What is Reinsurance?

Reinsurance is like buying a home security system…

Everyone already has a lock on the front door. But many people also choose to invest in a home security system for extra protection. In other words, you’re spreading the job of keeping your family safe among a few different safeguards. Insurance companies normally spread out risk among a large pool of policyholders. When they buy reinsurance, they spread the risk out even further.

Reinsurance is a type of insurance policy that insurers purchase to protect themselves from financial losses. Just like you buy auto or health insurance to minimize your costs in the event of an unforeseen disaster, insurance companies protect themselves by buying reinsurance.

Like consumer policies, every reinsurance policy looks a bit different depending on the type of losses it protects against and when coverage kicks in. In general, all reinsurance policies help protect providers against financially crippling losses from covering insurance claims.

The details of reinsurance policies vary, but common features include:

• A primary insurer (also known as a ceding company), which is the insurance company writing policies for consumers
• A reinsurer, which writes the policy to cover the primary insurer in the event of certain financial losses
• A reinsurance policy, which is the contractual agreement between the two parties
• A reinsurance premium, which the primary insurer pays to the reinsurer
• Cession, or the portion of the potential losses that the primary insurer transfers to the reinsurer
• Retention, which is the net amount of risk that the primary insurer keeps (in other words, the dollar amount or percentage of losses the primary insurer is responsible for)

There are two primary types of reinsurance: treaty and facultative.

With treaty insurance, the reinsurer takes on the risk of the primary insurer for a particular type of business. For example, a primary insurer might buy reinsurance to cover all of its auto insurance policies. This type of policy covers a company on a continuous basis — If the primary insurer files a claim, the reinsurer has to cover it. Treaty reinsurance is kind of like your health insurance policy — It only covers losses related to your health, not your car or home.

Suppose you want a more specific type of health insurance to cover a particular hospital visit or procedure. That’s kind of how a facultative reinsurance policy works — Primary insurers purchase these policies to cover a specific contract or risk, often those that are more hazardous and not covered by treaty insurance. With faculty insurance, the reinsurer can choose whether to accept all or part of the policies the primary insurer offers. With treaty insurance, on the other hand, the reinsurer has to accept all policies that fall under the agreement.

A reinsurance policy is a contractual agreement between two parties. The first party, the primary insurer, pays a premium to the reinsurer, who agrees to cover some of the primary insurer’s financial losses. In other words, the primary insurer transfers some of its risk to the reinsurer.

Reinsurance policies typically work in one of two ways. First, a reinsurance policy might be an excess-of-loss agreement. In this situation, the primary company retains a specific amount of the liability for any losses it incurs. The reinsurer covers any costs beyond that predetermined amount, usually up to a limit.

Reinsurance policies can also be proportional (aka pro rata) agreements, in which the two companies each cover a certain percentage of the losses. The two companies agree on the split ahead of time in the policy contract. This type of agreement is most common in the case of property insurance. The primary company and reinsurer often share the premium from the policyholder, as well as any potential losses.

There are several main reasons insurance companies may want to buy reinsurance:

• Increasing the company’s capacity: Insurance companies can only write policies if they’re able to cover the losses that could result. By buying reinsurance, an insurer can increase its capacity to write new policies.
• Providing some stability: Just like any other company, those in the insurance industry strive for a steady level of growth and return on investment (ROI). But because of the nature of the business, companies can take minimal losses in one quarter and massive ones in the next. Reinsurance helps create some stability.
• Providing catastrophe protection: Just as a catastrophe could result in financial destruction for you if you don’t have insurance, the same is true for insurance companies that purchase reinsurance. If your house burns down and you don’t have homeowners insurance, you’re going to have a hard time covering those financial losses. And if an insurance company has to pay out a massive amount of claims at once, especially in the case of natural disasters, that could be financially crippling without reinsurance.
• Spreading out risk: Reinsurance helps to spread the risk of losses among many different companies. Suppose a reinsurance company provides coverage to homeowners insurance providers in many states. If a natural disaster hits one of those states, the companies there will probably take on huge losses. But because the reinsurance company covers firms all over the country, most of its customers aren’t filing huge claims. It’s as if insurance companies from the rest of the country are helping to cover the losses of insurance companies in the state where the natural disaster occurred.

Insurance and reinsurance are different types of policies that achieve the same goal: risk management.

Insurance is a contractual relationship between an insurance company and a policyholder. The policyholder pays a premium, and in return, the insurance company promises to shield the policyholder from certain financial losses.

Reinsurance involves the same basic concept. The insured party pays a premium to the other party, who then promises to minimize the risk of the policyholder. In the case of reinsurance, both parties are insurers.

The two types of insurance also operate in similar ways. For example, some reinsurance policies work on an excess-of-loss basis, meaning the reinsurance company covers the losses of the insured company over a particular amount. This concept is similar to paying a deductible — You have to cover the deductible yourself, and then the insurance coverage kicks in.

The other form of reinsurance, proportional reinsurance (aka pro rata), is similar to the concept of coinsurance that exists in health insurance policies. After you meet your health insurance deductible, you’re still responsible for coinsurance (the percentage of your medical bill you have to pay), while the insurer covers the rest. Similarly, a proportional reinsurance policy means that the insured company and the reinsurance company share the cost burden based on predetermined percentages.