It is not for nothing that the laws of the land prescribe a minimal portion of the insurance business to be compulsorily reinsured with another insurer / reinsurer.

The insurance business is inherently and intrinsically risky as the losses are of a probabilistic nature, and when they take place, they do so with a randomly varying frequency. This is more so, in the case of new or small insurers, or where existing insurance companies underwrite new classes of business. In such cases, a certain portion of their insurance risk cover must, in their own interest, be reinsured to ensure that the risks are spread.

In India, at least till the market attains maturity, it is essential for compulsory / obligatory cessions to remain in the statute book (or alternatively in subordinate legislation like insurance regulations).
In medium size and mega value risks, it is inevitable that certain cessions are placed on an optional (what we in insurance business parlance refer to as facultative) basis. Facultative reinsurance arrangements always carry a lower rate of reinsurance commission. For example, in the fire businesses an insurer gets 30 per cent reinsurance commission through obligatory cessions, whereas on high-value risks the optional portion fetches anywhere between 17 per cent and 25 per cent depending on market conditions. Thus, the insurer stands to gain substantially on direct cessions.

Obligatory cessions apply to all policies across the board. Motor insurance, particularly, in India is a bleeding portfolio. An insurer, therefore, has the advantage of minimising his losses in motor insurance by at least 20 per cent, thanks to the obligatory cessions. For the national reinsurer, the loss in the motor portfolio due to the obligatory cessions is so high, that it often wipes out the profit earned in other classes of business.

As mentioned earlier, in the Indian market, which has a combination of new, small and existing insurers underwriting new businesses, the 20 per cent obligatory cessions has always been a matter of comfort. It is a source of reassurance to the insured as well.

Therefore, obligatory cessions create an automatic capacity to the extent of the amount ceded, so that the direct insurers do not become vulnerable to the vagaries and whims of the foreign reinsurance market and brokers.

Obligatory cessions ensure that a minimum of 20 per cent (subject to certain quantum restrictions in fire and engineering) premiums are retained within India provided, of course, the reinsurer again does not cede them on proportionate basis.

In case of perils like earthquake and terrorism, among others, foreign reinsurers are usually unwilling to provide full cover. This has paved way for market pools to provide the capacity / cover. Market pools are also a form of obligatory cession, normally managed by the national reinsurer.

However, it must be conceded that this concept of obligatory cession should be progressively phased out as the market grows and gets integrated with world markets.

The concept of obligatory cession may seem restrictive to insurers, who feel that they should be given the freedom to choose their own reinsurer. Even so, regulators must ensure that even if risks were to be reinsured abroad in the absence of obligatory cessions, the premium loss on account of such cessions should be replaced by corresponding 'inward acceptances'. Through this, they achieve:

• good spread of risks geographically and class-wise
  
• foreign exchange cost is restored
  
• insurers also learn and get experience in the foreign reinsurance business

Incidentally, the concept of obligatory cessions is still practised in countries like Malaysia, Thailand, Singapore, etc, in one form or other. It may not be called obligatory cession, but there is the peremptory dictum that market retention capacity locally must be retained if not enhanced year to year.