In insurance, the insured transfers his risk to the insurer. This primary insurer transfers a part or all of the risks he has insured to another insurer to reduce his own liability (the risk that he has assumed). This is known as reinsurance. Reinsurance is primarily an insurance of risks assumed by the primary insurer known as the ceding company. This risk is shifted to another insurer known as the reinsurer. The ceding company may shift part or all of the insurance originally written to the reinsurer. The amount of the insurance retained by the ceding company for its own account is called the retention. Retention is the amount of risk that an insurer is prepared to take on his own account. The amount of the insurance ceded to the reinsurer is known as the cession. The proportion of risk to be retained by the ceding company depends on factors such as company’s assets and investment income, portfolio of the risks premium levels, inflation, and reinsurance market conditions.
Reinsurance operates on the same principle as direct insurance, i.e., to spread sharing of risks as widely as possible. The insurers seek protection of their own risk by reinsuring with reliable reinsurers. Reinsurance evolved as a natural corollary to insurance. Reinsurance is used for several reasons:
To increase the company’s underwriting capacity which, in turn, would help to render improved service to the reinsured and expand the market.
To spread the risks with as many insurers as possible.
To obtain valuable advice and assistance with respect to pricing, underwriting practices, retention, and policy coverage.
To stabilise profits by leveling out peak risks/losses.
To provide protection against catastrophic losses arising due to natural disasters, individual explosions, airline disasters and so on.
To retire from the business or class of business or territory.
The reinsurance business assumes greater importance in the event of war anD natural calamities when the smaller insurance firms find themselves unable to take on the full risk due to their lower capital base.