Reinsurance is insurance of insurance. This means that the original insurer,who originally accepted the risk from the original insured, gets the risk covered with another (Reinsurer) for the same reason the original insured got protection for. There are many risks in almost all classes of business which may be too big for an insurer to digest or to bear on his own account. Because, the financial strength of the insurer on that account may not be healthy enough to bear a loss, if it takes place at all.
Moreover, there is the question of big catastrophe losses which might cripple down the insurer financially and force him to disown any liability to the insured simply because of inability to honor a claim. Whilst this possibility is very much there, on the other hand the insured is also most reluctant to go from insurer to insurer and to place only that amount of business to each, as each would be able to bear.
It is indeed amidst these two extremes that we see the development of a system wherein the insured goes to one insurer who usually takes the whole risk and reinsures any balance beyond his retention capacity (i.e. beyond which he cannot consume from the viewpoint of financial strength for that class of business) with the reinsurers.
Reinsurance, like insurance in general, has the element of chance involved. The reinsurer hopes that his premiums will take care of his losses and that in the course of events he will obtain a profit. When an insurer accepts a risk for a very large amount against one event, although he may be in a position to make a reasonable gain, yet indeed he has subjected himself to serious possible liabilities.
Under such a, circumstances he may desire to reinsure a part or all of the risk with some other company or insurer. Reinsurance steps in as a method whereby the insurer may receive indemnity from his reinsurer in the event of reinsured’s liability to the original insured. Some examples may be considered at this stage.
Example 1: In life insurance, the actuary can predict with some certainty as to how many lives of a given age will die within a certain period. What he cannot forecast is which of the named persons will exactly die. This ignorance or limitation of knowledge in fact has aggravated the necessity of reinsurance further, If a life company has 100000 lives all aged 20 and each insured for CAD $10,000, and if this company now gets a fresh proposal from a man, aged 20 but for an amount of CAD $30,000 then problem would arise since the company shall have to run the risk of an additional amount of CAD $20,000 which will definitely imbalance the account if simply the new entrant dies first. Therefore, this company shall feel the necessity of getting its load (CAD $20,000 in this case) reinsured with another company.
Example 2: A general insurance company may have the capacity to bear up to CAD $100000 for any property insurance or liability insurance. If a risk is placed for CAD $300000 by the insured then the insurer shall have to reinsure CAD $ 200000. In case of assuming unlimited liabilities the extent of loss may be sometimes very big and, therefore, in all fairness should have reinsurance arrangement beyond capacity.