Risk Management: Reinsurance

Now let’s look at Project Finance from a different point of view, from the insurance companies. As you can image there are all sorts of catastrophic losses involved with Project Finance whether it is a space station, nuclear power plant, water utility, and so on. About a year ago Japan was hit by a massive earth quack that destroyed a lot of projects like nuclear power plants. Imagine that one insurance company covered all of these nuclear power plants in Japan. The company would go bankrupt and investors in the project will lose everything they have put in. One way to prevent this is with reinsurance.

Reinsurance is a way for insurance companies to protect themselves from massive losses by selling their policies. Their are companies that deal with reinsurance such as Willis Re, Towers Watson has a massive department, TOA Re, and so on. These companies buy insurance policies after analyzing them.

There are six principal functions of reinsurance:

  1. Increase large line capacity – A max amount that an insurance company can accept in polices.
  2. Provide catastrophic loss – If a loss, like in Japan, happens then the loss is spread over the primary insurance company and the reinsurance or multiple reinsurance companies.
  3. Stabilize loss experience – protects companies from losing stock value or losing their credit rating.
  4. Provide surplus relief – during periods of rapid growth some insurance companies may be forced to slow down because they cannot cover all of their polices. Reinsurance allows them to grow by selling off some of their policies.
  5. Facilitate withdrawal from a market segment – If a market becomes too risky, like Japan, an insurance company can sell all of its policies.
  6.  Provide underwriting guidance – insurance and reinsurance companies working together to value risks.

I will talk more about types of reinsurance in other blog posts. Its good to understand how risk is managed behind the scenes.

Picture from: http://www.flickr.com/photos/martini_dk/369891979/

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