Have you ever pondered over how life insurance companies manage to settle substantial death claims? Let’s begin by delving into the fundamental concept of insurance and then transition to reinsurance. While reinsurance is a vast subject, I’ll provide an overview of its basic principles.
About the author: Ajay Pruthi is a fee-only SEBI registered investment advisor. He can be contacted via his website plnr.in. Ajay is part of the freefincal list of fee-only advisors and fee-only India.
Consider this scenario: Ajay, a 30-year-old individual, opts for a term insurance policy worth Rs. 1 Crore for 30 years, paying an annual premium of Rs. 12,000. Tragically, Ajay passes away in an accident after four years, entitling his family to receive Rs. 1 Crore from the life insurance company. This exemplifies the basic mechanism of claim settlement in a life insurance scenario.
But how can an insurance company afford to pay such a substantial sum assured of Rs. 1 Crore with a premium of just Rs. 12,000? The answer lies in understanding the concept of mortality. Insurance companies assess the probability of death among a specified group, factoring in age, gender, and other variables. For instance, if the likelihood of 3 out of 1,000 individuals dying annually is established, the mortality rate would be 0.003.
Insurance companies incorporate base mortality rates, add loading for costs and profit, and determine premiums. However, this might not suffice. Despite maintaining solvency ratios per regulatory standards, unforeseen events such as the COVID-19 pandemic could surge claims, surpassing the company’s capacity to pay.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! 🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
This is where reinsurance steps in to safeguard insurance companies. Just as insurers need protection, they purchase reinsurance to mitigate risks and protect their capital. Reinsurance companies assist insurers in managing their losses by assuming risks beyond a certain sum assured, with premiums shared accordingly.
How does Reinsurance work?
Life insurance companies typically assume risks up to a specified sum assured. However, the risk is transferred to reinsurance companies for amounts exceeding this threshold, known as the retention limit. Moreover, the premium collected from policyholders is shared with these reinsurers.
For instance, consider an insurance company with a retention limit of 30 Lakhs. In cases where the sum assured is 30 Lakhs or less, the insurance company retains the risk. Conversely, for amounts surpassing 30 Lakhs, the risk is ceded to the reinsurer, with the premium distributed accordingly between the insurer and reinsurer.
Reinsurance operates in two primary forms: facultative reinsurance and obligatory reinsurance. Facultative reinsurance involves a case-by-case approach to risk transfer, whereas obligatory reinsurance entails a contractual agreement between insurers and reinsurers to share risks within a portfolio.
Given the sheer volume of cases, reinsurers often provide underwriting guidelines to insurance companies. These guidelines empower insurers to handle cases autonomously and up to a predetermined sum. However, cases exceeding this limit typically necessitate reinsurer involvement.
For instance, consider an underwriting guideline where insurers can independently handle cases up to Rs. 1 Crore. Beyond this threshold, reinsurer intervention becomes imperative. It’s important to note that these thresholds may vary among insurers based on their risk retention capacity and underwriting guidelines.
In large claims scenarios, the insurance and reinsurance companies share the burden. This collaborative approach ensures that risks are adequately managed and that policyholders receive the necessary financial support when claims arise.
Now, let’s explore how reinsurance companies earn profits:
Diversification of Risk: Reinsurance companies spread their risk exposure across diverse geographical regions, industries, and types of insurance. This diversification minimizes the impact of significant losses in any single area or sector, ensuring financial stability.
Investment Income: Reinsurance companies earn income from investment portfolios and underwriting profits. Premiums collected from primary insurers are invested in various assets, generating returns contribute to overall profitability.
Other Factors: Underwriting discipline, risk management, and hedging strategies also play crucial roles in reinsurers’ profitability.
These explanations provide a foundational understanding of reinsurance. For those interested in delving deeper into this subject, additional resources are available for exploration. You can access further details through this SwisRE reinsurance guide.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)