What is Reinsurance?
Risk is at the
very center of the concept of insurance.
It is defined as “the uncertainty of
loss”. Uncertainty has two
dimensions i.e. frequency and severity of the occurrence. Loss is
measured in financial terms. When the
combination of frequency and severity in terms of risk leads to a financial
loss at a level that one is no longer able to bear, something must be done to
manage and/or mitigate it. Insurance has
been an important mechanism to manage such risks.
Under the conventional concept
of insurance, an insured transfers risk to an insurer, in exchange for a
certain amount of money called a premium.
The insurance company as the supplier
of insurance protection faces similar problem as an individual insured,
i.e. determining which probable claims cost will arise from the collection of
risks received from the insured. The
total aggregate of probable claims the insurer may have to incur (the total of
sums insured in its portfolio) is very likely to be much higher than the total
amount of premiums collected plus investment income on insurance fund assets.
Furthermore, not all of the
amount of these premiums is available to pay claims or for investment. Some portions of it have to be spent on other
posts such as acquisition costs, staff salaries, operational expenses and
other fixed costs. Even though the
probability that all individual risks in the insurer’s portfolio give rise to claims
in the financial year is quite small, the possibility of the aggregate claims exceeding the total premiums collected is not. Just as the individual policyholder wants to
protect itself by taking out insurance against the unforeseeable economic
consequences of certain events, the insurer who has taken over a magnitude of such
risks also has the need to replace some of the variable costs created in this
way by fixed costs. Thus the insurer needs
to insure itself with other risk carriers.
This leads to the concept of reinsurance.
Simply speaking, reinsurance
can be defined as ‘insurance of insurance’.
In other words, reinsurance is insurance taken out by an insurance
company which is insuring its policyholders, i.e. a direct insurer, and which
transfers or cedes some of the resultant policies to a reinsurer.
A more descriptive definition is
given by Robert Kiln in his book ‘Reinsurance in Practice’ as follows:
- The business of insuring an insurance company
or underwriter against suffering too great a loss from their insurance
operations; and
- allowing an
insurance company or underwriter to lay-off or pass on part of their liability
to another Insurer on a given insurance which they have accepted.
The direct insurance company
that is being protected by reinsurance is called the reinsured and the company that insures it is called the reinsurer.
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Adapted from Akoob, M. (2008). Reinsurance and Retakaful. In S. Archer, R. Karim, & V. Neinhaus, Takaful and Islamic Insurance: Concept and Regulatory Issues. Singapore: John Wiley & Sons (Pte) Ltd.
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