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What is Financial Reinsurance?

Jim B.
Jim B.

Financial reinsurance is a type of insurance used primarily by life insurance companies to keep profits steady from one year to the next. Other insurance companies may also use the technique, which employs another company known as the reinsurer to essentially hold the money of the original insurance company. This money is invested by the reinsurer and then returned to the insurance company in times of need. Life insurance companies generally need financial reinsurance to adapt to the possibility of higher payouts in some years than in others.

A typical life insurance policy requires an individual to pay regular premium payments to a life insurance company. At the time of the policy-holder's death, the life insurance company then pays out benefits to the beneficiaries of the deceased as stipulated in the policy. Since there is no way to definitively tell when insurance holders will die, life insurance companies run the risk of having some years when they have to pay out significantly high amounts. To prevent against this, life insurance companies take out their own policies known as financial reinsurance to keep profit levels smooth from year to year.

Man climbing a rope
Man climbing a rope

Any life insurance company interested in financial reinsurance must pay a premium to a company specializing in reinsurance. If the life insurance company has a good year financially, it can put the surplus into the reinsurance policy. Reinsurance companies generally take the money and reinvest it in safe securities and generally keep a percentage of the profits from these investments as payment for their services.

When the life insurance company has a year in which a higher than average number of policy-holders pass away, it may need access to its financial reinsurance. It is important to note that the reinsurer generally does not pay out anything much higher than the premium it originally received from the first company. For that reason, there is little risk transferred to the reinsurer, which is why the rates they offer to insurance companies are relatively low.

Other insurance companies that have inconsistent profits but wish to keep a constant bottom line may also seek out financial reinsurance. One of the benefits of this arrangement over a typical loan arrangement is that it is dependent on how profitable the insurance company is. A loan, by contrast, may necessitate repayment by the insurance company even in lean financial times. In addition to that, the insurance company is generally guaranteed the return of its premium payments at the very least. Some reinsurance arrangements have a term limit attached to them specifying when the premium will be returned by the reinsurer.

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