What are Reinsurance Companies?

What are Reinsurance Companies?

Reinsurance companies, also known as reinsurers, are companies that provide insurance to insurance companies. In other words, reinsurance companies are companies that receive insurance liabilities from insurance companies.

It is important to realize that, similar to any other businesses, insurance companies require protection against risk. Insurance companies manage their risk through a reinsurance company.

Roles of Reinsurance Companies

Reinsurance companies are used by insurance companies to:

1. Transfer risk

Insurance companies can issue policies with higher limits due to some of the risk being offset to the reinsurer.

2. Smooth income

The income of insurance companies can be more predictable by transferring highly risky insurance liabilities to reinsurers to absorb potentially large losses.

3. Keep less capital at hand

By offsetting the risk of loss in insurance liabilities, insurance companies do not need to keep as much capital on hand to cover potential losses. Thus, they can invest the capital elsewhere to increase their revenues.

4. Underwrite more policies

Reinsurance enables insurance companies to underwrite more policies, due to a portion of their liabilities being transferred to reinsurers. This enables insurance companies to take on more risk.

5. Lower claimant payout during natural disasters

Natural disasters such as earthquakes and hurricanes can cause claims to be abnormally high. In such cases, an insurance company can potentially go bankrupt by having to issue out payments to all the claimants.

By shifting part of the insurance liabilities to reinsurers, insurance companies are able to remain afloat in such extreme events.

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6. Realize arbitrage opportunities

Insurance companies can potentially purchase reinsurance coverage from reinsurers at a rate lower than what they charge their clients.

Reinsurers use their own models to evaluate the riskiness of policies. Therefore, reinsurers may accept a lower insurance premium from the insurance company if they deem it as less risky.