Some companies in the insurance sector engage in reinsurance because they want to reduce risk. Reinsurance is basically insurance that insurance companies buy to protect themselves from excess losses due to high exposure. Reinsurance is an integral component of insurance companies' efforts to keep themselves solvent from the risk of default due to payouts, and regulators mandate it for companies of a certain size and type.
For example, an insurance company may write too much hurricane insurance based on models that show low chances of a hurricane inflicting a geographic area. If the inconceivable did happen with a hurricane hitting that area, considerable losses for the insurance company could ensue. Without reinsurance taking some of the risk off the table, insurance companies could go out of business whenever a natural disaster hit.
However, insurance companies are systemically important; many people rely on them for their everyday needs such as health insurance, annuities or life insurance. Therefore, the industry needs to manage risk tightly to prevent instability. Essentially, the negative externalities of an insurance company going bust are massive.
Regulators mandate that an insurance company must only issue policies with a cap of 10% of its value, unless it is reinsured. Thus, reinsurance allows insurance companies to be more aggressive in winning market share, as they can transfer risks. Additionally, reinsurance smooth out the natural fluctuations of insurance companies, which can see significant deviations in profits and losses, making the sector more appropriate for investors.For many insurance companies, it is more like arbitrage. They charge a higher rate for insurance to individual consumers, and then they get cheaper rates reinsuring these policies on a bulk scale.
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