What Is Reinsurance?

Reinsurance Explained

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While it’s unlikely you’re familiar with the term “reinsurance,” you’ve probably heard of Warren Buffett. And you likely see the value in the fact that if a hurricane hits your house, your insurance company won’t go bankrupt.  

If reinsurance didn’t exist or wasn’t adequate, the insurance sector could collapse due to economic losses from high claims. In effect, it’s insurance for insurance companies. Reinsurance helps to stabilize the life, homeowner, auto, and health insurance markets—and is profitable enough that Warren Buffett has invested in the industry through his company Berkshire Hathaway. 

A reinsurer steps in to help the original insurer pay claims. Reinsurance has been around since at least 1846 when urban fires in Europe stressed insurance companies. Since then, reinsurance has allowed insurers to remain stable despite one-off catastrophic events, such as the 1904 San Francisco fire, the 1912 Titanic sinking, and more extended losses stemming from world wars and pandemics.

Without reinsurance, 2005’s Hurricane Katrina would have caused 12% of U.S. insurers to fail. And in 2001, two-thirds of losses were paid by reinsurers for 9/11 damage. So, reinsurance is important. Let’s look at how it works, who uses it, the types of reinsurance, and how it benefits you as a consumer. 

Definition and Examples of Reinsurance

The purpose of insurance is to transfer and share risk—your auto policy allows you to share the risk of a potential auto accident with a large company. Direct insurers sell homeowner, auto, health, and life insurance policies directly to you, the consumer. Then, the direct insurer turns to a reinsurance company to help assume the risk of those policies, either partially or entirely. The direct insurer is called the “ceding” insurer.

As noted, insurance companies turn to reinsurance for their own coverage. So when you take out a homeowners policy, your insurance company insures your policy with a reinsurer. That reinsurer can even buy coverage with yet another reinsurer. The reinsurers help cover a claim, should it occur. 

The major reinsurance companies include Lloyd’s of London, Munich RE, and Berkshire Hathaway.  

Some insurance companies don’t rely on reinsurance for coverage but instead sell catastrophe bonds to investors to help cover costs.  

How Reinsurance Works

Before offering you a policy and rate, an insurance company reviews your age, location, driving history, credit history, and other variables to determine how likely it is that you’ll cause an accident or otherwise be an expensive risk. 

Similarly, a reinsurance company needs to evaluate how risky an insurance company’s policies will be to cover. Will the insurance company rack up repeated losses due to offering insurance in a hurricane-prone zone, for example? If so, the reinsurance pricing may go up in exchange for coverage. 

Where homeowners insurance is concerned, reinsurers use computer-generated catastrophe models to determine the characteristics and probability of severe weather that could impact the insurance companies, including hurricanes, floods, and tornados. The models are generated using data from the National Centers for Environment Information (NCEI) such as cyclone tracking data, tornado and hail data, and temperature and precipitation data. 

NCEI data is also used to validate how well the computer models work. According to NCEI, this data allows reinsurance companies to underwrite insurance policies for $60.5 billion. 

Reinsurance companies can’t always predict future risks, however. For example, some reinsurers ran out of money for claims due to commercial policies written between 1950-1970 due to workers’ asbestos exposure and the dumping of toxic waste.

Types of Reinsurance

Much like a policy sold to you, a reinsurance contract is negotiated with the direct insurance company. Reinsurance is focused on transferring risk from the direct insurer to the reinsurer, so reinsurance contracts may differ by how risks are shared or passed along.

Treaty or Obligatory Contracts

With a treaty or obligatory reinsurance contract, certain classes of the insurer’s policies are covered, usually a large portfolio of similar risks. For instance, all of an insurance company’s policies concerning auto insurance in California.

Facultative 

With a facultative reinsurance contract, only individual policies are reinsured on a case-by-case basis. For example, all of an insurance company’s auto insurance policies concerning California government vehicles. Facultative insurance can also help close coverage gaps after treaty reinsurance is negotiated. Insurance companies may use layers of treaty reinsurance and facultative reinsurance contracts to achieve their coverage goals. 

There are two sub-categories within these contract types (treaty or facultative): Pro-rata/proportional and non-proportional. 

Pro-Rata or Proportional

With a pro-rata reinsurance agreement, the reinsurer covers a portion of the losses and also accepts a portion of the insurer’s premiums. Proportional reinsurance prearranges premiums, losses, and expenses between reinsurer and insurer. 

Non-Proportional 

With this type of reinsurance, the reinsurer reimburses or covers costs above a certain cap (much like your deductible) up to a limit or ceiling. These policies could cover all losses over a certain amount or only for those in a particular risk category or portfolio. 

Just like your own insurance policy, there are likely maximum coverage amounts that the reinsurer is willing to cover, exclusions for certain types of coverage or events, and possibly different ways of handling claims. 

Benefits of Reinsurance

Reinsurance offers many benefits to insurance companies. By purchasing reinsurance, insurance companies limit their liability for individual policies and major catastrophes from either one major event or many claims that stem from one event (such as an earthquake). Reinsurance, therefore, helps stabilize the natural fluctuations within the insurance industry. 

Reinsurance can also benefit the consumer, too, by helping to cover catastrophic claims, allowing more insurance companies to remain in the market. Insurance companies must have enough money to pay any claims they’ve agreed to underwrite, which protects consumers but limits how much business the insurer can commit to. When the insurance company passes along the risk and requirements to the reinsurer, the insurance company can take on more policies, and perhaps keep the insurance marketplace more competitive in pricing. 

For homeowners, climate change is making reinsurance increasingly important. Weather-related losses have risen more than 350% since 1980, and weather-related damage has caused more than $1 trillion in damage in the U.S. alone. A $20 billion catastrophe happens every 10-12 years, on average. When a large natural disaster occurs, insurance companies turn to reinsurers to help cover the losses—and reinsurers bear around 65% of those losses.

Key Takeaways

  • Reinsurance is insurance for insurance companies.
  • Reinsurance can be offered in a variety of ways, including insuring a class of risk, a portfolio, or on a case-by-case basis.
  • Reinsurance companies evaluate potential risks that an insurance company’s portfolio presents before offering a policy and premium, much like an individual policy.
  • Reinsurance companies help stabilize the overall insurance market and prevent it from collapsing financially.