What is reinsurance?

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Each year, natural catastrophes like tornados, hurricanes, wildfires and flooding take their toll on the planet, on property and on people. The devastation of these and other types of disasters leave their mark on both emotional and financial levels.

Positioned to alleviate some of the pain that goes along with loss, insurance companies act as primary resources in the initial steps needed to move past disaster. And just as policyholders tap insurers to help mitigate risk around catastrophic events, insurance companies also seek risk mitigation by tapping reinsurers.

A kind of behind-the-scenes aspect of the insurance industry, reinsurance offers insurance companies and their policyholders a safety net in the worst of times.

What is reinsurance?

Reinsurance acts as a kind of insurance for insurance companies. Essentially, reinsurance refers to shared risk among multiple insurers to limit the risk of single insurers on their own. A single catastrophe sometimes carries a price tag capable of wiping out any one insurer. But reinsurance spreads losses among primary insurers and their reinsurance partners to reduce 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 or through a reinsurance intermediary.

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, primary insurers look to 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 aim of ensuring solvency, proper market behavior, fair contract terms, fair rates and effective consumer protections, each state regulates the reinsurance industry across the country. By maintaining a solid structure and sound practices, regulators ensure coverage for inevitable losses in their states.

Who needs reinsurance?

Insurers look to reinsurance companies for a number of reasons, including limitation of risk, stabilization of loss, protection around insurance catastrophes and to increase capacity. By partnering with a reinsurance company, insurers not only transfer portions of risk but also increase margins through arbitrage and capital management.

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 certain 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 automotive 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.

How does reinsurance affect insurance rates?

The risk transfer element of reinsurance plays a vital role in helping primary insurers to remain solvent in the aftermath of catastrophic events, essentially reducing volatility in the insurance industry. Because catastrophe in any part of the world affects global insurance rates, reinsurance provides a kind of buffer against significant rate increases for policyholders.

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 through increased premiums for policyholders.

Frequently asked questions

What types of policies include reinsurance?

Policies of all stripes include reinsurance as part of the coverage mix. Primary insurers offering auto, home, business and other categories of coverage buy treaty reinsurance or facultative reinsurance to help cover policyholder claims for losses.

What types of risk does reinsurance cover?

Treaty reinsurance helps primary insurers cover a whole category of policies— auto, home, etc. Facultative reinsurance covers single items that typically include high risk.

What is the best car insurance company?

Finding the best car insurance company depends on an individual’s personal situation. The needs of someone who drives a new car with a hefty loan, for instance, differ from the needs of someone who drives an older car that carries no loan. After determining personal needs around car insurance, plenty of resources exist to find the best insurance company.