What is reinsurance?

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Every year, unexpected events occur that cause damages to a person’s property such as car, home, rental, boat, etc. The impact of unexpected events can leave a devastating effect on your emotional and physical health, as well as your financial health. Although insuring your property are ways to lessen the financial blow, it can still incur unexpected costs depending on the damages. Even insurance companies will suffer the impact of the unexpected event if it causes damages to any of your insured property and belongings.

This is why reinsurance exists. Reinsurance is a type of insurance that can be purchased by your insurance company for additional security. By having reinsurance, your insurer can limit the amount of loss that it will incur from any type of unexpected event or damage. Reinsurance not only protects insurance companies, but it also protects the policyholder from any uncovered losses. Since the impact of a damage to your car or other property can provide large financial implications, obtaining reinsurance may be a great idea.

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?

Reinsurance is often for insurance companies. Insurance companies will look at other insurance companies that provide reinsurance 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.

  • 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 specific losses that may occur.
  • 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 capital.
  • Solvency margins: A solvency margin indicates an insurance company’s ability to meet unexpected costs. Reinsurance can help as a security so that insurance companies will have extra capital and security if an unexpected event were to happen.
  • 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.

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.

Proportional and non-proportional agreements

A proportional reinsurance is also known as a “pro rata.” Under this agreement, the reinsurer will receive a prorated share of the 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 is noted in the retention or priority. The stated amount is determined by the insurance and reinsurance company.

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.