Reinsurance Definition: How It works Explained

Reinsurance Definition How It works ExplainedReinsurance is the insurance of insurance, where one or more insurance companies agree to indemnify the risk, partially or altogether, for the policy issued by other one or more insurance companies.

Reinsurance indicates to the process where the original insurer accepted the risk from the original insured gets the risk covered by another insurer or reinsurer for the same reason the original insured got protection for.

Before proceeding to the study of reinsurance, it is required of the students to understand the meaning of certain terminologies commonly used in the transaction of reinsurance business.

In the absence of such understanding, the student is likely to get confused and the study might mean obsolete to him.

The terminologies are:

What is Reinsurance or Reassurance?

This means insurance of insurance. The original insurer gets the risk, assumed from the original insured (primary insured), and covered (reinsured) with another insurer (known as reinsurer) for the same reason as the primary insured does.

The primary insurer, here, in fact, becomes the insured (known as reinsured) and the person or body or company giving him the protection becomes the insurer (known as reinsurer).

Definition of Reinsurer or Reassurer

Meaning the person, body or company giving reinsurance cover. They protect the interest of the insurer in case of loss/damage of the property or subject matter insured and for which the insurer is liable under the policy of insurance.

Definition of Reinsured / Reassured /Ceding Company / Direct Co-primary or original Insurer

All these terms relate to, indicate, or identify the insurer who primarily assumes the risk from the primary insured and then gets the same reinsured according to need.

When, therefore, an insurer reinsures the risk he becomes known as reinsured/reassured/ceding company/direct company/original or primary insurer.

Read: Importance of Reinsurance Industry

What is a Ceding Company

The company ceding the risk, i.e., getting the risk reinsured, and has already been discussed.

What is Cession?

Means the amount of risk ceded for reinsurance, i.e., the amount reinsured.

What is Retrocession?

Means reinsurance of reinsurance. A reinsurer may like to get his interest protected by further reinsurance and so on.

What is Retention?

This refers to the amount of risk retained by the ceding company. The balance is usually reinsured. The amount of retention is dependent on the financial strength of the ceding company for that class of business. It is the refined figure of another term known as LIMIT.

Normally “Limit1’ is a rough guide of the ceding company and depending on the quality and nature of the risk the ceding co. may decide to enhance or reduce the limit for the purpose of actual retention.

What is Line?

A line is equivalent to retention, i.e., the amount retained by the ceding co… A reinsurance arrangement is usually expressed in terms of “line” meaning that if a ceding company has a ten- line or twelve-line reinsurance arrangement (TREATY) it can automatically cede or reinsure up to ten times or twelve times of the amount retained.

Who is a Primary Insured / Assured?

This refers to the primary insured (assured) originally insuring the risk at the first instance. He is one of the parties to the insurance contract and not in the reinsurance contract.

What is Reciprocity?

This is a widely used term in the transaction of the business of reinsurance, indicating a situation involving the desire for the satisfaction of mutual interest.

Normally, the direct insurers, at one time or the other, do transact reinsurance business also in addition to the insurance business.

Read: Legal Aspect of Reinsurance

When they cede reinsurance business as such to another company, they also expect that at different times that company also would cede reinsurance business to them. This understanding of looking after each other’s interest is expressed by the term ’’Reciprocity”.

Broadly, speaking reinsurance is insurance for insurance. This means that the original insurer (who originally accepted the risk from the original insured) gets the risk covered with another (Reinsurer) for the same reason the original insured got protection for.

There are many risks in almost all classes of business that may be too big for an insurer to digest or to bear on his own account.

Because the financial strength of the insurer on that account may not be potent enough to bear a loss if it at all takes place.

Moreover, there is the question of big catastrophe losses, which might cripple down the insurer financially and force him to disown any liability to the insured simply because of inability to honor a claim.

Whilst this possibility is very much there, on the other hand, the insured is also most reluctant to go from insurer to insurer and to place only that amount of business to each, as each would be able to bear.

It is indeed amidst these two extremes that we see the development of a system wherein the insured goes to one insurer who usually takes the whole risk and reinsures any balance beyond his retention capacity (i. e., beyond which he cannot consume from the viewpoint of financial strength for that class of business) with the reinsurers.

Reinsurance, like insurance in general, has the element of chance, involved. The reinsurer hopes that his premiums will take care of his losses and that in the course of events he will obtain a profit.

When an insurer accepts a risk for a very large amount of one event, although he may be in a position to make a reasonable gain, yet indeed he has subjected himself to serious possible liabilities.

Under such circumstances, he may desire to reinsure a part or all of the risk with some other company or insurer. Reinsurance steps in as a method whereby the insurer may receive indemnity from his reinsurer in the event of reinsured’s liability to the original insured.

Some examples may be considered at this stage.

Example #1

In life insurance, the actuary can predict with some certainty as to how many lives of a given age will die within a certain period. What he cannot forecast is which of the named persons will exactly die.

This ignorance or limitation of knowledge, in fact, has aggravated the necessity of reinsurance further.

If a life company has 100000 lives all aged 20 and each insured for $10,000, and if this company now gets a fresh proposal from a man aged 20 but for an amount of $30,000 then problem would arise since the company shall have to run the risk of an additional amount of $20000 which will definitely imbalance the account if simply the new entrant dies first. Therefore, this company shall feel the necessity of getting its load ( $20000 in this case) reinsured with another company.

Example #2

A general insurance company may have the capacity to bear up to $100000 for any property insurance or liability insurance.

If a risk is placed for $300000 by the insured then the insurer shall have to reinsure $200000.

In the case of assuming unlimited liabilities the extent of loss may be sometimes very big and, therefore, in all fairness should have reinsurance arrangement beyond capacity.

Now after seeing the terms related to Re-Insurance and examples let us look at the various definitions it given in following paragraphs.

By a reinsurance agreement, the reinsurer may undertake to reinsure the assured (i.e., the reinsured or reassured), in consideration of the assured paying him a portion of the premium the assured receives against the proportionate amount of all assured’s losses arising from insurances along a certain line.

This arrangement could not constitute a partnership but would, in fact, be a contract of reinsurance (English Insurance VS. National Benefit Insurance (1929), A. C. 114 ). This definition understandably refers to a treaty agreement discussed later.

Reinsurance is an agreement to indemnify the assured (meaning reassured), partially or altogether, against a risk assumed by it in a policy issued to a third party.
– (Friend Bros V. Seaboard Surety Co, 56 N. E. 2d 6).

A direct company may find that it has placed itself under liability to a very large number of policy-holders. It may consider that it has undertaken more than it can safely carry.

Therefore the company, because of its outstanding contractual obligations, may desire to protect itself. It may seek to lessen its burden by getting some other company to assume a part of its liability in case of a loss.

The ORIGINAL OR PRIMITIVE OR DIRECT insurer, as is often called to represent the direct-writing company, may transfer or cede the whole or part of a risk to another company.

The first insurer or cedar, in turn, enters into a contractual relation with the second company which is called the REINSURER. The original or the primary insurer is obligated directly to his insured or the policy-holder. The reinsurer is obligated to the ceding company.

The original insurer has to account to its original assured in case of loss under a primary policy.

The direct company, known as the reinsured, by its contract may obtain the power to collect from the reinsurer by reason of the loss suffered by the original assured under the terms of the original policy. From the business relationship established between the reinsurer and the reinsured, there may arise a contract of reinsurance.

The students should appreciate that the risk assumed in reinsurance is necessary to be determined by examining the intention of the parties to reinsurance contract itself, since it may so happen that the risk covered by the reinsurance contract is not the same as that covered by the original, policy.

A reinsurance transaction is a relationship of utmost good faith, established between two parties, which is based primarily on contract or understanding whereby one party, called the reinsurer, in consideration of a premium paid by the reassured agrees to indemnify under certain terms and conditions, another party, the reassured, against a risk previously assured by the latter, the direct writer, in its primary insurance covering the original assured.
(Kenneth Thompson).

“Reinsurance is a contract which one insurer makes with another to protect the first insurer from risk already assumed”, (Bethke Vs. Cosmopolitan Life Insurance Co., 262, APP 586).
“It involves the principle of indemnity” ( Union Central Life Insurance Co. Vs. Lowe, 182 N. E. 611).

The contract of reinsurance was also defined in the American case of Stickel Vs. Excess Insurance Co. of America, Ohio Supreme Court; Nov. 22, 1939, 23 N. E. ( 2nd) 839 as “A contract whereby one, for a consideration, agrees to indemnify another wholly or partially against loss or liability by reason of a risk the latter has assumed under a separate and distinct contract as insurer of a third party”.

It should be recalled by the students that the primary concept of insurance is to spread the risk or loss of one onto the shoulders of many.

Whilst it becomes unbearable for a man alone to bear the load of a loss, it becomes quite easier when a group collectively shares the same. In reinsurance also the same principle or concept is involved. It is indeed sharing and re-sharing of risks or spreading and further spreading of risks.

The necessity emerges out of the same need as is felt by the original assured.

Reinsurance is not double insurance or co- insurance ( discussed later ) since in such contracts, unlike reinsurance, there is a direct contractual relationship in between the insured and insurer or co-insurer.

The students should get themselves acquainted with a very common term, known as retrocession, widely used in reinsurance transactions. This virtually means reinsurance of reinsurance.

It should be appreciated by the students that reinsurance enjoys no immunity from the operation of the principles governing sound practice for insurers.

The reinsurer also must avoid a concentration in conflagration areas or catastrophe situations, and must maintain a wide distribution of its risks assumed from the ceding company.

It is probable that the reinsurer may have sufficient amounts ceded from a number of different sources and unfortunately the cession may relate to the same risk.

To relieve itself from this undesirable accumulation, the reinsurer would itself have to resort to reinsurance. This act of reinsuring any part of a reinsurance is termed as retrocession and comes within the same study of reinsurance.

To sum up, therefore, it may be said that:

  1. In order to secure a large number of similar risks to permit the prediction of losses with a reasonable degree of certainty, insurance companies have devised the practice of reinsurance.
  2. Reinsurance is the transfer of insurance business from one insurer to another. Its purpose is to shift risks from an insurer, whose financial security may be threatened by retaining too large an amount of risk, to other reinsurers who will share in the risk of large losses.
  3. Reinsurance tends to stabilize profits and losses and permits more rapid growth.
  4. The entire area of reinsurance and retrocession is an example of the essential need for a spread of risk among many risk bearers. Much of the process goes on without the policy-holder being aware of its existence since he is not a party to the reinsurance arrangement.
  5. Reinsurance enables a risk to be scattered over a much wider area, which is the primary concept of the whole business of insurance.
  6. The need for reinsurance arises in the same way as an original insured needs insurance protection.
  7. The original insured is not a party to the reinsurance contract.

Forms of Reinsurance

Having completed the various types of reinsurance arrangements, discussions will now be made as to the forms they usually take. There are two forms of reinsurance, irrespective of the type of reinsurance discussed so far. These are;

  1. PARTICIPATING OR PRO-RATA: Where the proportion of amounts payable by the insurer and the reinsurers in respect of a loss is determined and agreed beforehand, i.e., before a loss. Here the premium received by the insurer is also distributed in between himself and the reinsurers in the same proportion.

    Examples are facultative, quota share, surplus or pool.

  2. NON-PROPORTIONAL: Where the reinsurance is on different terms and the reinsurers do not stand to be proportionately liable for a loss.

    Therefore, the premium received by the insurer is also not required to be proportionately distributed to the reinsurers.

    Examples are, an excess of loss treaty, stop loss treaty etc.


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