Need for reinsurance
The basic principal of reinsurance is to spread the risk further than just the life offices own life pool of funds. The life office pays away reinsurance premium to the reinsurer and receives in return a reinsurance policy that could be called upon when claims reach a certain unfavourable level.
Life office premiums are based on the mortality risk and mortality tables. These tables have been drawn up over a number of years and have a high accuracy level. These tables predict the number of people at a certain age that will die during a year. Life offices use a level premium basis and over the years build up a fund for each policy until the claim is due to be paid. The cost of the claim is therefore the sum insured less the fund that already exists for that policy. This difference is called the death strain on the life office. Whilst mortality tables predict the number of deaths they do not predict the size of the sum insured.
Retention
The life office will set a maximum limit (sum insured) they want to retain on any one life. This is called the offices retention limit. A life office may well issue a policy in excess of this retention limit, but only if they can purchase reinsurance to cover the excess amount. In this way the life office can control the maximum exposure they have for any one life and this helps avoid the adverse exposure they would have if a life with a large sum insured was to die early on when its fund accumulation was well below the sum insured.
This retention limit will be regularly reviewed to reflect growth in the life fund, the financial strength of the life office and inflation.
Retentions vary per life office and are largely dependent on the size of the life fund, the level of free reserves and the average sum insured. Retention levels may be varied depending on the age of the life insured. With lower retention limits for older lives and sub standard risks. The class of policy may also affect retention. Because Reinsurers see a larger portfolio of substandard cases they have built up a level of expertise in this area. A large established life office may have a retention level of £500,000 whilst a small new office may have a retention level of only £10,000.