Memo on Reinsurance

Reinsurance, at first, is insurance. Therefore, to understand reinsurance, we can start with the concept of insurance.

Insurance is a way to mitigate risks. The risks are mostly financial risks due to either medical problems, or natural disasters, or other sources.

We don't want to go bankrupt because of, say, the unexpected high medical bills. It does not always happen, but it is possible at some points. That's why we buy insurance to mitigate some risk.

By giving up a little money each period, a group of people, usually the customers of an insurance company, have a pool of money that can cover some medical bills of that group in that period. What's left in the pool is to cover the expenses for the insurance company.

Similarly, direct insurance companies, which are the one deals with customers, don't want to be broke either. It does not always happen, but it is possible at some points.

Insurance companies can go bankrupt when the total cost of covering customers' medical bills and the corporate expenses exceed the pool of the money because there are more medical bills than they expected.

That's why the insurance companies want to buy insurance to mitigate some risk, like the insured customers. Here we have reinsurance companies that provide insurance to direct insurance companies.

Customers are better off by adding a layer of insurance protection; direct insurance companies are also better off by adding another layer of reinsurance protection.

Reinsurance companies can further mitigate some risk using retrocession insurance, which refers to the reinsurance specifically for a reinsurance company. Here we have another layer of protection.

As a social planner, the government requires all of us (customers, direct insurance companies, and reinsurance companies) to have some insurances.

By the way, Bermuda is the center of the reinsurance sector. The insurance and reinsurance sector makes it a leading offshore financial services center in the world.


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