What is Reinsurance and why haven’t I heard about it?
To quickly define what reinsurance is in general terms it’s the option insurance company’s use when they want to insure their businesses, diversifying their portfolio and reducing risk. Basically, the insurance for insurers.
Insurance companies seek the same kind of protection they offer their clients for a variety of reasons spanning from reducing & diversifying risk or exposure due to a big catastrophic event to something as simple as expertise in a given area. This is where the reinsurance market comes into play. A player in the background and a market you may have just now heard of, & it’s a very big player. Warren Buffet himself has invested billions into the market.
Historically the origins of insurance in itself came about with the desire for security and to prevision any possible future event that may jeopardize our current situation. It is said that the initial push came about around the time people began to navigate and transport things at a commercial scale. As a matter of fact the oldest signed contract to date with re insurance characteristics was signed in Geneva, Italy around 1370.
Modern insurance is based on a probability theory called the Law of Large Numbers (LLN) which describes the result of doing the same experiment a large number of times to find a median or average. That average obtained from the amount of trials should be an expected value to estimate a future occurrence. This law can almost guarantee stable long term results for random events. This is the main factor to determine or predict future claims.
Given an individual case under these terms will not provide us enough hard data to make estimations, it is necessary to observe a group of similar cases to make any determination. The bigger the group the closer our (probability) estimations will be to an actual individual case (item to be insured).
Thanks to this law, the predictions that can be made for all the probable losses of the group are much better than for each member. The foreshadowed loss load is then divided between all of the insurers and the coefficient will equal the premium needed to cover the item.
The calculation of the loss load and its distribution in individual premiums is based on extensive amounts of statistics. Now keep in mind, statistics are always based on the past, while the estimation of probabilities allows the projection of these data to the present, as well as emitting predictions of future trends or tendencies. The theory of probabilities is highly developed, but between theory and reality they have shown us that our predictions can have differences. These differences are called technical risks and they explain the need for reinsurance.
For example predicting when a person will pass away is a difficult task and it is very uncertain to predict. Now through empirical data and observation, we can predict with very close precision how many of 100,000 new borns, male or female will reach the age of 20, 50 or 70 years old.
This is a brief description of some basics to understanding Reinsurance. In the following posts I’ll give more insight into this interesting market and introduce other technical aspects of the business model and more.
Most information I gathered from work experience along with bibliography from Swiss Re manuals I own.
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