Understanding Reinsurance: A Complete Overview

Reinsurance is the process through which insurance companies share risk by purchasing insurance policies from other insurers to limit total loss. Reinsurance is insurance for insurance companies, according to the Reinsurance Association of America. The purpose of reinsurance is to protect all insurance companies from excessive exposure to a large disaster. This, in turn, stabilizes the industry and allows for wider coverage. Read on to understand what is reinsurance and how it factors into the insurance industry.

What is Reinsurance in Insurance?

The idea of reinsurance has been around for centuries. In fact, the Reinsurance Association of America states dates back to the 14th century when it offered marine and fire reinsurance. Unlike primary insurance, which is offered to individuals and companies, reinsurance is offered to insurance companies to protect them from certain losses and risks. U.S. regulations require reinsurers to be financially solvent so they can meet their obligations to insurers.

Reinsurance insurance plays a vital role in insurance companies. It allows them to expand and take on additional clients while sharing part of the risk with a third party, called the reinsurance company. The original insurance company that collects premiums from clients and distributes some of this risk with other insurers is called the ceding insurer because they cede both some of the insurance premiums and some of the risk to another insurer.

The insurer that accepts this risk in exchange for a portion of the premiums is called the reinsurer or assuming insurer. They may take on different types of risk depending on the type of reinsurance offered. 

For example, catastrophe insurance is one of the most popular and costly types of reinsurance. Catastrophe insurance covers low-probability, high-cost events like natural disasters or man-made disasters. This is costly for insurance companies but ensures that in case a hurricane or earthquake hits, the insurance company can maintain solvency. 

How Does Reinsurance Work?

Reinsurance works to make insurers solvent by recovering some of the amounts paid out to claimants. It's designed to reduce net liability on individual risks and catastrophe protection from large or multiple losses. Reinsurance allows insurance companies to increase their underwriting capabilities in the number and size of risks by covering the insurer against accumulated liabilities to withstand unusual events.

Different Types of Reinsurance

There are several types of reinsurance, from the most common catastrophe reinsurance to facultative insurance for a specific purpose, each with distinct advantages. 

Facultative Reinsurance

Insurers purchase facultative reinsurance for a single risk or a defined package of risks. This is usually a one-off transaction when the reinsurance company performs underwriting for some policies to be reinsured. If several risks or contracts need reinsurance, the insurance and reinsurance companies are renegotiated separately. 

Pros

• Decreased risk for the insurer
• Increased insurance capacity
• Protects against catastrophe
• Stabilizes loss on a specific insurance transaction

Cons

• Large amounts of administration
• Full details of risks
• May not be able to confirm cover immediately or need to wait on the reinsurer

Treaty Reinsurance

Treaty reinsurance is a contract between a reinsurer who agrees to accept the risks and a ceding insurance company for a predetermined class of policies over a period of time. Insurance companies underwrite a new policy and agree to take on additional risk in exchange for a premium.

Pros

• Coverage against a class of predetermined risks
• Gives the ceding insurer more security 
• More stability during major events 
• Protects against catastrophe
• Insurers can tailor specific terms for each risk

Cons

• The insurer operates within certain constraints

Proportional 

Proportional reinsurance insures a part of original insurance premiums and losses being shared between a reinsurer and insurer. In that way, the insurer and the reinsurer share the premiums and the claims on a given risk in a specified proportion.

Pros

• Shared coverage against losses
• Covers a proportion of the risk for the ceding insurer
• Protects against catastrophe
• A portion of the risk is distributed among multiple insurers

Cons

• The insurer operates within certain constraints
• Premiums can be high

Non-Proportional

With non-proportional reinsurance, the ceding insurer agrees to accept all losses up to a predetermined level. It's based on loss retention, in which the reinsurer agrees to reimburse the ceding insurer for losses up to certain levels. 

Pros

• Transfers a significant part of the risk to third parties
• Offers capital relief
• Increased capacity
• Decreased risk 
• More stability during major events 
• Protects against catastrophe

Cons

• The insurer operates within certain constraint

Catastrophe Reinsurance

Insurance companies purchase catastrophe reinsurance to reduce exposure to the financial risks related to catastrophic events and natural disasters. Catastrophe insurance allows insurance companies to shift some or all the risk associated with policies it underwrites. In exchange, the insurance company pays a portion of the premiums it charges policyholders to the reinsurance company.

Pros

• Protects against natural disasters like earthquakes, floods, hurricanes and man-made disasters
• Offers capital relief
• More stability during low-probability, high-cost events 
• Protects insurers and their clients in case of catastrophe

Cons

• Adds to insurance premiums
• Costly for insurance companies

Does Reinsurance Have an Impact on Insurance Rates?

Reinsurance plays a crucial role throughout the insurance industry and can have a direct impact on insurance premiums. Reinsurers provide risk management support that enables primary insurers to underwrite more individuals and companies. This, in turn, means that reinsurers have a significant influence on insurance underwriting, management and pricing.

Reinsurance Opportunities

While most consumers are familiar with insurance, few understand the role of reinsurance. Reinsurance offers peace of mind to clients and protection to insurance companies. Reinsurance spreads the risk between many insurers, significantly reducing the risk of insurance collapse. The reinsurance market is a stable, growing part of the insurance industry that offers a crucial security net that serves to stabilize the market. 

Frequently Asked Questions