As a business owner, you protect your company against certain types of losses by purchasing insurance. Reinsurance serves a similar purpose for insurance companies. Reinsurance is essentially insurance for insurers. A reinsurance company insures risks assumed by insurance companies.
Purpose of Reinsurance
Reinsurance serves several purposes. First, it helps spread risks across multiple insurers. By sharing its risks with a reinsurer, an insurance company can protect itself against catastrophic losses.
Reinsurance also helps stabilize the insurance market. If reinsurance did not exist, insurers would likely have wide swings in profitability, losing large sums in one year and making big profits in another. Reinsurance helps minimize large fluctuations in profits and losses.
Another purpose of reinsurance is to increase insurers' capacity, meaning the maximum dollar amount of risk insurers can assume. For example, if an insurer can issue a maximum of 1,000 policies, each of which has a $1 million limit, the insurer's capacity is $1 billion.
For each policy an insurer issues, it must maintain a certain amount of money in reserves to pay future claims. The amount of reserves an insurer must maintain is established by state law. If an insurer has not put aside enough money to pay future claims on behalf of its current policyholders, it cannot issue any more policies. Because a reinsurer shares an insurer's losses, reinsurance helps an insurer increase its capacity. If reinsurance did not exist, insurers would issue fewer, more expensive policies.
An insurer that purchases reinsurance is called the ceding company or cedent. The insurer cedes (transfers to a reinsurer) a portion of its premiums and losses for a risk or group of risks. The reinsurer pays a commission to the insurer or to the reinsurance broker, if a broker is used.
Types of Reinsurance and Sharing
There are two basic types of reinsurance, treaty and facultative. Under both types of reinsurance, the reinsurer shares the insurer's losses in exchange for a premium.
Loss sharing between insurers and reinsurers typically occurs in either of two ways. One is on a proportional basis. For example, an insurer negotiates with a reinsurer. The insurer agrees to retain 70% of the premiums and to pay 70% of the losses on all homeowners policies the insurer issues. The reinsurer agrees to assume 30% of the premiums and to pay 30% of the losses. Proportional sharing is often used in commercial property insurance.
Another option is for the insurer and the reinsurer to share any losses that exceed a specified amount. For example, suppose that an insurer has issued liability policies with a $1 million limit. The insurer agrees to retain the first $750,000 of any loss that occurs. In exchange for a premium, the reinsurer agrees to pay any remaining amount that exceeds $750,000, up to an additional $250,000. This excess of loss sharing method is often used in general liability insurance.
Treaty reinsurance covers broad groups of risks, such as all homeowners policies or all commercial auto and general liability policies. Treaty reinsurance contracts are typically long-term arrangements that continue for many years. Once the contract has been finalized, the reinsurer must accept all risks of the type described in the reinsurance treaty. For instance, if the reinsurer has agreed to reinsure all homeowners policies issued by the insurer, the reinsurer must accept all homeowners policies. It cannot pick and choose among policyholders.
Here is an example of how treaty reinsurance protects an insurer. Suppose that the Elite Insurance Company has issued 25,000 commercial property policies to small business owners located in 15 states. The total premium for all the policies is $250,000. Elite has ceded 40% of the premiums and losses to Reliable Reinsurance. Reliable receives $100,000 for its share of the premium (40% of $250,000). A devastating tornado sweeps across two states and affects 1000 Elite property policyholders. The policyholders suffer a total of $25 million in property damage. Elite pays $15 million (60% of $25 million) and the reinsurer pays the remaining $10 million.
Unlike treaty reinsurance, facultative reinsurance applies to an individual risk. That is, an insurer obtains facultatitve reinsurance for each insured individually, based on its own characteristics. For example, suppose you operate a non-profit organization for disadvantaged children. You have a commercial auto liability policy that has a $1 million limit. A local church has donated a 15-seat bus to your organization. You plan to use the bus every few months to take a group of children on a field trip. You notify your commercial auto insurer about the bus and describe how you plan to use it. At first, your insurer refuses to insure the bus. However, after much negotiation, it agrees to cover it on the condition that it can obtain facultative reinsurance for the bus.
The insurer contacts Reliable Reinsurance. Elite agrees that for any accident that occurs involving the bus, it will pay the first $500,000 in damages. In exchange for a premium, Reliable agrees to pay any remaining damages, up to $500,000. For instance, suppose that your bus is involved in a serious auto accident that results in a $750,000 claim. Elite will pay the first $500,000 and Reliable Reinsurance will pay the remaining $250,000.
Reinsurers Insure Each Other
Finally, to help spread risks, reinsurers may assume risks on behalf of other reinsurers. For example, Reliable Reinsurance agrees to reinsure 40% of the Elite Insurance Company's homeowners policies. Reliable then negotiates with another reinsurer, which accepts half of the risk that Reliable has assumed on behalf of Elite. When one reinsurer insures another, the transaction is called a retrocession.