The concept of reinsurance is fairly simple. When a person takes on insurance, they transfer their risks to the insurance company. The insurance company sells the same contract to many people to create a pool of money. Since all the people are not likely to face an adverse event at the same time, insurance companies can pay money out of the pool and still be left over with additional money for profits.

However, as insurance companies sell more policies, the quantum of risk that they undertake also increases considerably. Therefore, insurance companies also need to purchase another insurance policy wherein they can insure their risks to a certain extent. This second-degree insurance is called reinsurance.

To a layman, it may appear as if buying reinsurance is an optional add-on that insurance companies may or may not choose. However, the fact of the matter is that reinsurance is a vital component that enables the smooth functioning of insurance companies across the world.

The main benefits which are derived as a result of reinsurance have been explained below in this article.

• Enables Safe Expansion of Business: We already know that as the business of an insurance company grows, the riskiness of the business also increases greatly. In fact, if the business of the insurance company is concentrated in a single industry or a single geographical area, then the risk increases manifold when additional business is taken on.

  Reinsurance allows the company to transfer this risk to a different insurance company that does not have similar or related risks. This allows them to lower their overall risks and continue expanding their business even if it means that most of their clients are geographically concentrated.

• Enables Economies of Scale: From the above point, it is evident that the concept of reinsurance enables insurance companies to take on more risks even if it is in the same geographical or technical area. This becomes a huge benefit for insurance companies who have strong marketing networks concentrated in a particular area. The concept of reinsurance allows these insurance companies to leverage their network to the maximum without worrying about not being able to fulfill their obligations in the future.

• Enables Diffusion of Risk: The entire concept of insurance is based on the diffusion of risk. The premise is that risk cannot be eliminated. However, by its very nature, risks impact only a small percentage of the population at a given time.

  For example, the recent hurricane has impacted the entire state of Florida which is a very large geographical area. However, on the world map, Florida is still a very small percentage of the total area.

  Reinsurance enables insurance companies to diffuse the risks to different parts of the world. The end result is that even if all of Florida is destroyed by a flood, Florida’s insurance companies will still not go bankrupt. This is because they would have reinsured the risks with companies in different parts of the world such as Switzerland or even Japan. This diffusion of risk helps the insurance system withstand the shocks posed by big natural calamities.

• Ensures Systemic Stability: It is important to note that reinsurance is one of the major factors which enables systemic stability in the insurance industry. This is because reinsurance ensures that no insurance company will come under economic duress even if it has to pay out a large number of claims. Insurance companies are able to pay their liabilities despite the most difficult situations in the external environment. This is because of the fact that reinsurance ensures that no single insurance company goes bankrupt.

  Even if one insurance company goes bankrupt, the entire industry will face the aftereffects. This is because firstly there will be direct losses as insurance companies transact extensively with each other. Also, the customers will lose faith in the insurance industry as a whole. This could also mean that the insurance companies will face a tough time selling more policies

• Helps in Smoothening Profits: Reinsurance also helps stabilize the financials of the companies in the insurance industry. This is because, in the absence of reinsurance, the revenues and profits of insurance companies would witness a lot of ebbs and flows.

  Reinsurance enables companies to pay premiums which reduces their revenues in normal years. However, when a catastrophe hits, the revenue received via claims helps bring the revenue back to the normal level. The end result is that reinsurance enables predictable cash flows which helps companies meet their other liabilities without stretching their finances too much.

• Helps in Covering Large Assets: Reinsurance also helps remove the necessity of purchasing multiple insurance policies which a company faces when they want to insure a large asset. For instance, if a car company wants to insure its manufacturing location, it would have to purchase multiple policies. This is because the sum assured would be very large and many insurance companies may not be able to take on such a huge risk. Reinsurance helps remove this problem.

  One insurance company assumes the risk and hence the customer has to deal with that company. However, at the back end, the insurance company can further pass on the risk to multiple companies. This eliminates the need for purchasing multiple policies while providing the same level of financial protection.

The fact of the matter is that reinsurance is a very important part of the overall insurance industry as there are several benefits to it.