Key Differences Between Insurance and Reinsurance

When we define reinsurance, we often say that is a type of insurance for insurance companies themselves. This statement gives the impression that the reinsurance contract is very similar to the insurance contracts which individuals enter into. This is not completely true.

There are significant differences between an insurance contract and a reinsurance contract. Some of these differences are quite subtle which is why an average person has difficulty understanding them.

In this article, we will have a closer look at the various differences between insurance and reinsurance.

• Customer Base: As mentioned above, insurance contracts are generally signed by individuals and corporations. However, reinsurance contracts are signed by insurance companies themselves. This may seem like a small difference. However, it has a huge impact on the way the industry functions.

  The retail buyers of insurance contracts are not savvy about the functioning of the insurance industry. This is the reason why in the retail insurance industry, branding plays a huge role.

  Retail insurance companies have to woo their customers by advertising and creating a brand recall. On the other hand, reinsurance is like a transaction between two parties who understand the insurance business very well.

  Hence, when insurance companies choose a reinsurer, they do it on a purely statistical basis. Brand preference and brand recall have very little influence on the decision-making process. Hence, it can be said that since the customer base changes, the entire market strategy which needs to be used to sell reinsurance products also needs to change.

• Motive: The motive for buying reinsurance is quite different from the motive for buying insurance. As a result, the type of policies sold also varies quite significantly.

  A person purchasing insurance wants to protect themselves in the event of a single adverse event. However, when an insurance company purchases a reinsurance policy, it is done to protect itself from a large number of claims arising simultaneously.

  A large number of claims can arise together only if there is some kind of catastrophe. Hence, it can be said that reinsurance is generally undertaken to protect against some kind of natural calamity or catastrophe. This also means that the policies sold are quite different.

  Reinsurance contracts generally pay out losses after they reach over and above a certain threshold. This means that the cash flow structure of reinsurance policies is completely different from that of normal insurance policies.

• Regulation: Insurance companies sell financial products to end customers. Many of these customers may not be financially savvy. As a result, the government has to intervene in order to protect its financial interests.

  Also, even if a single insurance company fails, it can create problems for the entire industry since customers will end up losing confidence. This is the reason that governments all over the world ensure that insurance companies are highly regulated. The amount of risk they are undertaking as well as the quantum of capital that they have on hand is monitored by the government. The same cannot be said about reinsurance companies.

  Since reinsurance contracts are made between two parties who are well-versed in the industry and have the knowledge required to protect their own financial interests, governments do not generally interfere in such contracts. There is some form of regulation on reinsurance as well. However, it is not as intrusive as the regulation for insurance companies.

• Financing Mechanism: The manner in which reinsurance companies finance the payment of their claims can be quite different than that of insurance companies. Insurance companies sell policies to create a money pool and a risk pool. As and when an adverse event occurs, money is taken out from the money pool created by selling policies. In case of a catastrophe, claim payments are financed by using the proceeds of reinsurance claims.

  However, in the case of reinsurance, the funding pattern can be quite different. Of course, premiums received by selling policies are used to pay the claims. However, there are other sources of funding such as catastrophe bonds. These bonds allow the reinsurance company to obtain funding from people who are not their policyholders! There are many such financial instruments that have been created and floated in open markets in order to finance reinsurance payments.

• Risk Factors: The risk factors and risk modeling of individual insurance contracts are quite different as compared to reinsurance contracts.

  For instance, individual car insurance contracts are affected by the age of the driver, the miles driven, the type of car, etc. However, when it comes to reinsurance contracts, these things do not matter.

  Reinsurance companies will have to pay out claims for cars in the event that a natural calamity arises. In that case, the age of the driver and the miles driven every year will become irrelevant. Hence, pricing a reinsurance contract on the basis of such factors would be pointless.

  The fact of the matter is that the underwriting algorithm which is used to determine the premium of individual policies will not be very effective when reinsurance contracts are considered.

The fact of the matter is that reinsurance companies are quite different as compared to traditional insurance companies. Every aspect of their business, right from deciding the premium to be received to actually paying out the claim is significantly different from regular insurance companies.

Hence, the reinsurance industry is an industry in its own right with a significantly different risk-return profile as compared to insurance companies.