What is reinsurance?

Key points

• Reinsurance policies can help insurance companies cover significant losses and stay afloat.
• They’re issued directly to other insurance companies, not consumers.
• Several types of reinsurance coverage are available including options that cover entire groups of policies (like home or auto) and those that cover individual policies or assets.

Ever wonder how one insurance company can afford to pay out thousands of claims in the event of a major natural disaster? The answer to this question may surprise you: Sometimes it’s not one insurance company paying out all the claims, but multiple insurers. Even if you have insurance through one company, another company could actually be paying your claim.

There’s a concept called reinsurance out there that makes this scenario possible. Here’s everything you need to know about reinsurance and how it works.

What is reinsurance?

Reinsurance is essentially insurance for insurers. This type of coverage transfers some of the liability to the reinsurer, lowering the risk for the primary insurer and freeing up capital for them to issue new policies. It’s a way for insurance companies to help mitigate their risk of total financial loss in case of a major disaster.

Reinsurance coverage can be purchased through an insurance company or brokerage that specializes in reinsuring primary insurers.

How does reinsurance work?

Reinsurance works by spreading the risk for insurers to multiple parties.

“Insurance companies do an excellent job of underwriting risk and setting their premiums appropriately, but they still need to diversify,” says Herman Thompson, Jr., a Certified Financial Planner with Innovative Financial Group “It is not uncommon for an insurance company to become dominant in a particular geography, industry, etc. If one company retained too much risk in a particular city and an unusually destructive natural disaster came along, it could destroy that insurance company.”

For instance, an insurer might purchase reinsurance on some of its homeowners policies in an area prone to hurricanes, fires, or tornadoes. That way, they won’t be on the hook to pay out thousands of claims if a major natural disaster occurs. Reinsurance coverage could protect insurers from total financial ruin and allow them to remain solvent.

So what’s in it for the reinsurer? Why would they be willing to assume the risk? In exchange for assuming some of the liability, they also get a portion of the insurance premiums.

What types of reinsurance are there?

There are four common types of reinsurance:

• Facultative.
• Treaty.
• Proportional.
• Non-proportional.

With facultative reinsurance, the reinsurer covers individual assets — often, they’re high-risk, high-value assets. For instance, the reinsurer might cover a high-rise commercial building in a hurricane zone. This type of reinsurance coverage is underwritten for each asset or risk.

Treaty reinsurance works differently and involves reinsuring a group of policies. So in this case, the reinsurer might purchase a particular line of business from a primary insurer, like all its homeowners or auto policies. Any new policies issued in the same group would typically be covered under a treaty agreement as well.

There’s also proportional and non-proportional coverage available. With proportional or pro rata coverage, reinsurers cover a certain percentage of claims in the event of a loss, in exchange for receiving a portion of the premiums. With non-proportional or excess of loss coverage, reinsurers only make payouts if claims exceed a certain amount.

The regulation of reinsurance

Reinsurance wasn’t subject to much regulation initially, though that changed after the adoption of the Credit for Reinsurance Act in 1984. The act was spurred by concerns about reinsurers’ ability to repay claims in the event of a disaster, and was meant to help ensure the financial solvency of the reinsurance company.

Reinsurers are required to submit financial reports to the National Association of Insurance Commissioners (NAIC) or other regulators and abide by certain financial regulations. This helps protect not only the reinsurer, but also the primary insurance company purchasing reinsurance. In addition to submitting reports and following regulations, reinsurers must also be licensed or authorized to do business in the states they’re offering reinsurance coverage.

Who needs reinsurance?

Reinsurance is for insurance companies, not consumers, so you won’t see a reinsurer working directly with a policyholder. A primary insurer might decide they need reinsurance if it makes financial sense for them to obtain it. So if they’re issuing thousands of homeowners policies in a hurricane zone, they might decide they need to reduce their liability with reinsurance coverage.

How does reinsurance affect insurance rates?

On one hand, reinsurance helps keep costs down for consumers because it spreads the risk from one company to multiple companies. For instance, if a lone company had to bear the burden of countless claims after a natural disaster, policy rates and premiums would almost certainly increase after that event. Reinsurance can help prevent this from happening frequently.

But on the other hand, if reinsurers see patterns in catastrophic events — for instance, if they’re often on the hook for paying out homeowners claims in a specific region — it may result in rising rates for primary insurers. The primary insurers could then increase consumer’s rates to recoup this cost.

Frequently asked questions (FAQs)