LAM10020 - Reinsurance: What is reinsurance?
Reinsurance provides insurance for insurers. It is an agreement which enables primary insurers to manage their risks and limit their liabilities in return for the payment of a premium. A reinsurance company is a wholesale seller of insurance to a primary insurer (the ‘cedant’) who offers insurance to the end customer (the policyholder). A reinsurance company may also enter into a further reinsurance with another reinsurer which spreads the original risk across the market. This is known as a ‘retrocession’.
When an individual buys a policy all or some of the risk insured (and the corresponding premium) passes up the chain through insurer to reinsurer to retrocessionaire. When insured events occur claims move along the same chain. Insurers benefit from reinsurance by obtaining capital advantages, reducing the amount of capital held by the business, and protection from underwriting risk. This improves the capacity of the insurer to accept further risks which might otherwise be limited by the amount of solvency capital they hold. Reinsurers are able to diversify their business both geographically and in terms of the types of business they accept and that can give rise to capital benefits which cannot be enjoyed by the primary insurer. In this way reinsurers can reduce their overall risk exposure, and therefore the amount of regulatory capital they hold, because adverse outcomes from one set of risks can be offset by a more positive outcome from other risks which are not correlated.
Reinsurers need to have a strong capital base to attract business and the majority are rated at least ‘A’ by the ratings agencies.
Reinsurance can also occur where the counterparty is a member of the same group of companies as the primary insurer. Although intra-group reinsurance does not give rise to risk transfer outside the group, capital benefits for regulatory and rating agency purposes can still be obtained through, for example, risk diversification. Where the reinsurer is located in a low tax jurisdiction corporation tax mitigation can also be a significant factor driving such arrangements.