And how does it affect you?
Reinsurance is known as “insurance for insurance companies.” By purchasing it, an insurance company can limit its own total losses in case of disaster. While you’re not purchasing reinsurance, your insurer’s agreements with its reinsurer can affect your premium.
Reinsurance companies function similarly to traditional insurance companies, but instead of selling policies to individuals or businesses directly, they sell insurance policies to other insurance companies.
Insurers use reinsurance to protect against catastrophes in two ways. First, it protects against catastrophic financial loss resulting from a single event, such as a total fire loss of a large manufacturing plant. Second, it protects against the aggregation of many smaller claims resulting from a single catastrophic event, such as an earthquake, flood, or major hurricane. While the insurer can cover individual losses, the total cost may be more than the insurer can pay, which is where the insurer kicks in, sharing in the underwriting profits as well.
These are the biggest companies in the reinsurance market, which spans the United States and beyond.
To put it simply, the first insurance company (the cedent) transfers risk to the reinsurance company, meaning they cede financial responsibility. It works as a reimbursement system that protects insurers from very high claims once they pass a certain dollar amount. However, if a liability happens, the original insurance company may provide some of the payouts.
Say a massive hurricane makes landfall in Florida and causes billions of dollars in property damage. If one insurance company sold policies to all the homeowners in the area, the chance of it being able to cover the losses would be extremely unlikely. Instead, the retail insurance company would transfer some of the financial risk to a reinsurance company to mitigate the total cost.
In exchange for taking on this risk, the reinsurance company collects a portion of the premiums that the original insurance company collects from its policyholders. The reinsurer can then invest those premiums in stocks, bonds, or real estate, and take any gains these investments yield as profit.
Treaty reinsurance policies are agreements that cover broad groups of policies, such as an insurance company’s auto business. These agreements cover all policies that fall within the terms of the contract automatically unless either company cancels the policy.
Facultative reinsurance policies cover specific individual, high-value, or hazardous risks, like a hospital. In contrast to treaty agreements, the reinsurer has the power (or faculty) to accept or reject all or a part of any agreement with the insurance company.
Reinsuring a hospital, for example, requires the company to consider a variety of factors, including all aspects of the hospital’s operation and safety records, as well as the attitude and management of the primary insurer seeking coverage.
Treaty and facultative policies can be proportional or nonproportional in structure.
A proportional (also known as pro rata) agreement obligates the reinsurer to cover a portion of the losses for which it receives a prorated share of the insurer’s premiums. For a claim, the reinsurer bears a portion of the losses based on a prenegotiated percentage.1 The reinsurer also reimburses the insurer for processing, business acquisition, and writing costs. Proportional agreements are most commonly applied to property coverages.
Nonproportional, or “excess of loss,” agreements kick in when the insurer’s losses exceed a set amount per policy or per year.2 Most often, nonproportional reinsurance agreements cover individual policies or events that may affect multiple policyholders.
Reinsurance raises insurance rates because both companies share the profits of the insurance company. However, if an insurance company decides to take on more of the risk, it doesn’t have to profit share and thus can charge less for insurance.3
However, because reinsurance protects insurance companies from financial ruin, it also protects customers from uncovered losses. If an insurer has too much exposure to a potentially costly event, like a hurricane or earthquake, then the company could go bankrupt or even shut down if it’s unable to cover the total loss. After Hurricane Ian, for example, Allstate said its estimated gross catastrophe losses totaled $671 million pretax, but its reinsurance coverage reduced that amount to $366 million.4
In this system, risks are transferred from individuals and companies, through primary insurers, to the reinsurance company. While reinsurance can raise your premium, it’s an important safety net for insurance companies if they cannot feasibly cover payments related to a costly event like a recession, war, or natural disaster.
A disadvantage of reinsurance is that it can raise the cost of your insurance premium to offset the profit-share that the primary insurer owes to the reinsurance company.
Reinsurance companies make money by identifying and accepting policies that they believe are less risky and then reinvesting the insurance premiums they receive.
According to Insurance Business Magazine, Munich Re is the world’s largest reinsurer, with a reported total profit of $3.6 billion in 2022.
The main difference between insurance and reinsurance is the target customer. Individual consumers buy policies from insurance companies like Allstate or Progressive. Insurance companies, in turn, sign contracts with reinsurance companies to mitigate losses in the event of a disaster.
These companies tend to cover the kinds of risks that normal insurance companies do not want or are not able to cover. These sorts of risks tend to be large in scope: war, severe recession, or problems in the commodity markets.
Core Curriculum for Insurance Supervisors: Module 5.1.1 Reinsurance. International Association of Insurance Supervisors. (2017, Dec).
Insurance Handbook – Reinsurance. Insurance Information Institute. (2023).
Insurers Are Facing a Steep Rise in Insurance Rates. The Wall Street Journal. (2022, Nov 8).
Allstate to recover 45% of $671m Hurricane Ian loss from reinsurers. Reinsurance News. (2022, Oct 20).