REINSURANCE DEFINED AND EXPLAINED

Reinsurance is a specialized type of insurance that insurance companies purchase to mitigate risk in their business operations. Essentially, reinsurance allows insurance companies to transfer a portion of their policy risks to another insurer – the reinsurer. The purpose of reinsurance is to diversify risk and protect insurance companies from catastrophic losses.

Under a reinsurance contract, the original insurer passes along some percentage of its policy premiums to the reinsurer. In exchange, the reinsurer agrees to cover a set amount of any future claims that the original insurer incurs from customers. For example, in a type of reinsurance called treaty reinsurance, the reinsurer might cover any claims over a certain dollar amount, say $250,000 per event. So if an insurance company paid out $500,000 to a policyholder after a major storm, they would simply turn around and bill their reinsurer for the amount over $250,000.

Reinsurance increases the capacity of insurance companies – allowing them to underwrite more policies than they could solely on their own. Reinsurers often have greater financial resources and geographic diversification. So they can take on risks that are too large or complex for regional insurance providers. In this sense, reinsurers act as shock absorbers for insurance markets. They prevent insurance volatility or gaps in disaster-prone areas.

The definition and regulation of reinsurance varies globally, however. Some countries consider reinsurance a separate business from insurance. Hence they have distinct rules and licensing requirements for reinsurers. In the United States though, reinsurance falls under standard insurance regulations since reinsurers just provide wholesale insurance.

The architecture of reinsurance contracts can also vary dramatically. Proportional reinsurance sees the reinsurer receive a set percentage of premiums and provide reimbursements up to the same percentage. In non-proportional contracts like expected loss reinsurance, complicated calculations around anticipated average losses dictate the reinsurance terms. There are also facultative agreements in which insurers “facultatively” cede some part of a single policy’s risk rather than their whole book of business. The reinsurance market thus requires complex risk modeling and actuarial expertise to function profitably and sustainably.

With accelerating climate change and mounting natural disaster costs globally, experts anticipate rising demand for reinsurers moving forward as organizations’ many functions make them an indispensable pillar of the wider insurance marketplace.