From what has been said so far the students should be able to grasp the reason as to why reinsurance is resorted to.
to sum up in a systematic disciplined way the reasons can be grouped as under:-
Risk Minimization by Spreading
The fundamental concept of insurance is to spread the risk over as wider an area as possible as so to reduce the burden of loss at each stage.
To an insurer, the need for reinsurance protection arises in the same way as the insured needs insurance protection.
But for reinsurance, the business of insurance would not have developed to the extent of the present day growth.
In the absence of reinsurance, insurers would have been bound to limit their acceptance of risk only up to such an amount which they could possibly digest.
In other words,
the insurers would have been unable to accept a risk beyond their financial strength or resources for that class of business. Consequently, insurers’ service to the public would also have been limited.
Reinsurance gives flexibility to insurers by creating a condition which enables them to accept a risk beyond their financial capacity or resources.
The insuring community is also left care-free with regard to various risks to which they are subjected to, irrespective of whatever may be the value per single risk.
Reinsurance reduces the possibility of getting involved in undesirable additional risk-load, which is otherwise eminent from the accumulation of risks coming from different sources.
Examples of such accumulation are,
(a) Heavy commitment on the cargoes of the same vessel,
(b) Heavy commitment on the cargoes lying in the same port possibly because of the arrival of all vessels at the same time and,
(c) The heavy commitment of an insurer on the property of a particular hazardous locality from the viewpoint of fire or conflagration fire.
It is possible that the various branches of an insurer, without knowing each other’s position, may commit individually thereby giving rise to a situation of heavy unbearable commitment as mentioned in (a) (b) or (c) above.
Reinsurance reduces such worries of insurers and keeps down the pressure of accumulation to a sustainable limit.
The growth of an insurance company is particularly dependent on sound financial standing, which is primarily based on the stability of profit and loss. Profit cannot be expected if there is an untoward charge on the fund by way of claim which it cannot sustain or for which there is no provision.
Reinsurance tends to stabilize profits and losses and permits more rapid growth of an insurance company.
Prediction for Rating
An insurer needs to have a large number of similar cases in his book for the purpose of predicting an accurate rating structure.
But assuming a large number of similar risks is in itself undesirable unless some precautionary measure is taken.
It may not also be possible to get a large number of similar cases by an insurer because of the operation of numbers of insurers in the market. Whatever it is, reinsurance takes care of such a situation in both the ways.
On the one hand, it provides protection to the insurer by way of providing unsustainable losses, and on the other creates a forum for getting a large number of, similar cases through reciprocity.
A new insurer who has recently started transacting insurance business cannot certainly develop and possibly cannot survive in the absence of reinsurance protection.