The concept of reinsurance is a relatively simple one. It enables an insurer to offset some of the risk on an individual policy or group of policies to another insurer. One of the main ways that reinsurers make money is through arbitrage. That’s the idea that you can bring together a group of risks and have a greater degree of certainty about the overall pay-out in claims than you had on a single risk – this enables reinsurers and the original insurer to make money.
An Example
Let’s say an insurer wants to sell a policy to a truck driver. It is difficult to tell the precise chances of making a payment on a single truck driver; they may be right inside the bell curve or a statistical outlier. However, if you could bring 100 such policies together; it is much more likely that you can accurately predict how much you would pay out under those policies because they are much more likely to conform to a statistical norm.
A reinsurer can thus buy the risks on the single polices for less money than the original insurer needed to collect in premiums. As long as they pay less than the required premium amount for each of the 100 drivers treated as individuals, and more than the required premium as they would have been paid if the 100 drivers had insured themselves collectively – there’s a guaranteed profit to be made.
One of the constraints on arbitrage deals is that the transaction costs (the admin costs, bank fees, etc.) must be less than the available margin. Otherwise a paper profit can quickly become a loss.
Not all arbitrage deals are the same. Imagine the case of two homes being insured. Each lays in the same flood plain as the other. In this case, there’s no improvement in risk for multiple policies. If one home makes a claim for flood damage then the other home is also going to make a claim. This is a constraint on arbitrage because packaging these risks together doesn’t reduce the overall risk of a claim and the only way for arbitrage to work would be to charge an increased premium over the combined premiums of the two policies.
In this instance, an insurer wanting to take out reinsurance is likely to have to use two separate reinsurers in order to offset their risk because there’s no value in paying a 2 home surcharge on a policy when each individual policy can be offset for risk more cheaply on its own.
Another way to overcome this constraint is to examine layering the risk; this allows an insurer to reinsure specific risks under the policy (as opposed to the policy as a whole). In some cases this would allow the sum of the risk layers to drop below the original policy value and make it manageable for reinsurance.
Summary
Reinsurance is an industry standard practice in order to reduce the level of risk that any particular insurer is exposed to. It is important to overcome the constraints of arbitrage in order to do this successfully.
