The insurance is a mechanism of spreading losses over larger group of persons exposed to loss based on law of large numbers. By contrast, reinsurance soothes out the financial burden of the primary insurer by providing it with off-balance sheet capital in a bid to increase their solvency margin. To run a financially sound insurance company, it is essential that there is an efficient management of the risks assumed as also the capital deployed. Reinsurance provides this cushion to the insurers by way of lending the necessary contingent capital which is otherwise known as “off-balance sheet capital”. The major losses arising from natural catastrophes or large man-made disasters tend to deplete the capital content of the insurance industry quite rapidly. When these uncertain losses tend to become unmanageable by its own capital outlay, the insurance company then seeks a financial arrangement with another insurer by passing part of a risk or liability that was originally accepted.
Reinsurance is therefore an extension of the fundamental concept of pooling. By spreading this pool over a large domain, reinsurers ensure that a major concentration of the risks is obviated.
The role of reinsurance in the arena of risk management is indispensable. Even then, there are many reasons why insurers and in many cases, reinsurers fail. Since insurance and reinsurance business is very much claim-sensitive, the problems arise when the claim costs are not well appreciated in terms of its significance and probability of occurrence. Claims cost generally rise due to increase in the underlying frequency and/or severity of losses.
Besides, the random occurrence of very large losses or the fluctuation of the annual aggregate claims experience around the mean value are also the factors behind increased claims cost. Without reinsurance facility, insurers cannot run for its plethora of underlying benefits. If the reinsurance mechanism is not properly handled, the seemingly innocuous situation can be a nightmare for the CEO of an insurance or a reinsurance company.
There is a marked line of difference in transacting the business of insurance and that of reinsurance. The insurance provides a financial benefit to the original assured against the insured loss and hence there is a direct contract between the two. By contrast, the contractual relationship in the mode of risk transfer by way of ‘reinsurance’ relates with one insurer to another where the original assured, either an individual or a body corporate, does not have a privy to the contract of reinsurance while seeking the benefits of insurance policies.
A reinsurance contract constitutes a separate contract of insurance between the reinsurer and the reinsured (means the insurance company). The method of passing of an exposure to financial loss of an individual to a company is called “insurance” and when the same exposure is again passed on by the insurance company to another insurer, is called “reinsurance” and finally, when that part of exposure once again is passed on by the reinsurance company to another group of insurers, is known as “retrocession”. In insurance parlance, these three set of risk sharing players are known as “insurers, reinsurers and retrocessionaires”.
Primary functions of reinsurance usually encompass the following areas:
To protect the insurers from underwriting losses which may imperil their solvency;
To stabilise underwriting results;
To increase the flexibility of an insurer in the size and types of risk and volume of business being underwritten;
To further spread the risk of losses;
To assist in the financing of insurance operations.
Although the major aim of insurance is to meet the liability incurred when the insured peril occurs, the claims paying function between the primary insurer and the reinsurer differ considerably. When the claim is lodged, the primary insurer follows certain procedure to determine the propriety of the loss and its quantum before meeting the liability incurred whereas the reinsurer is strictly to follow the contract of reinsurance that emanates from the “insurance of contractual liabilities” and pay their share of loss to the primary insurer as and when asked for. '
There are occasions when the distinction between an actual payment and a corresponding liability to pay may be of the utmost importance. The reinsurer is only liable to pay for a share of loss for which the primary insurer is also liable and not beyond. For instance, when the original claim includes some amount in the claim as litigation cost or interest for which the insurer was not liable to pay under the policy, and although the reinsurance policy issued by the primary insurer contained a clause “to pay as may be paid thereon”, it was held that the reinsurer was not liable. This is because the words must be construed as meaning “to pay as may be liable to pay thereon”.
If the primary insurer fails to pay the claim to the original assured, the policy holder cannot have recourse to his claim from the reinsurer just because this risk was reinsured with another insurer. Unless otherwise specified by a specific wording within the contract of reinsurance between the insurer and the reinsurer, the contractual liability does not pass on to the original assured as the beneficiary.
The distinction between a payment and a liability to pay is also of significant importance when the primary insurer goes into liquidation. In such a case, once the insolvent insurer’s liability to pay a claim has been established, the reinsurer is liable to pay its full share of ascertained liability, even though in fact the primary insurer did not make any physical payment to the policy holder. Such payments made by the reinsurer do not go to the claimant on the risk which was reinsured since there is no contract between claimant and reinsurer—but fall into the pool of resources held by the liquidator.
Reinsurance is the process of spreading the risks far and wide, the essence of which is pooling. It is this quality that renders the insurance business itself to be run on sound lines.Thus, reinsurance is the backbone of the global insurance activity.
The writer is the Director, International Business, KadenBoriss Lawyers
Disclaimer: Any content, views, opinions and/or responses on any of the pages of www.indiainfoline.com, expressed or submitted by the creators, contributors, sponsors or advertisers, other than the content provided by IIFL, are solely the views, opinions and responsibility of the person submitting them and do not necessarily reflect the opinions of IIFL. IIFL does not warrant the accuracy, completeness or usefulness of the information. Nothing contained in or provided through this page is intended to constitute advice or solicitation for any investment/financial products or services, neither does it constitute an offer for the purchase or sale of any financial instrument or confirmation of any transaction.
IIFL does not hold any responsibility for the consequences of any action or omission thereof based on any information related to investment/financial products or services that may be available on /through this page. Any reliance you place on such information is strictly at your own risk. We may include links to other web pages, but these links are not an endorsement of those pages, products or services. IIFL is not responsible for the content of any web site by other operators. Under no circumstances will IIFL be responsible or liable in any way for any content, including but not limited to, any errors or omissions in the content, or for any injury, death, loss or damage of any kind by any person as a result of any content communicated whether by IIFL or a third party. In no event shall IIFL be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits arising out of or in connection with the availability, use or performance of any information communicated on this page.
- Save upto Rs.2.67 lakh with Pradhan Mantri Awas Yojana ...Know more
- Now Save Rs.3150 on your Demat Account ...Click here
- Now get IIFL Personal Loan in just 8* hours...APPLY NOW!
- Get the most detailed result analysis on the web - Real Fast!
- Actionable & Award-Winning Research on 500 Listed Indian Companies.