What is Reinsurance?

Insurance companies protect consumers, but who covers them? The answer is reinsurance companies. 

Reinsurance allows insurer companies to pass some of their risks to reinsurance companies — an arrangement that, while it does not impact consumers directly, helps keep insurance rates competitive. 

Here we explore what reinsurance is, how it works, and why it is necessary.   

What is reinsurance? 

Insurance for insurance companies is known as reinsurance. Insurance companies use reinsurance to transfer some of their liability to another player, known as the reinsurer, in the same way that you buy car or home insurance to financially protect yourself against certain events.

Why would an insurance carrier want to do that? 

There are four main reasons: 

1. To reduce the amount of reserve money insurance companies need

Insurance carriers pay claims on a regular basis. As such, they are required to keep a certain sum of money in the bank at all times. While the process of calculating the amount of reserve money needed is rather complicated, it basically involves predicting how many claims will occur in the next few months. For example, if an insurer thinks it will pay out $10 million in claims over the next six months, it must keep at least that much money in the bank.  

But predictions can go wrong. A natural disaster — like a once-in-a-lifetime ice storm — can cause tens of billions of dollars in damage. For an insurance company, a major disaster can mean lots of claims to pay at the same time. 

However,  insurers cannot afford to stash billions of dollars waiting for a major catastrophe. If they were to do so, insurance premiums would be so high that few people would be able to afford them. 

That is where reinsurance comes in handy. 

By passing some of their risk to the reinsurer, the primary insurer can afford not to keep billions of dollars in the bank for an exceptional or unexpected claim event. 

2. Protects insurance carriers against severe financial loss in the event of a major disaster

Without reinsurance, an insurer will likely face severe financial loss in the event of a major natural disaster, like a once-in-a-century wildfire. Transferring some of their liability to another party helps insurance providers mitigate their risk of major financial loss in the case of an unexpected event. 

3. Allows insurers to take on more risk

Reinsurance allows insurance companies to assume greater risks. That could mean issuing policies with larger face values or offering policies to high-risk applicants. 

4. Freeing up capital for insurers to expand

When an insurance company is starting out or looking to expand aggressively, it may not have enough reserves to cover all expected claims. Since reinsurance frees up cash for other purposes, it can help insurance companies expand.  

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How does reinsurance work?

Reinsurance is a legal contract between a reinsurer and an insurance provider. In return for regular reinsurance premium payments, the reinsurer takes some of the risk assumed by the primary insurer. This arrangement helps insurance companies avoid severe or total financial loss in the event of extreme circumstances. 

For example, let us say that a home insurance provider enjoys a virtually unchallenged monopoly in a certain region. In normal circumstances, this is a huge advantage but what if a major catastrophe, like a tornado or hurricane, were to rock that area? 

If thousands of homes get destroyed simultaneously, the insurer in question will likely find it extremely hard to pay out all the claims. In the worst-case scenario, it could even go bankrupt. 

By leveraging reinsurance, the primary insurer can transfer part of its risk to the reinsurer, limiting its losses in the case of a severe natural disaster. 

What are the different types of reinsurance? 

Reinsurance contracts are mainly of four types: 

• Facultative reinsurance
• Treaty reinsurance
• Proportional reinsurance
• Non-proportional reinsurance

Facultative reinsurance

Facultative reinsurance is a type of reinsurance that an insurer purchases to cover individual assets, such as high-value assets. The reinsurer reviews each policy to be reinsured and can either accept or reject it. 

Suppose an insurer is approached to cover a commercial building for $20 million, but it believes it can afford to pay out only $15 million in liability if the building is severely damaged.  So before writing the policy, the insurer will try to find one or more reinsurers for the remaining $5 million. 

Treaty reinsurance

With treaty reinsurance, an insurer transfers all risks within a particular class of policies — like home insurance policies — to the reinsurer.  The reinsurance company does not review each policy in that class separately. Also, any future policies in the pre-agreed class are usually automatically covered by the reinsurance contract. 

Let us say a homeowner insurance company wants to write $200 million in policies but has only $150 million in capital. To be able to meet its target, it must shop for treaty reinsurance for the remaining $50 million. The reinsurer will assume risk for the $50 million deficit, including those policies that have not been issued yet. 

Proportional reinsurance

In the case of proportional reinsurance, the reinsurer shares a fixed percentage of the losses. In exchange, it receives a part of the premiums. For instance, a reinsurance agreement may stipulate that the reinsurer will cover 30% of losses.

Non-proportional  reinsurance

The reinsurer chips in only if the total claims exceed a specific amount. For example, an insurer may enter a non-proportional reinsurance agreement in which the reinsurer will make payouts if the claims resulting from a natural disaster exceed $2 billion. 

Who needs reinsurance?

Reinsurance is meant for insurance carriers, not consumers. An insurance company may opt for it if it reduces their risk and allows it to leverage their capital position. For example, an insurer that covers thousands of homes in an area prone to natural disasters may transfer a portion of its risk to one or more reinsurers. 

How does reinsurance impact insurance rates? 

Reinsurance helps keep insurance rates affordable since the risk is shared by one or more players. If one company had to pay out thousands of claims all at once after a covered event, like a hurricane, insurance premiums rates would certainly increase after that. 

Without reinsurance, the insurance market would be more volatile. Consumers would  likely face a sharp increase in premium rates after a natural disaster. Since reinsurance reduces the amount of capital an insurer is required to have, insurance companies are able to provide cover to more people and take on risks they would otherwise be less likely to cover. 

Conclusion

Reinsurance companies exist to lessen the impact of losses on insurance companies. At the end of the day, reinsurance helps primary insurers avoid severe losses in the event of an unexpected or exceptional event. It also helps insurance companies leverage their capital position to write more policies, offers coverage they would otherwise be less likely to approve, and keep insurance rates affordable. 

Frequently Asked Questions

What types of policies are covered by reinsurance? 

Reinsurance can cover a wide range of insurance policies, including commercial, automobile, and homeowners policies. The specific types of risks covered by the reinsurance contract largely depend on the needs and goals of the primary insurer.

What is the difference between facultative and treaty reinsurance? 

In the case of facultative reinsurance, the reinsurer covers an individual risk or a series of risks. Each policy included in the reinsurance contract is considered a single transaction and the reinsurer can perform underwriting for each of the included policies. It can reject one or more policies that the primary insurer wants to reinsure. Facultative reinsurance is generally used for high-risk or high-value policies. 

Treaty reinsurance, on the other hand, involves transference of all policies within a specific risk class, like commercial auto, to the reinsurer. The reinsurance company is under an obligation to accept all policies within the pre-agreed risk class. The reinsurance contract will also cover all policies that the primary insurer will write in that class in the future.