How Reinsurance Works

Nov 23, 2023 By Susan Kelly

In dispersing the risk, an insurance company could take on clients whose protection would be too big of a burden for a single insurance company to manage on its own. In the event of reinsurance, the cost of insurance due by the insurance company will be divided among the insurance companies. Suppose one company takes on the risk independently. In that case, the expense could cause financial hardship or financially cripple the insurance company. It may not even cover the loss for the original company, who was the one to pay the insurance premium.

Consider, for instance, an enormous hurricane that the landfall in Florida and resulted in billions of dollars of damages. If one company were to sell all homeowners insurance, the likelihood of it being able to cover the damages is not likely. Instead, the insurance provider distributes a portion of the insurance with other insurers (reinsurance) and spreads the risk's burden across numerous insurance companies. Insurers purchase reinsurance for four main reasons: to limit their liability on a particular risk, to ensure stability in losses, to safeguard them and their customers from disasters, and to expand their capacity.

Types of Reinsurance

Reinsurance can be classified into two categories: facultative and treaty. Treaties are agreements that protect large groups of policies, like all of a primary insurance company's auto business. The term "facultative" refers to specific risks, usually high-value or dangerous, like hospitals, which an agreement would not cover. In many treaty agreements, after the conditions of the agreement, including the risk categories to be covered, have been formulated, the policies covered by the terms of the contract - in most instances, both existing and new business - are covered automatically until the contract is canceled.

With facultative Reinsurance, the reinsurer has to take on each particular "risk," said a hospital, in the same manner, as the main company would, taking into consideration every aspect of the business, the hospital's attitudes to safety and its record. Additionally, the reinsurer must consider the management and attitude that the principal insurer has when seeking the reinsurance coverage. This kind of reinsurance is referred to as facultative since the reinsurer can decide "faculty" to accept or refuse all or a portion of any policy provided to it as opposed to treaty reinsurance under which it is required to accept all policies that are applicable after the agreement has been completed.

In an agreement for excess of loss in which the main company is responsible, it retains an amount of liability to pay for any loss (known in terms of the ceding firm's retained) and is required to pay a fee to the reinsurer for coverage that is greater than the amount, usually subject to a predetermined upper limit. The excess of loss agreement may be applied to individual policies, to an incident like a hurricane that has a large impact on policyholders, or the total losses of the primary insurer over a specific amount, per policy or for the entire year.

A company's reinsurance plan could be extremely complex. Suppose it were to be diagrammed as a pyramid. In that case, it could appear as a pyramid with increasing levels of insurance for more distant events, distributed among several reinsurance firms, each taking a share. It could comprise layers of proportional and excess loss treaties and perhaps a facultative excess of the loss layer on top.

Reinsurance Regulation

U.S. reinsurers are regulated on a basis of state-by-state. The regulations are intended to guarantee that the reinsurer is solvent, has proper market conduct, fair rate, terms and conditions of contracts, and protects consumers. In particular, regulations require the reinsurer to be financially sound to meet the obligations it has to cede to insurers.

Breaking Down Reinsurance

Through the distribution of risk, an insurance company may take clients whose coverage may be too costly for one insurance firm to manage alone. The cost of the insured will usually be split among all insurance companies in the event of reinsurance. Suppose a single business assumes the responsibility by itself. In that case, the cost of covering the cost could lead to the insurance company being financially devastated or even going bankrupt, even in the worst-case scenario. It could also lead to the company not being able to pay for the loss that the original company paid for the insurance premium.

Advantages of Reinsurance

The risk of substantial coverage is spread between other businesses. Reinsurance can help companies reduce their losses by sharing certain risks with other businesses. This could help free funds for other firms. Reinsurance allows companies to take on new clients by purchasing additional relief insurance.

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