What Is Financial Reinsurance?

Financial reinsurance is a technique used by life insurance companies to even out their returns and stay profitable. This technique can also be utilized by other companies that want to increase their returns without taking on a great deal of additional risk. Here are the basics of financial reinsurance.

Life Insurance Companies

One of the primary users of financial reinsurance is the life insurance industry. Life insurance companies tend to have large swings in profitability from one year to the next. One year, fewer people will pass away than in an average year, and their new policies will continue to come in at the same rate. During that year, the life insurance company will be very profitable. Then, the next year, more than the average amount of people might die, while the policies continue at the same rate. When this happens, the company's profitability can suffer. The purpose of financial reinsurance is to smooth this process out. Instead of going through "boom" and "bust" periods, the insurance company can have about the same amount of money at all times.

In order to achieve this, the life insurance company will pay another company a premium to handle a portion of the life insurance company's money. The financial reinsurance company will keep the money for the first company and, generally, will invest it. Then, when the original life insurance company goes through hard times, it can get access to the money again from the other insurance company. 

Other Companies

Although life insurance companies are usually the most common users of financial reinsurance, some other companies will use this type of service as well. When this occurs, the company pays the reinsurance company a certain amount of money known as the premium. The reinsurance company will invest that money and, if things go well, earn a return for the other company. The reinsurance company usually keeps the money for a term of 2 to 3 years. If the investments are profitable for that entire period, it will return the money to the company at the end of the term while keeping a certain amount of margin for itself for providing the service. If the investments lose money, then the company will return the premium to the original investor. In either case, the company that gave the reinsurance company the money will generally be able to get back the entire amount that it invested. Even though it is referred to as financial reinsurance, very little transfer of risk is taking place with this arrangement.

Benefits

Financial reinsurance offers companies some benefits when compared to a traditional loan arrangement. With financial reinsurance, the repayment of the money will typically depend on how profitable the company is. With this type of arrangement, the transaction does not need to be recognized as a liability on the company's financial statements. This makes it more attractive, as the company knows that the money will be repaid when the company needs it. 

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