What effect does the purchase of reinsurance have on an insurer's regulatory capital?

The purchase of reinsurance allows an insurer to manage their risk more effectively, enabling them to underwrite more insurance coverage without the need to proportionally increase their regulatory capital. When an insurer enters into a reinsurance agreement, it effectively transfers a portion of its risk to another insurer. This risk transfer reduces the amount of capital that needs to be held against potential claims, since the reinsurer will assume part of the liability.

By alleviating the capital burden associated with the risks retained, insurers can expand their underwriting capacity. This means they can accept additional policies and risks, enhancing their ability to operate in the market while maintaining regulatory compliance. Essentially, the insurer's capital is used more efficiently, and the capital requirements remain stable or even decrease due to lower risk exposure.

This concept underscores the critical importance of reinsurance in risk management strategies, especially within the London Market, where underwriting large and complex risks is commonplace.