Reinsurance definition
Think of reinsurance as insurance for insurance companies. Just like you get a homeowners policy in case something devastating happens to your home, an insurance company buys reinsurance to protect against exceedingly large losses.
An insurance company buys reinsurance that covers some or all of its risk to help ensure it can pay policyholders after a catastrophic event. If a large number of the company’ policyholders experience catastrophic events, then it may be able to recoup some of the money it pays out in claims.
How reinsurance works
At a minimum, reinsurance involves two parties who enter a contract. The first party is the one that buys the reinsurance coverage. It’s sometimes called the ceding party because it “gives up” some of its liability to the second party, the reinsurer. In exchange for taking on the ceding party’s liability, the reinsurer gets paid according to the terms of the contract.
This is what insurance people mean when they talk about transferring risk, and it’s essentially the same as what happens when you buy a policy. You pay a premium so that some of your risk transfers to your insurance company. Few people can take on all of the risk of owning a home, but home insurance makes it possible.
That’s basically the idea behind reinsurance, too. By getting reinsurance, the ceding company, which is usually an insurer that sells policies to consumers, limits its exposure to catastrophic loss.
Imagine, for example, you own an insurance company that specializes in Florida home insurance. Your policyholders rightly expect that you can pay their claims if a covered event occurs. But with so many homes in a high-risk area, you have to think about what might happen if a major hurricane blows through and causes damage to most (or all!) of your policyholders’ homes.
To guard against that possibility, you buy reinsurance. Now if a hurricane or some other covered peril does cause catastrophic damage, your company is prepared to meet its obligations.
Types of reinsurance
Most insurance companies use reinsurance, but what that looks like can vary quite a bit. First, there are two general methods for reinsurance:
- Facultative coverage, which means reinsurance is negotiated for each policy separately.
- Treaty reinsurance, where the reinsurer covers a portion of all the insurance company’s policies.
Next, there are an additional five types of reinsurance:
- Proportional. In this type of reinsurance, which falls under the treaty reinsurance method, the ceding company sells a prorated portion of each policy to one or more reinsurers. The reinsurer gets a portion of each premium in exchange for paying a portion of each claim.
- Non-proportional. Another type of treaty reinsurance, non-proportional reinsurance only kicks in if the ceding company’s claims exceed a certain amount in a given period.
- Risk-attaching coverage. Any claims stemming from the ceding company’s policies are covered no matter when the loss occurs as long as the policies were created during the reinsurance contract. Claims aren’t covered for policies that began outside of the reinsurance contract, even if the loss occurred while reinsurance was in force.
- Loss-occurring coverage. In loss-occurring reinsurance, it doesn’t matter when the policies were created. The reinsurer covers all claims that occur during the life of the reinsurance contract. Losses that happen after the reinsurance contract expires are not covered.
- Claims-made coverage. Claims are covered as long as they’re reported to the insurance company during the reinsurance contact. This is different from loss-occurring coverage because here the date of claim report is considered the date of the actual loss. Loss-occurring coverage only kicks in if the date of the loss happens during the reinsurance contract.
Why reinsurance is important
When an insurance company has a large number of policies in a particular area, it becomes more susceptible to catastrophic claims. Reinsurance provides insurance companies in that situation with the finances to pay claims they may not be able to financially handle. In some extreme cases, reinsurance can even help an insurance company stay solvent.
But there’s a benefit to reinsurance for homeowners, too, particularly if they live in an area where extreme weather is common. Basically, reinsurance provides a cushion that allows insurance companies to take on more risk. One of the reasons we can insure homes in Florida is because we have a strong reinsurance program that helps us offer coverage that people can afford.
