Reinsurance is a means by which an insurance company can protect itself against the risk of losses with other insurance companies. Individuals and corporations obtain insurance policies to provide protection for various risks (hurricanes, earthquakes, lawsuits, collisions, sickness and death, etc.). Reinsurers, in turn, provide insurance to insurance companies.
Reinsurance helps primary insurers to reduce their capital costs and raise their underwriting capacity since major risks are transferred to reinsurers’’; the primary insurer no longer needs to retain capital on its balance sheet to cover them. Reinsurance thus serves the primary insurer as an equity substitute and provides additional underwriting capacity. This indirect capital is cheaper for the primary insurer than borrowing equity, since reinsurers can offer to assume risks at more favorable rates thanks to their superior risk diversification.
The additional underwriting capacity permits the primary insurers to assume additional risks which without reinsurance they would either have to refuse or which would compel them to provide a lot more of their own capital. In a globalized world, in which potential financial claims are steadily rising and in which the limits of insurability are being constantly extended, reinsurance thus assumes a major significance for the whole economy.