Have you ever thought about how insurance companies cover massive claims? It might sound alien, but they reinsure themselves as well. Do you want to know how? Read ahead about the types of reinsurance and how it works.
No one is ever sure when their lives or properties are at risk. Although it is possible to make predictions about natural disasters, no one can tell whether a fire will break at your house or a tree in your backyard will fall on your home’s roof. Unless you have a tarot card reader beside you, it is impossible to get an exact time.
In this case, it is essential to stay prepared beforehand. But how is that possible? It is possible by getting insurance. However, insurance companies may not be able to cover large-scale risks. Thus they come in contact with reinsurance companies. First, they determine the types of reinsurance and then initiate the claiming process.
Reinsurance is a secure way to reduce the claimed amount for insurance companies. However, before moving towards the types of reinsurance, it is vital to familiarize yourself with how many reinsurance there are. To get a knack for the topic, let’s dive in!
Table of Contents
- 1 Reinsurance- an overview
- 2 Who needs reinsurance?
- 3 Why do you need reinsurance?
- 4 Types of reinsurance
- 4.1 Facultative reinsurance
- 4.2 Proportional reinsurance
- 4.3 Non-proportional reinsurance
- 4.4 Excess-of-loss reinsurance
- 4.5 Treaty Reinsurance
- 4.6 Risk attaching reinsurance
- 4.7 Loss-occurring coverage
- 5 Facultative and treaty reinsurance: what’s the difference?
- 6 How does reinsurance work?
- 7 Objectives of reinsurance
- 8 Functions of reinsurance
- 9 Benefits of reinsurance
- 10 What is reinsurance responsible for?
- 11 Cases of reinsurance
- 12 Does reinsurance affect insurance applications?
- 13 Bottom line
Reinsurance- an overview
Do you know what reinsurance is? Reinsurance or stop loss insurance is the insurance for the insurance company itself. It allows insurance companies to distribute the risk of insurance claims to third parties to reduce the amount. There are various types of reinsurance, and the insurer can make a deal for one relevant to his needs.
Let’s say that you have insured your mansion to the same insurance company that sold its insurance to all houses in your area. In a calamity like a tornado, the insurance company is prone to lose too much money. They make a reinsurance deal with a third party to be safe from the risk. This will enable the insurance company to cover a less significant portion of the insurance claim.
Who needs reinsurance?
So the question is, who needs reinsurance? Is it you? Is it the person who lives near the sea and is insecure because of the predicted tsunami? Is it the one whose house has been on fire once, and he doesn’t want to risk losing everything again?
The answer is no!
Reinsurance is made for insurance companies. Paying multiple claims at a time might create a financial burden on an insurance company; thus, to lower the load and spread the risk of loss, they seek help from the reinsurers.
The reinsurer has no direct contact or contract with the policyholders. It is the insurance companies of those policyholders who approach reinsurance.
The primary insurer will require reinsurance in a stance when it makes sense financially or when they want to reduce the liability they are responsible for.
Why do you need reinsurance?
Although reinsurance is the extension of insurance, it has its significance, meaning, and responsibilities. In reinsurance, a part of emerging risk has to be transferred to the other company spreading the chances of potential danger.
It merely relies on the complexity of risk for insurers to add protection to their agreement policies themselves. Reinsurance possesses a great deal of importance. It aids in the safety of the ceding against large claims, for instance, in case of catastrophes.
Furthermore, reinsurance reduces the risk of possession for the liable policyholder. It keeps the cap on claims which insurers have to pay. In addition, they enable the increase of capacity of the original insurer by spreading the risk.
Types of reinsurance
There are seven major types of reinsurance. All are discussed below:
Facultative reinsurance is the insurance purchased by the primary insurer to cover one or a group of risks. It is usually a one-time contract that covers a single transaction. It is referred to as facultative reinsurance because the insurer has the power to accept or reject the amount proposed policy. Facultative reinsurance is regarded as one of the oldest types of reinsurance.
For instance, an insurance firm can go for the reinsurance of a textile mill for fire insurance. This way, the original insurer will not have to pay for the comprehensive insurance. The reinsurer will cover the decided amount on behalf of the insurer.
- Provides insurers the security
- Independence for the reinsurer to propose any risk
- It makes liquid assets of the insurer accessible in case of a loss
- Good for short-term needs
- Confidential insurance information has to be disclosed to a third party.
- Inconvenience involved in the process
- Low commission for the insurer
In proportional reinsurance, the insurance company shares profits and losses with the reinsurer. Whatever is earned is divided in the same proportion among both parties. It is also referred to as the “pro rata.” The allocated part of the percentage of insurance is mandatory to be paid to the reinsurer.
Proportional reinsurance has been divided into two broad categories.
In quota reinsurance, the reinsurer settles for the agreed percentage of the reinsured insurance. In addition, the reinsurers share all the premiums and claims equally.
For Example, you have arranged for the 40-60 for insurance with the reinsurer. 40% is what the reinsurer is responsible for, and 60% is your responsibility. The reinsurer is bound to pass the 40% premium it has received from the parties. However, the reinsurer will also be responsible for the 40% risk. Thus, the proportion of compensation to the risk is equal for reinsurers.
Surplus reinsurance is the second form of proportional reinsurance. The insurer determines the maximum sum insured with each risk in this form. Here the stakes are guaranteed above the specified amount of the insurance.
There is a requirement for an insurer. A reinsurer to transfer and accept the part of each risk that exceeds the already decided limit.
- Easy to administer
- Protects the reinsured in both high frequency and severity claims
- It responds to all kinds of losses
- Reinsured has to share every pound of premium with its reinsurer in an agreed proportion.
- Expensive to reinsured in a long run
Non-proportional reinsurance covers the losses up to the predetermined limit of insurance. In this scenario, a reinsurer company will only get involved when the insurance company’s failures exceed the retention limit. Sounds confusing, right? Let me clear that up for you!
In non-proportional reinsurance, the reinsurer will not have an equal share in premiums or losses as in proportional reinsurance. Instead, their deal will include an unequal proportion. However, the retention limit is based on a business category or risk possession. In short, premiums and losses are not shared here pro rata but in layers.
- Give an outright limit to retained claims cost.
- Reduces administration expenses.
- Retain a large percentage of premiums of all time.
- Claim to be paid at the beginning of the contract.
- Protection against only large claims
It is the form of non-proportional reinsurance. Like non-proportional reinsurance, excess loss reinsurance occurs when a specified amount of loss must be covered in insurance. However, the difference is that it only applies to a catastrophic event.
- Defined top limit.
- Premium is not shared beforehand.
- Ability to provide excellent coverage.
- Reinsurers pay above the predetermined limit.
- Limited liability of reinsurers.
Treaty reinsurance is one of the significant types of reinsurance. What happens here is that another insurer or an insurance company takes the insurance. It is more like a contract between two parties.
Treaty reinsurance relies on premium sharing. It is helpful in such a way that it provides stability to the insurer during significant events. It is best to obtain treaty reinsurance as it possesses fewer risks. However, it could include either a sum or a bundle of insurance policies.
- No requirement for a facultative certificate when transferring risks.
- Inexpensive to operate.
- Gives security to the ceding company for its stability.
- Cover specific types of risk.
- The reinsurer charges the right to underwrite risk.
Risk attaching reinsurance
Another type of reinsurance is risk-attaching reinsurance. Here, the reinsurer pays the reinsured for losses claimed in the contract period regardless of when the loss occurred.
Loss occurring or loss arising coverage is the opposite of risk attaching reinsurance. In this type, the reinsurer pays reinsured the amount that happened during the contract period of reinsurance. It does not matter when the loss is generated through the insurance policy.
Facultative and treaty reinsurance: what’s the difference?
Once we have gone through all the types of reinsurance, it is crucial to know the significant differences between them.
|Treaty reinsurance||Facultative reinsurance|
|Coverage of multiple risks of numerous types||Fall under the coverage of one single risk|
|It is a long-term agreement.||It is considered a one-off transactional deal|
|Less expensive||More expensive|
|No acceptance of individual risk by reinsurers.||Individual risk review|
|Supported by a contract.||Certificate to be made for agreement.
|No right to reject on a per-risk basis||The reinsurer has the right to accept or reject the agreement.
How does reinsurance work?
It must be clear now how many types of reinsurance are there; now it is time to move to the working of reinsurance.
Reinsurance enables the ceding company to stay solvent. But how is that? It is possible to recover all or some amount from the party who made the insurance claim.
This also increases the capacity of the ceding company’s underwriting with respect to the amount and size of risks.
Objectives of reinsurance
Different types of reinsurances cover distinct objectives. Meanwhile, spoke of the significant purposes of reinsurance are mentioned below:
Allows stability of underwriting during the period of the claim.
Distribution of risk to guarantee the coverage of a claim.
They have exceeded the financial obligations of a firm to be outsourced to another insurance firm.
Functions of reinsurance
Along with the types of reinsurance, it is better to understand the significant functions of reinsurance and why you should have it as an insurance company.
Protection against catastrophe
A tragedy or crisis can occur at any time; thus, making necessary preparations beforehand can be beneficial. Getting insurance against a natural disaster can save you from getting homeless. However, there should be an awareness about the management of finances on a large scale.
Here are the reinsurance policies. In the event of a catastrophe, the ceding company closes a deal with the reinsurance company, which divides the amount claimed. In case of significant losses, the reinsurers share part of the claim with the ceding company. This protects the finances of the ceding company practically, and the net loss is reduced.
Another function of getting reinsurance is that the ceding company gets increased capacity. But how does that work? The spell is straightforward. An increase in capacity enables insurers to issue policies more significant than the loss claimed.
On the other hand, the reinsurer allows the insurer to accept beyond the risk amount the retention limit.
Spreading the risk means dividing the payable amount of the claim with another reinsurance company. This way, the risk of loss will be less distributed among the reinsurance company.
Spreading risk not only helps in stabilizing the finances but also in building a trustworthy relationship among the competitors.
Retain financial stability
Another vital function of reinsurance is that it stabilizes finances. We have been talking about the finances’ stability since the article’s beginning. But how does it retain it? Let’s look into that.
By financial stability, we mean that losses are balanced so that it does not affect the regular operation of a company. However, it is stabilized by spreading the risk of loss. When a contract is made with the reinsurance company, the ceding company will burden the decided proportion onto the reinsurer. It helps the risk percentage to be divided among them.
In this way, the amount to be covered by the ceding company is lowered. In addition to that, the potential risk of loss also decreases.
Benefits of reinsurance
Although different types of reinsurance possess various benefits, all reinsurance companies provide the same benefits. Some of those benefits are discussed below.
Insuring properties possessed risks. It is never known when a catastrophe will strike the property and leave the place in havoc. When one party is responsible for the insurance, it will be a potential burden.
When the insured company reinsures, the amount of the insurance gets divided among both parties. That division is based on the percentage decided before.
Reinsurance plays a vital role in stabilizing the profits and losses of the insurance company. It is difficult to pay all the claims, even the smaller ones, at once. However, if the insurance company still retains the risk claim, the finances will be highly influenced, resulting in instability.
Protection against natural disasters
Let’s say that there has been a fire in a neighborhood, and the entire community comes under the possession of a single insurance holder. What must be done in that case? It is challenging to cover all the claims along with stabilized finances.
In these cases, the insurers seek reinsurance to reduce the claim burden. Reinsurance helps them maintain their finances as well as fulfilling their claims.
Competition exists in every business, whether an ice cream seller or an insurance company. However, when two companies join hands, the competition between them ends right there. They both start relying on each other for benefits and losses.
Working cooperatively will increase the chances of growth in both firms. It is correct to say that reinsurance aids in the controlling of competition.
What is reinsurance responsible for?
So the question that surfaces is how the types of reinsurance work. The answer is lengthy yet straightforward.
Reinsurance is not only a golden ticket for you to protect you from height risk as an insurer. It is also a vital structure that provides a higher capacity to work the claims out. Reinsurers are supposed to provide capital to the ceding company in exchange for the premiums they receive. This is only applicable to the policy issued to policyholders by the insurance company.
However, the insurance policies become insolvent if the losses that the insurance policy generates are huge. Meanwhile, insurance companies are much more interested in more risk policies. Reinsurers are interested in knowing what the ceding company’s exposure is and where they will be occurring, like whether they are from fire insurance or flood insurance.
Furthermore, the reinsurers depend on the insurance company to provide all the necessary details about the policy. Ceding companies are responsible for giving reinsurers the risk analysis(what or when a risk could occur or on what level it will be).
A reinsurance company must compensate the losses of the ceding company following the contract terms.
When there are chances of emerging risk, the principles of settlements might run under strain, particularly when the insurance company chooses to compensate those emerging losses which were not previously brought to light. However, reinsurers have the right to know about any emerging risks beforehand.
Cases of reinsurance
Following are some cases that have been followed by ceding companies and reinsurers.
For ceding company
Using the spread risk strategy, the ceding company transfers its risk from its portfolio to the reinsurer.
Some insurance companies are required to have liquid assets. To make a sale in this situation, the ceding company must have covered the amount not covered by the liquid assets available.
The majority of the companies use income smoothing. By following this strategy, a more stable income is promised.
Sometimes there is a restriction for ceding companies to exceed a particular premium to surplus ratio. You may wonder why. It is because reinsurance policies are responsible for lessening the premium income. Thus, they allow ceding companies to the issuance of additional procedures.
Some companies have key performance indicators regarding the revenue generated. In this case, the reinsurers help them to reach that specific goal.
Arbitrage strategy comes to the implementation when the price of a product differs concerning its location. Thus, in this scenario, the reinsurers exploit price differences to maximize the prices.
As the ceding company transfers its risk from its portfolio to the reinsurer, the reinsurance company takes the risk of the portfolio. As a result, the risk is minimized.
Does reinsurance affect insurance applications?
Although there is no direct relation between reinsurance companies and direct insurance, it still affects insurance applications and their outcomes. It highly influences the insurance market.
It is known that reinsurance helps stabilize the insurance market by spreading the risk. Thus, it influences the chances of coverage of applications prone to high risk. Reinsurance companies consider climate change as a threat and an increased risk factor. Therefore, they adjust the policy rate accordingly.
Furthermore, suppose the ceding company is working on a facultative basis (one of the types of reinsurance) with the reinsurance company. In that case, the insurance companies will take more time to process. It is because the reinsures will have to follow their underwriting processes.
Types of reinsurance are recognized by the policies made. However, it is a significant saving point from risk. The risks can be managed by spreading them to the reinsurers.
Size and amount of reinsurance differ with the area. If there has been a natural disaster and a community at a high level has been affected, the size and amount will eventually be larger.
If you own an insurance company, you should agree with the reinsurers. In this way, you will have protection against losses, making your financial position more reliable.