more predictable by absorbing larger losses and reducing the amount of capital needed to provide coverage. The risks are diversified, with the reinsurer bearing some of the loss incurred by the insurance company. The income smoothing conies forward as the losses of the cedant are essentially limited. This fosters stability in claim payouts and caps indemnification costs.
(c) Surplus relief
An insurance company’s random writings are limited by its balance sheet (this test is known as the solvency margin). When that limit is reached, an insurer can do one of the following: stop writing new business, increase its capital, or (in the United States) buy “surplus relief”.
The insurance company may be motivated by arbitrage in purchasing reinsurance coverage at a lower rate than they charge the insured for the underlying risk, whatever the class of insurance. In general, the reinsurer may be able to cover the risk at a lower premium than the insurer because:
- The reinsurer may have some intrinsic cost advantage due to economies of scale or some other efficiency.
- Reinsurers may operate under weaker regulation than their clients. This enables them to use less capital to cover any risk, and to make less prudent assumptions when valuing the risk.
- Reinsurers may operate under a more favourable tax regime than their clients.
- Reinsurers will often have better access to underwriting expertise and to claims experience data, enabling them to assess the risk more accurately and reduce the need for contingency margins in pricing the risk.
- The reinsurer may have a greater risk appetite than the insurer.
(e) Reinsurer’s expertise
The insurance company may want to avail itself of the expertise of a reinsurer, or the reinsurer’s ability to set an appropriate premium, in regard to a specific (specialized) risk. The reinsurer will also wish to apply this expertise to the underwriting in order to protect their own interests.
(f) Creating a manageable and profitable portfolio of insured risks
By choosing a particular type of reinsurance method, the insurance company may be able to create a more balanced and homogeneous portfolio of insured risks. This would lend greater predictability to the portfolio results on a net basis (after reinsurance) and would be reflected in income smoothing. While income smoothing is one of the objectives of reinsurance arrangements, the mechanism is by way of balancing the portfolio.