Riskonomics, Uncategorized

What is Reinsurance?

Risk is at the very center of the concept of insurance.   It is defined as “the uncertainty of loss”.  Uncertainty has two dimensions i.e. frequency and severity of the occurrence. Loss is measured in financial terms.  When the combination of frequency and severity in terms of risk leads to a financial loss at a level that one is no longer able to bear, something must be done to manage and/or mitigate it.  Insurance has been an important mechanism to manage such risks.

Under the conventional concept of insurance, an insured transfers risk to an insurer, in exchange for a certain amount of money called a premium.  

The insurance company as the supplier of insurance protection faces similar problem as an individual insured, i.e. determining which probable claims cost will arise from the collection of risks received from the insured.  The total aggregate of probable claims the insurer may have to incur (the total of sums insured in its portfolio) is very likely to be much higher than the total amount of premiums collected plus investment income on insurance fund assets. 

Furthermore, not all of the amount of these premiums is available to pay claims or for investment.  Some portions of it have to be spent on other posts such as acquisition costs, staff salaries, operational expenses and other fixed costs.  Even though the probability that all individual risks in the insurer’s portfolio give rise to claims in the financial year is quite small, the possibility of the aggregate claims  exceeding the total premiums collected is not.  Just as the individual policyholder wants to protect itself by taking out insurance against the unforeseeable economic consequences of certain events, the insurer who has taken over a magnitude of such risks also has the need to replace some of the variable costs created in this way by fixed costs.  Thus the insurer needs to insure itself with other risk carriers.  This leads to the concept of reinsurance.

Simply speaking, reinsurance can be defined as ‘insurance of insurance’.  In other words, reinsurance is insurance taken out by an insurance company which is insuring its policyholders, i.e. a direct insurer, and which transfers or cedes some of the resultant policies to a reinsurer. 

A more descriptive definition is given by Robert Kiln in his book ‘Reinsurance in Practice’ as follows:
– The business of insuring an insurance company or underwriter against suffering too great a loss from their insurance operations; and
– allowing an insurance company or underwriter to lay-off or pass on part of their liability to another Insurer on a given insurance which they have accepted.

The direct insurance company that is being protected by reinsurance is called the reinsured and the company that insures it is called the reinsurer.

Adapted from Akoob, M. (2008). Reinsurance and Retakaful. In S. Archer, R. Karim, & V. Neinhaus, Takaful and Islamic Insurance: Concept and Regulatory Issues. Singapore: John Wiley & Sons (Pte) Ltd.

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