In our first eBook entitled “Principles of Insurance”, it is shown that the insurer will compensate the policyholder who experiences negative economic consequences from a specified insurable event such as fire to residential property, death of a life or diagnosis of a critical illness. For this protection, the policyholder pays a premium to the insurer.
But the insurer faces the risk that payments made to policyholders may exceed the total amount of premiums it receives from policyholders. This presents a crucial risk for the insurance company that can negatively affect its long-run survival. A typical technique utilised by the insurer to manage this risk is called risk-pooling. (We described this technique in our first blog).
However, risk pooling is less effective if the insurer faces exposure to catastrophic events such as earthquakes, hurricanes and terrorism which create claims from many policyholders all at the same time. This is called a contagion effect. Clearly, the insurer faces the possibility of a severe cash flow problem.
How can an insurance company deal with this risk?
It may seek to buy insurance from another insurance company in order to cover losses from catastrophic events. This is called reinsurance.
Insurance companies buy insurance from other insurance companies (called reinsurers) in order to manage risks from catastrophic events. For this protection, the insurance company pays a premium to the reinsurer.
Do you want to find out more about reinsurance? Download our eBook “Reinsurance” by Dr. Abdul Rahman and Dick Harryvan. You can also follow Dr. Rahman on Twitter at @AHRahman88.