The purpose of risk sharing is to spread the risk among those involved. The principal, or direct, insurer may pass on some of the risk to another insurance company, which, in this role, is called the reinsurer. In doing so, the direct insurer is purchasing insurance from the reinsurer. In addition, the direct insurer may structure the policy such that the policyholder – the insured party – is responsible for some of the risk, by including a deductible or policy excess in the conditions of the cover. In this case the insured party has to bear a specified sum whenever a claim is settled – the direct insurer is only responsible for the payment of the amount over and above the excess. The relationship the policyholder has with the direct insurer is parallel to the relationship the direct insurer has with the reinsurer – both the policyholder and the direct insurer are buying insurance to cover part of the risk they are exposed to.

Buying insurance protects the policyholder against the effects of “large” losses. Similarly, the inclusion of a reinsurance arrangement often protects the direct insurer against the effects of “very large” claims. In particular it protects the direct insurer against having sole responsibility (or any responsibility) for the tails of the distributions of large claims.