Definition
Reinsurance is a practice in the insurance industry where an insurance company reduces its risk of exposure by transferring part of its liabilities to another insurance company. This secondary company is called a reinsurer. This system allows the primary insurer to remain solvent by mitigating large losses and stabilizing financial results.
Key Takeaways
- Reinsurance refers to the practice where insurance companies transfer portions of their risk portfolios to other parties, to reduce the likelihood of having to pay a large obligation resulting from an insurance claim. This is done to prevent catastrophic losses.
- The party that diversifies its insurance portfolio is known as the ceding party. The party that accepts a portion of the potential obligation in exchange for a share of the insurance premium is called the reinsurer.
- There are two main types of reinsurance: treaty and facultative. Treaty reinsurance implies that the ceding company and the reinsurer agree that the reinsurer will cover a certain portion of specific insurance policies issued by the ceding company. Facultative reinsurance is negotiated separately for each insurance contract that is reinsured.
Importance
Reinsurance is a critical term in finance and insurance industries, because it refers to the practice where insurance companies share risks to protect themselves from significant losses.
It allows insurance companies to remain viable and capable of covering their policyholders even in the face of substantial claim events.
The concept provides stability for the insurance market, avoids huge losses by distributing risk, and enhances the insurer’s creditworthiness.
Additionally, reinsurance allows insurers to underwrite policies that cover larger risks than their size would allow.
Through reinsurance, insurance companies can insure more clients and larger risks, which aids in protecting economies and societies from the impacts of disasters like floods and hurricanes.
Explanation
Reinsurance serves a crucial function in the global insurance industry by providing the primary insurers with the safety net against large-scale losses. It acts as a form of ‘insurance for insurers’ where they mitigate their risk exposure by passing on a portion of their risk to another insurer called the reinsurer. This strategy helps insurance companies manage their risk levels effectively and maintain their financial stability.
When insurers assume responsibility for large policies, such as natural disaster coverage, there is a potential for claims that could exceed their ability to pay. Therefore, they turn to reinsurance as a solution to spread this risk and soften the potential loss. The use of reinsurance is not solely for risk management; it also contributes to an insurance company’s solvency capacity and expands its underwriting capabilities.
With reinsurance, primary insurers can write policies which have coverage amounts that go beyond their capital thresholds. Reinsurance enables insurance companies to increase their capacity to underwrite more policies and retain more customers. The ability to spread their potential losses across a broader base allows insurers to endure the financial impact of large scale disaster events and ultimately, it benefits the policyholders as their insurers are more robust and secure.
Examples of Reinsurance
Natural Disaster Coverage: One of the most common uses for reinsurance is in the insurance industry’s coverage of natural disasters. For example, a Florida insurance company that provides homeowner’s insurance needs to be prepared for the possibility of a devastating hurricane, which could potentially cause damage that would cost more than the company could afford. The insurance company may then purchase reinsurance from another company that agrees to pay for claims over a certain amount in the event of such a disaster. Thus, the original insurance company mitigates its risk of insolvency due to a single highly destructive event.
Life Insurance Policies: Let’s consider a life insurance company that writes a $30 million policy for a client. The company is now at risk of having to pay a significant sum in the event of the client’s death. To reduce its exposure to this risk, it might purchase reinsurance for the amount of the policy over $10 million, for example. Therefore, the reinsurance company would be responsible for the amount over $10 million if a claim is made, reducing the risk for the original life insurance company.
Health Insurance Companies: In the health sector, a patient might undergo a very expensive treatment which would cost more than what the health insurance company could cover. In this case, health insurers would approach a reinsurer to cover part of that risk. For example, if a patient’s treatment would cost $1 million, the insurance company can work with a reinsurer to cover any costs that exceed $500,
This way, the insurer is sheltered from severe financial loss.
FAQs on Reinsurance
1. What is reinsurance?
Reinsurance is a practice where insurers transfer portions of their risk portfolios to other parties. This strategy enables insurance companies to reduce the likelihood of having to pay a large obligation resulting from an insurance claim, thereby protecting the company’s solvency and profitability.
2. What are the types of Reinsurance?
There are two main types of reinsurance: facultative reinsurance and treaty reinsurance. Facultative reinsurance is negotiated separately for each insurance policy that is reinsured. Treaty reinsurance, on the other hand, covers a proportion of an insurer’s entire book of insurance business.
3. Why do insurance companies buy reinsurance?
Insurance companies buy reinsurance to protect themselves from the risk of large losses. They may also do so to increase their capacity to underwrite more policies. By transferring some risk to a reinsurer, an insurance company can free up capital and potentially take on more business.
4. What does a reinsurance broker do?
A reinsurance broker acts as an intermediary between the insurance company and the reinsurance company. They play a crucial role in the negotiation of reinsurance contracts, helping insurance companies to find the best reinsurance deals and assisting in the settlement of claims.
5. How does reinsurance affect policyholders?
While reinsurance might not directly impact policyholders, it provides long-term stability for insurance companies. By spreading its risk, an insurer is better able to withstand large losses and to offer competitive premiums to policyholders. Therefore, reinsurance indirectly benefits policyholders by contributing to the health and stability of insurance companies.
Related Entrepreneurship Terms
- Ceding Company
- Facultative Reinsurance
- Treaty Reinsurance
- Risk Retention
- Surplus Share
Sources for More Information
- Investopedia: An extensive financial education website that provides information on various financial terms and concepts, including reinsurance.
- Swiss Re: A leading global provider of reinsurance and insurance who’s website provides detailed insights into the field.
- Insurance Information Institute (III): Offers in-depth information about all aspects of insurance, including reinsurance.
- Lloyd’s of London: A British insurance market where members join together as syndicates to insure risks, including reinsurance.
