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.
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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.