Why is obligatory reinsurance needed ?

P B RamanujamIt is not for nothing that the laws of the land prescribe a minimal portion of the insurance business to be compulsorily reinsured with another insurer / reinsurer.

The insurance business is inherently and intrinsically risky as the losses are of a probabilistic nature, and when they take place, they do so with a randomly varying frequency. This is more so, in the case of new or small insurers, or where existing insurance companies underwrite new classes of business. In such cases, a certain portion of their insurance risk cover must, in their own interest, be reinsured to ensure that the risks are spread.

In India, at least till the market attains maturity, it is essential for compulsory / obligatory cessions to remain in the statute book (or alternatively in subordinate legislation like insurance regulations).
In medium size and mega value risks, it is inevitable that certain cessions are placed on an optional (what we in insurance business parlance refer to as facultative) basis. Facultative reinsurance arrangements always carry a lower rate of reinsurance commission. For example, in the fire businesses an insurer gets 30 per cent reinsurance commission through obligatory cessions, whereas on high-value risks the optional portion fetches anywhere between 17 per cent and 25 per cent depending on market conditions. Thus, the insurer stands to gain substantially on direct cessions.

Obligatory cessions apply to all policies across the board. Motor insurance, particularly, in India is a bleeding portfolio. An insurer, therefore, has the advantage of minimising his losses in motor insurance by at least 20 per cent, thanks to the obligatory cessions. For the national reinsurer, the loss in the motor portfolio due to the obligatory cessions is so high, that it often wipes out the profit earned in other classes of business.

As mentioned earlier, in the Indian market, which has a combination of new, small and existing insurers underwriting new businesses, the 20 per cent obligatory cessions has always been a matter of comfort. It is a source of reassurance to the insured as well.