Why is reinsurance necessary?

Insurance company would prefer to reinsure as part of its responsibility to control a portfolio of risks for the advantage of its policyholders and investors. Following are the functions of reinsurance.

Risk transfer

The main use of any insurer that might practice reinsurance is to allow the company to pass greater individual risks than its size, and to protect a company against losses. Reinsurance allows an insurance company to offer higher limits of protection to a policyholder than its own assets would allow. For example, if the principal insurance company can write only $20 million in limits on any given policy, it can reinsure the amount of the limits in excess of $20 million. Reinsurance’s highly refined uses in recent years include applications where reinsurance was used as part of a carefully planned hedge strategy.

Income smoothing

Reinsurance can help to make an insurance company’s   by absorbing larger losses and reducing the amount of capital needed to provide coverage. Buying reinsurance is generally done on a quota share basis and is an efficient way of not having to turn clients away or increase additional capital

Surplus relief

An insurance company's writings are limited by its   balance  sheet. When that limit is reached, an insurer can do one of the following: stop writing new business, increase its capital, or buy "surplus relief" reinsurance. Buying reinsurance is usually done on a quota share basis and is an efficient way of not having to turn clients away or raise additional capital.

Arbitrage 

The insurance company may   purchase reinsurance coverage at a lower rate than what they charge the insured for the underlying risk, which can be in the area of risk associated with any form of the asset that is being issued. For example car, a mortgage, an insurance etc.

Reinsurer's expertise

The insurance company may want to avail of the expertise of a reinsurer in regard to a specific risk or want to avail of their rating ability in odd risks.