What is reinsurance?
Simply, reinsurance is insurance that is purchased by an insurance company from another insurance company (the reinsurer) and enables risk to be spread across a number of financial backers. The reinsurer is paid a premium by the insurance company to cover a predetermined level of liability. The practice of reinsurance provides benefits for insurers including risk transfer, diversification, surplus relief, pricing arbitrage, tax mitigation and reduced volatility from large or frequent losses. A reinsurer may also purchase reinsurance from another reinsurer to further control risk. This process is known as retrocession.
What is investment “float”?
An insurer receives premiums upfront, while claims are paid out over time. This results in an interest-free pool of capital available for investment, which is known as the “float”. Warren Buffett refers to the reinsurance model as a “collect-now, pay later” model that provides significant capital to invest for the shareholder’s benefit, before eventually being paid out in claims.
Why do asset managers establish reinsurance companies?
The underlying principle of reinsurance is that premiums are paid upfront while claims are paid later. This results in an interest-free pool of capital available for investment. By reducing the Company’s overall cost of capital, combined with certain benefits inherent in favorable jurisdictions such as Bermuda, the asset manager is able to achieve a higher return on equity than an identical investment strategy without the reinsurance component. The additional return on equity from a reinsurer’s investment strategy can then be reinvested to compound gains.
What are key reinsurance terms?
Arbitrage: The insurance company may be motivated to purchase reinsurance coverage at a lower or higher rate than they charge the insured for the underlying risk.
Cedants: Companies that buy reinsurance are called ceding companies, or cedants.
Claims: A formal request to an insurer or reinsurer for payment based on the terms of a policy.
Float: The capital available to an insurer for premiums paid up front which is held and invested until required to pay claims and expenses.
Premium: Specified payments to an insurer or reinsurer to compensate for bearing risk of possible future payouts under an insurance policy.
Reserves: A stated amount of assets that are held as available to satisfy all claims on in-force policies and outstanding liabilities.
Retrocession: A practice whereby reinsurance companies purchase reinsurance to further mitigate risk.
Risk Transfer: With reinsurance, the insurer can issue policies with higher limits than would otherwise be allowed, thus being able to take on more risk because some of that risk is transferred to the reinsurer.
Underwriting: A process of evaluating risk exposures whereby financial backers accept some level of risk in exchange for a premium.