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. 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.
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.
Most insurance companies use reinsurance, but what that looks like can vary quite a bit. First, there are two general methods for reinsurance:
Next, there are an additional five types of reinsurance:
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.