Reinsurance is a way for insurance companies to transfer some of the risk they take on when they sell insurance policies. An insurance company buys reinsurance that covers some of its risk to help ensure it can pay policyholders after a catastrophic event.

Reinsurance explained

Reinsurance is like 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 rare and exceedingly large losses. If a large number of the company’s policyholders experience catastrophic events, then it may be able to use its reinsurance to fund claims payments to policyholders.

How does reinsurance work?

At a minimum, reinsurance involves two parties who enter a contract:

• The insurance company that buys the reinsurance coverage. 

• The reinsurance provider.

In exchange for taking on some of the insurance company's liability, the reinsurance provider 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. Few people can take on all of the risk of owning a home, so they transfer some of it to their insurance company by buying a homeowners policy.

That’s basically the idea behind reinsurance, too. By getting reinsurance, an insurer reduces 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 many 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: treaty and facultative coverage.

• Treaty reinsurance. Treaty coverage is where the reinsurer covers a portion of all the insurance company’s policies.

• Facultative coverage. With facultative coverage, an insurer buys reinsurance that protects a specified set of policies. 

Additionally, there are five different features of reinsurance, which vary based on how they distribute risk between the insurance company and the reinsurer. The five main types of reinsurance are proportional, nonproportional, risk-attaching, loss-occurring, and claims-made.

Proportional 

In this type of reinsurance, the insurance company sells a fixed percentage of each policy to one or more reinsurers. The reinsurer gets a portion of each policy’s premium in exchange for paying a portion of each claim.

Nonproportional 

Another type of reinsurance, nonproportional reinsurance only kicks in if the insurance company’s claims exceed a certain amount in a given period.

Risk-attaching coverage 

Any risk transfer stemming from the insurance company’s policies are eligible, as long as the policies incepted during the reinsurance contract. Risk transfer isn’t allowed for policies that incept outside of the reinsurance contract period.

Loss-occurring coverage 

In loss-occurring reinsurance, it doesn’t matter when the policies were created. The reinsurer accepts risk transfer for loss events that occur during the life of the reinsurance contract. Losses that happen after the reinsurance contract expires are not eligible for risk transfer.

Claims-made coverage 

Risk transfer is eligible as long as they’re reported to the insurance company during the reinsurance contact period. This is different from loss-occurring coverage because here the date of claim report is considered on whether that risk can be transferred to the reinsurer, instead of when the loss occurred.

Why insurance companies need reinsurance

When an insurance company has a large number of policies in a particular area, it becomes more susceptible to having to pay a lot of claims all at once. Reinsurance provides insurance companies with the liquidity to pay claims in these large events.

But there’s a benefit to reinsurance for homeowners, too, particularly if they live in an area where extreme weather is common. Reinsurance provides a way for insurance companies to spread risk globally, allowing them to have capacity to write more policies. 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.

Benefits of reinsurance

In a nutshell, the benefits of reinsurance include:

• Improved financial stability for the insurance company.

• A greater number of homeowners are able to get quality coverage.

Alternatives to reinsurance

There are a few alternatives to reinsurance that some insurance companies may investigate. One example is catastrophe bonds, or cat bonds, a type of debt security that transfers risk from an insurer to the capital markets. It behaves similar to a debt instrument, except that the debt holder loses their investment when a catastrophe event happens, instead of when a company fails to pay back its debt.

Does reinsurance impact insurance premiums?

Reinsurance can have a positive impact on home insurance premiums because it allows insurance companies to confidently write policies and be sure of their ability to meet their obligations to its policyholders. When reinsurance costs go up, however, it can mean higher premiums for policyholders.