By: foreyt

We have seen in Chapter Three that insurance is a mechanism whereby individuals or firms can, for a known premium, transfer the risk of losses of uncertain magnitude to an insurance company. By offering this service, an insurance company hopes to make a profit as a return on the capital invested in the business. As a result, the problems of uncertainty which faced the insured now confront the insurers and for several reasons they themselves may find it necessary to effect insurance, hence the term "reinsurance".

Terminology
Reinsurance. "Insuring again" is the literal meaning, and it entails insuring with someone else part (or all) of the risk which has been insured by a member of the public, i.e. insurance of insurance.

Ceding office. The insurers who have accepted a larger risk from the public than it is prudent for them to carry, and have "ceded" or given away the surplus to a reinsurer.

Reinsurer. One who accepts reinsurance from a ceding office or direct insurer?
Cession. The amount of insurance given or ceded to the reinsurer. Treaty (or automatic reinsurance). An insurance contract arranged between the ceding office and reinsurer(s), whereby the reinsurer(s) will accept automatically without further negotiations such cessions as the ceding office wishes to place in the future. This agreement or treaty will be for a certain time period, say one year or three years, and will be subject to restrictions as to type of risk or values involved. Under the treaty, there may be one of several reinsurers sharing whatever is ceded in fixed proportions.

Retention. The amount of risk retained or kept for their own accOunt by the ceding office. This would be the maximum net loss which the ceding insurer judged that it would be prudent to keep, bearing in mind how long they had been transacting that class of insurance, the financial status of their account in that class of business, the nature of the particular proposal being dealt with, and whether the maximum probable loss with respect to that proposal was equal to or less than the sum being proposed for insurance. When dealing with perils such as fire or explosion, it is not only the proposal in question which must be considered but also all other policies which could be affected by a single incident. The retention fixed by the underwriter would take into account all such potential liabilities.

Retrocession. This is the act of reinsuring what has been accepted under a reinsurance contract.

Purposes
The purposes of reinsurance could be said to be covered under the following headings.

Capacity. As the direct insurers can reinsure part of certain risks they can therefore accept more of the original risk. It could be that a particular insurer has calculated that he would not want to provide fire insurance cover for manufacturers of plastic goods where the sum insured was in excess of £100,000. Should he receive an inquiry from such a potential insured and the sum to be insured was, say, £400,000, he would be in a difficult position if it was not for reinsurance. With this available, however, he could accept the whole £400,000 in the knowledge that reinsurance exists for the £300,000 not retained by him. The exact ways by which this is achieved are shown later in this chapter. The result is growth within the insurance market as a whole and added prestige to the individual insurer.

Stabilisation. Just as the insured has no knowledge of when a claim will occur or what it will cost, similarly the direct insurer also lacks this knowledge. of The insurance company has a far greater experience of handling losses, and statistical techniques can assist the prediction of losses and their costs; nevertheless there is still considerable uncertainty. Reinsurance helps the direct insurer to stabilise their loss levels by removing some of the uncertainty. An insurer who has issued a public liability policy with an indemnity limit for anyone occurrence of £250,000 has no idea when a claim may arise or what it will cost. Such an insurer may agree with a reinsurance company or companies that they (the direct insurer) will pay the first £50,000 of each claim, leaving the balance, whatever it may be, to be met by the reinsurer(s). In this way, the insurance company has reduced the possible fluctuation in claims costs and it should result in the company being able to produce, ore accurate budgets and reserves based on a more certain claims penditure estimate.

Confidence. One of the advantages of insurance was shown to be the giving of confidence. In the knowledge that a large number of certainties have been removed, a manufacturer may be more willing to, vest money in his business. In exactly the same way the existence of insurance gives confidence to an insurer and encourages expansion of at company's business.

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