Reinsurance is how insurance companies get insurance
Your insurance coverage is there to protect you in the event of a covered loss. But what protections does your insurance company have? What happens if an insurance company incurs substantial losses after a catastrophe? This is where reinsurance steps in.
What does reinsurance mean?
Reinsurance is what insurance companies rely on when times get hard. Think of reinsurance as insurance for insurance companies. It limits the losses an insurance company can sustain. Reinsurance is especially useful in the event of a catastrophic loss, in which an insurer risks financial ruin after issuing a number of large payouts.
Events such as Hurricane Andrew in the 1990s are a good example of reinsurance's necessity. When the hurricane led to more than $15 billion in damages, some insurance companies became insolvent, putting consumers at risk of not receiving payouts for their losses and risking massive rate increases as a secondary consequence.
How does reinsurance work?
Reinsurance can get complicated, but there are general principles which remain true in most circumstances. Think of your auto or home insurance company as the primary insurer. The main function of reinsurance is to protect primary insurers against the financial consequences of catastrophic events that could deplete their finances.
Consider how a small car insurance company works. Because of its size, it isn’t likely to collect a huge amount in premiums. Regulations require the company to have enough money on hand to fulfill the policies it has written, but if the company faces a number of substantial losses in a very short amount of time, it may struggle to pay out all the claims.
A reinsurance policy reduces an insurance company's individual risk. In a reinsurance agreement, a reinsurer assumes part of the risk the primary insurer has taken on via the policies it has written. When your auto or home insurer pays a reinsurer to shoulder a portion of their risk, the primary insurer becomes known as the ceding company. There are a few different ways that these agreements are configured, which you can read about in more detail below.
What are the different types of reinsurance?
Sometimes, reinsurance companies share a portion of all premiums and risks. In other cases, losses must reach a certain threshold before reinsurance kicks in. They can cover an entire portfolio or be written for just a single risk. These two primary forms of reinsurance are treaty and facultative agreements.
What is treaty reinsurance?
A reinsurance treaty, otherwise known as obligatory reinsurance, is an agreement made between the primary insurer and the reinsurance company. It states that the primary insurer will cede certain risks and for the reinsurer to assume them. In this fashion, a reinsurer will often cover large groupings of policies, such as the entirety of an insurer’s automotive business. These agreements are valid for a specified amount of time.
What is facultative reinsurance?
Unlike treaty reinsurance, facultative reinsurance requires each risk be individually underwritten. Think of it as a case-by-case approach. These are typically high-risk, covering — for example — events such as hurricanes or buildings such as skyscrapers. Each agreement can be either proportional or non-proportional, as detailed below.
What are proportional and non-proportional agreements?
A proportional — or pro-rata — agreement dictates the primary insurer and the reinsurer will share both the premiums and any potential losses.
In a non-proportional — or excess of loss — agreement, the primary insurer agrees to cover a certain amount of risk, known as retention. The reinsurance company agrees to cover losses over a certain limit. This typically applies to catastrophic risks such as hurricanes.
How does reinsurance affect what you pay for insurance?
Individual consumers aren’t likely aware of reinsurance transactions. The reinsurance market is of huge importance, providing a vital form of risk transfer that helps insurance companies remain solvent after catastrophic events. What transpires in the reinsurance markets can have a big effect on the rates faced by everyday insurance customers.
Without reinsurance, the insurance industry would be more volatile. Customers would most certainly bear the brunt of sharp rate increases, and many might find coverage more difficult to obtain. Because reinsurance reduces the amount of capital = an insurance company is required to have on hand, insurers are freed up to write more policies and cover certain types of risk they would otherwise be less inclined to cover.
Reinsurance companies look closely at global events. Catastrophic losses in any part of the world can impact the global insurance market, be it a tsunami in Japan or an earthquake in Chile. In recent years, occurrences of flooding, wildfires, and hail have become more and more costly for the industry. With claims costs rising, that can mean higher insurance premiums for the average customer.
While it’s not likely that scientists or insurance companies will attribute any single event to an overall change in climate, it is likely that they will look at trends showing more powerful weather events that pose serious insurance risks. Such risks can lead reinsurers to pass along costs to primary insurers, which can then be transferred directly to the consumer through their home or auto insurance policy premium.
Which companies sell reinsurance?
Reinsurance companies are by no means limited to the United States. Insurance is a global business, and many of the larger reinsurers work with primary insurance companies around the world.
Some of the biggest reinsurers include:
- Swiss Re
- Munich Re
- Hannover Ruck Se
- SCOR Se
- Berkshire Hathaway
- China Reinsurance Group
- Reinsurance Group of America
- Great-West Lifeco
- Korean Reinsurance Company
By sharing risk exposure with these reinsurers, insurance companies reduce the cost of their policy premiums. All in all, reinsurance is a reliable form of risk management that smooths global insurance markets and keeps rates affordable.