More Capital or More Reinsurance?

CAPITAL and REINSURANCE, what to write for layman in a freestyle blogging competition?

There are many ways to write it.... but less words utilised is the best!

Insurance companies are risks carriers – they take the risks belonging to the Insureds into their books of business in exchange for a small token. The business of taking other peoples’ risks is not something easy to manage – simply because most profiles of risks that insurers normally underwrite have an inherently high volatility – volatility in terms of a single risk returning with a huge loss, or a large number of risks being hit by smaller losses (attritional), or both events taking place simultaneously or consecutively. To make things easily understandable, just say, insurers’ balance sheet is always susceptible to financial volatility – which means there will be tremendous pressure on the insurer’s capital. This translates into the the need of having a huge capital base in order to underwrite a pool of risks having small limit (or sum insured) cover, thus rendering the insurance business unsustainable in the longer term. You just cannot do business where its Return of Investment (ROI) is lower than the existing bank FD interest and the worst part, a single event loss may affects a large pool of risks which end up wiping out a large portion of the capital…. maybe overnight!

Thus the only sensible thing for insurer to do is to buy insurance to insure their total portfolio of business, very much similar to what the Insured is doing with their risks. In this simple concept of insurer buying insurance, we termed it as procuring reinsurance cover. With reinsurance cover, the insurer would then be able to transfer out targeted portion of their portfolio of risks to the reinsurer(s). This, if tactically drawn out should helps reduce volatility and therefore reducing the need for any  intensive capital to continue doing business.

One other important advantage here is enabling the insurer to work towards building an effective risks spreading mechanism. Simply puts, in risks spreading, the insurer can accept more business with the same amount of capital and consequently they do not need to allocate more capital in order to expand those risks into its portfolio. This ability of assuming more risks can be translated into economies of scale in managing overheads and benefits.  Thus expenses such as distribution networks, claims handling and other administration costs can be spread over a broader base of business portfolio. In addition, these achieved economies of scale would enable the insurer to better price products and come out with innovative policies that otherwise would not be insurable.

Do give me some feedbacks as to how this write up should be better written.

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4 comments for “More Capital or More Reinsurance?

  1. pkswain
    February 11, 2010 at 17:03

    Well scripted.But wdnt over reliance (howsoever sound)on RI tantamount to sort of fronting? Wouldnt a fusion be better? Pls lemme know ur views.

    • February 12, 2010 at 00:15

      Over reliance on RI would put the cedant in a position more of a commission agent rather than as a provider of risk assumption. This is definitely not good for business – might as well be a broker in the first place. Usually the cedant should examine their business model / strategy. risk-loss profiles and availability of capital before deciding on the level of RI cession….

      As for fusion, never know this has something to do with reinsurance or capital??? Perhaps you explain this to me for being ignorant.

  2. Anonymous
    February 8, 2010 at 00:46

    Perfectly written.

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