Reinsurance Definition, Types, and How It Works

What Is Reinsurance?

Reinsurance is sometimes called insurance for insurance companies because it’s a contract between a reinsurer and an insurer. It enables the insurance company, or ceding party (or cedent, as it’s commonly known) to transfer risk it has insured with a customer to a reinsurer. This gives part or all of a policy written by the insurance company to the reinsurance company.

Reinsurance – insurance for insurers – is a way of shifting risk to another firm and lowering the probability of a large payout of a claim.

Reinsurance allows insurers to remain solvent by recovering all or part of a payout.

Companies that seek reinsurance are called ceding companies.

Types of reinsurance include facultative, proportional, and non-proportional.

How Reinsurance Works

For example, under reinsurance arrangements, insurers remain in business because they get to recoup some or all of the payouts to claimants; over-simplifying somewhat, reinsurance lowers the net liability on each risk, while cap Table 1: Summary of important features of the various forms of protection provided by insurance companies Coverage typeNet risk Relationship to the covered peril Property insurance One year.

The occurrence of the event (fire, flooding, etc) results in a payout to the insured; catastrophe insurance Large or multiple losses.As above, but during events with a minimum number of losses.ReinsuranceThe full amount would need to be paid; the insurers involved can protect themselves against this.Some or all of the amounts paid out to claimants the insurance becomes cheaper for customers, while the company’s risk exposure shrinks.

The practice also serves to enable the ceding company – that is, the company seeking to reinsure its risk – to increase its capacity in terms of quantity and magnitude of risks underwritten. A ceding company is simply an insurance company that transfers risk to another insurance company.

Benefits of Reinsurance

Reinsurance provides the original insurer with cover against accumulated liabilities, and so helps to secure its equity and solvency by increasing its leverage-against-risk: if an event occurs that is unusual and major in its dimensions, it has the resources to foot the bill.

As a rule, insurers are statutorily obliged to hold adequate provisions to pay all possible claims on policies that have been issued.

With reinsurance, insurance companies can write more policies or aggregate more risk without having to transform solvency margins into commensurately higher administrative costs. The industry also makes large sums of liquidity available to insurers if major losses occur.

Types of Reinsurance

With facultative coverage, the reinsurer indemnifies the insurer for one individual or a pre-specified risk or contract. If a portfolio of risks or contracts needs reinsurance, contracts are negotiated afresh for each of them. By definition, the reinsurer holds full underwriting rights for facultative reinsurance.

Unlike an insurance policy, a reinsurance treaty runs for a specific period of time, rather than a per-risk or contract arrangement. The reinsurer takes on all or part of the risks assumed by the insurer.

Reinsurance Deconstructed

In proportional reinsurance, the reinsurer gets a share of all policy premiums the insurer sells, and then a share of losses for any claim, with both calculated as a share of pre-negotiated percentages. The reinsurer also reimburses the insurer for some of the costs of processing they incur, the costs of acquiring the policy, and the costs of writing the policy.

In non-proportional reinsurance, the amount guaranteed to the reinsurer depends on whether the losses paid by the insurer exceed a certain amount (call it the priority or retention limit).

With non-proportional reinsurance, the reinsurer takes no proportionate share in the insured’s premiums and losses, but the priority or retention limit is determined by a specific risk type or an entire risk category.

In excess-of-loss reinsurance, the insurer keeps a retained limit or surplus share treaty amount and the reinsurer covers losses that arise only above that. This non-proportional coverage is commonly deployed in catastrophic events and it can be on a per-occurrence or in the aggregate basis (that is, it may cover losses merely when the insurance company incurs them in the same event – say, losses caused by the same hurricane or flood: or it can cover cumulative losses in a given amount during a given time interval).

Risk-attaching reinsurance covers all claims established within the period of cover, whether the underlying loss occurs within or outside the period of cover, while it provides no cover against claims established outside the period of cover that are related to an underlying loss occurring within the period of cover.

What Is Reinsurance?

Reinsurance is insurance for your insurance company. When you buy more car insurance than you and your insurance company really want, or if the risk of your house catching fire elicits more nervousness than your insurer can handle, you can find someone to take on a portion or even the whole risk.

Only another insurance company, or reinsurer, would consider such an activity (or at least one who knew another company would take on the new risk, or who’s HQ was close by a lovely beach and a good bar). Ceding company contracts with their reinsurers generally are quite complicated, involving step-down and other complex arrangements whereby the reinsurer picks up only a portion of the risk, with the ceding company retaining the remainder but forfeiting the premium associated with the portion relinquished. Cut-through provisions often feature in the contracts in case one company coincidentally turns out to be insolvent.

Why Should Insurance Companies Have Reinsurance?

Common reasons that insurers buy reinsurance include: to increase the capacity of an insurance company; to act as a stabiliser to underwriting results; for financing; for catastrophe protection; to spread an insurer’s risk; and to gain expertise.

What Types of Reinsurance Are There?

It comes in two basic flavours: treaty and facultative. The former is an agreement covering a whole class of business – say, all of a primary’s auto business – while the latter covers a single individual risk, typically a very large one or a risk presenting an unusual exposure (such as a hospital) and therefore not suitable

The Bottom Line

Reinsurance is an arrangement between an insurer and a reinsurer (known as the assuming or reinsurance party), whereby the underwriter of insurance coverage (the ceding or insured party), in exchange for a premium, transfers to the reinsurer all or part of the underwriter’s risk for individual risks or entire portfolios of risk. In other words, reinsurance is really ‘insurance for insurance companies’, and it relieves the ceding party of some or all of their insured exposure by assuming some or all of their insurance policies. Reinsurance moves risk from one company to another to avoid the risk of having to pay a large sum of money for one or more insured losses.