Functions of Reinsurance

Protecting against catastrophic events is only one kind of reinsurance. There are many reasons an insurance company will choose to reinsure as part of its responsibility to manage a portfolio of risks for the benefit of its policyholders and investors.

Risk transfer

The main uses of reinsurance are to allow the ceding company to assume individual risks greater than its size would otherwise allow, and to protect the cedant against catastrophic losses. Reinsurance allows an insurance company to offer larger limits of protection to a policyholder than its own capital would allow. If an insurance company can safely write only $5 million in limits on any one policy, it can reinsure (or cede) the amount of the limits in excess of $5 million to reinsurers.

Reinsurances highly refined uses in recent years include applications where reinsurance was used as part of a carefully planned hedge strategy.

Income smoothing

Reinsurance can help to make an insurance companies results more predictable by absorbing larger losses and reducing the amount of capital needed to provide coverage.

Surplus relief

Reinsurance can improve an insurance company's balance sheet by reducing the amount of net liability, and thereby increasing surplus. Surplus, assets less liabilities, is roughly the same as shareholder equity on a balance sheet of a non-insurance company.

Arbitrage

The insurance company may be motivated by arbitrage in purchasing reinsurance coverage at a lower rate than what they believe the cost is for the underlying risk.