Cyber Risk in Reinsurance
February 12, 2025
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The concept of reinsurance is fairly simple. When a person takes on insurance, they transfer their risks to the insurance company. The insurance company sells the same contract to many people to create a pool of money. Since all the people are not likely to face an adverse event at the same time, insurance companies can pay money out of the pool and still be left over with additional money for profits.
However, as insurance companies sell more policies, the quantum of risk that they undertake also increases considerably. Therefore, insurance companies also need to purchase another insurance policy wherein they can insure their risks to a certain extent. This second-degree insurance is called reinsurance.
To a layman, it may appear as if buying reinsurance is an optional add-on that insurance companies may or may not choose. However, the fact of the matter is that reinsurance is a vital component that enables the smooth functioning of insurance companies across the world.
The main benefits which are derived as a result of reinsurance have been explained below in this article.
Reinsurance allows the company to transfer this risk to a different insurance company that does not have similar or related risks. This allows them to lower their overall risks and continue expanding their business even if it means that most of their clients are geographically concentrated.
For example, the recent hurricane has impacted the entire state of Florida which is a very large geographical area. However, on the world map, Florida is still a very small percentage of the total area.
Reinsurance enables insurance companies to diffuse the risks to different parts of the world. The end result is that even if all of Florida is destroyed by a flood, Florida’s insurance companies will still not go bankrupt. This is because they would have reinsured the risks with companies in different parts of the world such as Switzerland or even Japan. This diffusion of risk helps the insurance system withstand the shocks posed by big natural calamities.
Even if one insurance company goes bankrupt, the entire industry will face the aftereffects. This is because firstly there will be direct losses as insurance companies transact extensively with each other. Also, the customers will lose faith in the insurance industry as a whole. This could also mean that the insurance companies will face a tough time selling more policies
Reinsurance enables companies to pay premiums which reduces their revenues in normal years. However, when a catastrophe hits, the revenue received via claims helps bring the revenue back to the normal level. The end result is that reinsurance enables predictable cash flows which helps companies meet their other liabilities without stretching their finances too much.
One insurance company assumes the risk and hence the customer has to deal with that company. However, at the back end, the insurance company can further pass on the risk to multiple companies. This eliminates the need for purchasing multiple policies while providing the same level of financial protection.
The fact of the matter is that reinsurance is a very important part of the overall insurance industry as there are several benefits to it.
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