What Is Reinsurance in Car Insurance?

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 catastrophe in the following ways:

• Protects financial loss from a single event: This may refer to a large catastrophic event, such as a total fire loss of a large manufacturing plant.
• Protects against aggregation of small claims: Reinsurance provides financial backing when many smaller claims are being made at once, for example in the event of a 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.

The first insurance company (the cedent) transfers risk to the reinsurance company. This means it passes (or cedes) financial responsibility onto the reinsurance company. Reinsurance works as a reimbursement system that protects insurers from very high claims once they pass a certain dollar amount. That said, the original insurance company may still provide some of the payouts.

In the event of a significant natural disaster—say, a hurricane in Florida—it’s unlikely that one, or several, insurance companies could cover the millions or billions of dollars worth of damage. In this instance, reinsurance would transfer some of the financial risk to mitigate 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.

Reinsurance can also be used to cover less catastrophic risks, such as those associated with a regular auto insurance policy. This allows the first insurance company (the cedent) to branch out into new insurance markets and acquire new business.

Reinsurance increases insurance rates for policyholders 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.¹

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.²

For its policyholders, reinsurance means an insurance company will be able to honor its claims in the event of a catastrophe.

In addition to risk protection, reinsurance brings the following benefits for the insurance providers (cedents):

• Expertise: Collaborating with reinsurance companies facilitates shared expertise, which may help insurance companies improve their ratings and service.
• Risk Transfer: Risk is effectively distributed between companies, reducing individual exposure.
• Capital Management: Reinsurance helps maintain capital efficiency by preventing the need for excess reserves.
• Solvency Margins: In the event of a catastrophe, insurance companies can continue taking on new customers and do not need to raise extra capital.
• Arbitrage: A company can make additional profit purchasing reinsurance for less than the premiums it charges policyholders.

Treaty Reinsurance

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. Treaty reinsurance is the most common method of reinsurance.

Facultative Reinsurance

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. Facultative reinsurance involves higher management costs than treaty reinsurance, as the reinsurer is more involved in the process.

Proportional and Nonproportional

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.³ 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.⁴ Most often, nonproportional reinsurance agreements cover individual policies or events that may affect multiple policyholders.

According to the latest available data, these are the top five companies in the reinsurance market, which spans globally.⁵

• Munich Reinsurance Company
• Swiss Re Ltd.
• Hannover Rück SE
• Canada Life Re
• Berkshire Hathaway (the parent company of GEICO)

In the reinsurance 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. Because of this, reinsurance also helps protect policyholders.