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When an insurer transfers a part of his risk on a particular insurance by insuring it with another insurer or other insurers, it is called “Re-insurance”.
Reinsurance is insuring the same risk
Reinsurance means insuring again by the insurer of a risk already insured. Every insurer has a limit to the risk that he can bear. If at anytime a profitable venture comes his way, he may insure it even if the risk involved is beyond his capacity which is his retention limit. In such cases, in order to safeguard his interest, he may reinsure the same risk for an amount in excess of his retention limit with other insurers, so that the loss due to risk is spread over many insurers.
Contract between two insurers
Reinsurance is, therefore, a contract between two insurers and the original contract or the insured is not at all affected by it. Now there are two contracts on the subject matter. The first contract is between the original insurer or direct insurer and the owner of the subject matter or the original insured.
The other contract (reinsurance contract) is between the original insurer and the reinsurer. In the case of loss on the subject matter, the original insurer collects the insured sum from the reinsurer and then settles the loss value in full to the original insured.
Example of Reinsurance
An example will make the concept of reinsurance more clear:
Mr. X, a factory owner, approached an insurance company ‘A’ for an insurance of an amount of Rs. 40 crores. Company ‘A’ has two options before it. It can reject the risk or accept the entire risk and share a part of the risk with other insurer.
In case, the company ‘A’ decides to assume the risk, by retaining Rs. 20 crores worth of insurance with it and seeking assistance of other insurer for the excess of his own limit. i.e., for the balance of Rs. 20 crores. The excess for which the company ‘A’ is approaching the other insurer is called “Reinsurance”.
Definition of Reinsurance
Definition by W.A. Dinsdale:
When the amount of any risk or risks from one hazard is such that it is beyond the limits, which it is prudent for one insurer to carry, it is necessary to effect reinsurance.
Definition by Federation of Insurance Institute, Mumbai
Reinsurance is an arrangement whereby an insurer so has accepted all insurance, transfers a part of the risk to another insurer so that his liability on any one risk is limited to a figure proportionate to his financial capacity.
Definitions of Terms used in Reinsurance
Before going deep into the concept of reinsurance, it is necessary to understand the meaning of the various terms used in it.
1. Direct Insurer
An insurance company which accepts the risk from the proposer and which is solely responsible to the policyholder for the obligations undertaken.
The insurance company which provides reinsurance cover to the ceding company is called the Reinsurer. The offer made by the ceding company is accepted by the Reinsurer. The Re-insurer may be
a direct insurer, who in addition to accepting direct business, also accepts reinsurance business; or
a professional reinsurer who accepts only reinsurance business but does not transact direct business.
3. Ceding company
Insurance company that places reinsurance business of the original risk with a reinsuring company; or the original insurer; the insurer who obtains a guarantee (on fire policy).
This is the amount reinsured with the reinsurance i.e., ceded to the reinsurer.
5. Reinsurance policy
The contract of reinsurance; in fire insurance, it is called guarantee policy.
This is the amount retained by the ceding company for its own account i.e., maximum it is prepared to lose on anyone loss. It is also known as ‘net limit‘ or ‘net holding‘ or ‘net line‘.
This refers to the difference between the sum insured under the policy issued by the ceding company and its retention.
8. Reinsurance Commission
It refers to the amount paid by the reinsurer to the insurer (ceding office) as a contribution to the acquisition and administration costs. Usually, it is a fixed percentage of premium received by the reinsurer.
Characteristics of Reinsurance
1. Reinsurance is a contract between the two insurance companies.
2. The original insurer agrees to transfer part of his risk to other insurance company on the same terms and conditions.
3. The fundamental principles of insurance such as insurable interest, utmost good faith, indemnity, subrogation and proximate cause also apply to reinsurance.
4. In the event of fire, the insured is entitled to get the amount of claim only from the original insurer and not from reinsurer.
5. Original insurer cannot insure the risk with a re-insurer, more than the sum assured, originally by the insured.
6. The original insurer should intimate to the reinsurer about the alteration, if any, made in terms and conditions with the insured.
Objectives of Reinsurance
The following are the main objectives of reinsurance:
1. Wide distribution of risk to secure the full advantages of the law of averages;
2. Limitation of liability of an amount which is within the financial capacity of the insurers; .
3. Stability in underwriting over a period; and
4. A safeguard against serious effects of conflagrations. Apart from these, sometimes an insurer may undertake the insurance of certain risks at a higher rate of premium and may reinsure part of these or the whole of it with some other insurers at a lower rate with the objective of earning of profit out of it i.e., making profits by way of retaining the difference between the two premiums.
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 contractand 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.