Hurricanes, tornadoes, wildfires and other unexpected weather events can wreak havoc on cars, homes and other property. With the appropriate level of insurance in place, individuals can limit their financial loss. However, when these occurrences are widespread and impact a large number of people with the same insurance provider, the financial blow to insurance companies can be devastating. This is why reinsurance exists. Reinsurance is a type of insurance utilized by insurance companies to ensure enough funds are available to honor payments to policyholders when catastrophic claim payouts exceed what the insurance provider can handle.
What is reinsurance?
Reinsurance is a form of risk management available to insurance companies. A single catastrophe can potentially carry a very significant price tag that’s capable of wiping out any one insurer. Reinsurance companies share the risk with the primary insurance company—the company that issued the policy to the policyholder— which makes it a financially stronger company. Spreading losses among primary insurers and their reinsurance partners reduces the cost of claims paid by any single company.
The reinsurance industry includes companies that specialize in selling reinsurance to primary insurers and also includes primary insurance companies with internal reinsurance departments.
Primary insurers purchase reinsurance directly from reinsurers, from brokers, through a reinsurance intermediary or with institutional investors.
Spreading risk not only acts as a safeguard from potentially bankrupting events, it also allows insurers to increase their scope of clients with high coverage needs. Because of the shared risk, insurers enjoy more latitude in their policies and coverage.
How does reinsurance work?
Primary insurers include those companies that work directly with policyholders and agree to cover losses. In the event of catastrophes where insurers face substantial losses over a short period of time, companies face depleted finances or possible bankruptcy.
Primary insurers mitigate the risk of financial calamity by taking out their own policies with reinsurance companies. Acting as ceding companies — companies that pass some or all of their risk to other companies — primary insurers rely on reinsurers to help cover extreme losses.
Consider, for example, a massive tornado that ravages parts of Oklahoma and leaves billions of dollars of damage in its wake. While near impossible for a single company to cover the damage, spreading the risk across several insurers protects both the policyholders and the insurance companies from excessive losses.
According to the Reinsurance Association of America, a trade group for the industry, many of its resources go to “promoting a regulatory environment that ensures the industry remains globally competitive and financially robust.” The organization represents members in state, federal and international forums.
With the goal of ensuring solvency, proper market behavior, fair contract terms, fair rates and adequate consumer protections, the insurance division of each state is responsible for regulating reinsurance companies incorporated within its borders. By maintaining a solid structure and sound practices, state regulators ensure that both policyholders and insurance companies have enough coverage for catastrophic losses.
Who needs reinsurance?
Reinsurance is insurance for insurance companies and is not available to the general public. Insurance companies need reinsurance for numerous reasons, including limitation of risk, stabilization of loss, financial protection from catastrophic claims and to increase the company’s growth potential. By partnering with a reinsurance company, insurers not only transfer portions of risk but also increase solvency margins through arbitrage and capital management.
Common reinsurance terms
- Risk transfer: A risk transfer is an agreement between the insurance and reinsurance company. The insurance company will pay the reinsurance company to take responsibility for handling losses that exceed a certain threshold.
- Cedent: The cedent or the ceding company is the insurance company that passes on its risk to the reinsurance company.
- Arbitrage: The insurance company may be motivated to purchase reinsurance because of arbitrage, which is buying a less expensive policy than the one they are charging the insured for the underlying risk.
- Capital management: Reinsurance is a tool for capital management as insurance companies look for ways to manage risk and optimize profitability.
- Solvency margins: A solvency margin indicates an insurance company’s ability to meet unexpected costs. Reinsurance provides a layer of security so that insurance companies will have capital to honor catastrophic claim payouts without the fear of insolvency.
- Expertise: The reinsurance company may provide specific expertise to the insurance company as the reinsurer can set an appropriate premium for a specific risk. The reinsurer can also provide expert guidance on risk management.
- Retention: The maximum amount of risk held by the primary insurance company is known as retention. Once a loss exceeds the company’s retention limit, it is passed on to the reinsurance company.
What are the types of reinsurance?
Reinsurance sometimes involves shared premiums and risks of all policies generated by primary insurers — treaty reinsurance. Other times, reinsurance involves only losses above a predetermined threshold — facultative reinsurance.
Treaty reinsurance
Also known as obligatory reinsurance, treaty reinsurance establishes an agreement between the primary insurer and the reinsurance company. With treaty reinsurance, primary insurers cede certain risks and reinsurers assume them. Treaty reinsurance commonly involves an entire policy grouping like homeowners coverage, for instance.
Facultative reinsurance
Facultative reinsurance differs from treaty reinsurance in that it requires underwriting around each individual risk. Facultative reinsurance typically involves high risk events and property — things like hurricanes and skyscrapers.
Both treaty reinsurance and facultative reinsurance fall into one of two agreement categories. With a proportional agreement, primary insurers and reinsurers share both the premiums as well as the potential losses. With a non-proportional agreement, the primary insurer covers loss up to a specified amount and reinsurers cover losses above the primary insurer’s limit.
Proportional and non-proportional agreements
Proportional reinsurance is also known as a “pro rata.” Under this agreement, the reinsurer will receive a prorated share of the primary insurer’s premiums. It then requires the reinsurance company to take on a percentage of the losses.
Non-proportional reinsurance agreements are also known as “excess of loss.” Under this agreement, reinsurance companies are only required to pay out if the claim to the insurer exceeds a specific amount that surpasses the retention limit. The stated amount is predetermined by the insurance and reinsurance company.
How does reinsurance affect insurance rates?
Reinsurance allows primary insurance companies to grow and acquire more insurance policies and aids in keeping rates lower for policyholders. Sharing the risk of a potentially catastrophic loss with another company also ensures that the primary insurance company will remain solvent and be able to fulfill its financial duty to policyholders when needed.
At the same time, reinsurers look closely at patterns of catastrophe around the world. Increased rates of flooding or wildfires, for example, leads to increased claims. As the rate of claims rises, reinsurers pass costs to primary insurance companies. Primary insurers cover these higher costs by increasing premiums for policyholders.
Frequently asked questions
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