Reinsurance can also be called insurance for insurers or stop-loss insurance. It is a practice of insurers transferring portions of their risk portfolio to other parties through an agreement so they can decrease the chances of having to pay a large obligation in case of an insurance claim.
But then what is a reinsurance company? Keep reading to find out.
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What is a Reinsurance Company?
A reinsurance company essentially provides financial protection to insurance companies. Reinsurance companies handle risks that would be too large for insurance companies to handle on their own. They also make it possible for insurance companies to obtain business that they would not otherwise be able to obtain. Reinsurers also make it possible for primary insurers to cover potential losses by keeping less capital on hand.
The risks of any insurance company can be spread out by purchasing insurance from reinsurers. This transfer of risk from an insurance company to a reinsurer is known as cession. Premiums are paid to reinsurance companies by insurance companies the same way premiums are paid to insurance companies by individuals. Reinsurance companies can also choose to buy reinsurance themselves which is known as retrocession.
What is the Role of Reinsurance?
It is with the help of reinsurers that insurers manage to stay above the water by recovering some or all amounts that have been paid to claimants. Reinsurance can reduce the individual risks and catastrophe protection net liability from large or multiple losses. Reinsurance also provides companies that seek reinsurance, called ceding companies, the capacity to increase their underwriting abilities in reference to the number and size of risks.
According to the Insurance Information Institute, in 1992, Hurricane Andrew caused seven U.S. insurance companies to become insolvent with $15.5 billion in damage in Florida.
Benefits of Reinsurance
Reinsurance can give the insurer more security for its equity and solvency by protecting it against accumulated individual commitments. This is done so by increasing its ability to withstand the financial burden when anything unusual or major occurs.
Insurers can also underwrite policies through reinsurance that covers a larger quantity or volume of risk without raising any administrative costs in order to cover their solvency margins. Moreover, reinsurance can make substantial liquid assets available to insurers in case insurers suffer extraordinary losses.
Types of Reinsurance
There are three main types of reinsurance; facultative, proportional and non-proportional.
- Facultative coverage which protects the insurer from an individual or specified risk or contract. If there are several contracts or risks that require reinsurance, they are renegotiated separately. The reinsurer holds all rights and they can either accept or deny a facultative reinsurance proposal.
- A reinsurance treaty is the same thing except instead of on a per-risk or contract basis, it is for a set period where the reinsurer covers either all risks or a portion of risks that the insurer may incur.
- Proportional reinsurance also involves the reinsurer receiving a prorated share of all insurance policy premiums that have been sold by an insurance company. In case of a claim, the reinsurer then bears some of the losses based on a pre-negotiated percentage. The reinsurance company also reimburses the insurance company for any costs including business acquisition, writing and processing costs.
- With non-proportional reinsurance, if the insurer’s losses have exceeded a specific amount, also known as priority or retention limit, the reinsurer would be liable. This results in the reinsurer not having a proportional share in the insurance company’s losses and premiums. The priority or retention limit is either based on one type of risk or an entire risk category.
A type of non-proportional coverage included excess-of-loss reinsurance in which the reinsurer is responsible for covering the losses exceeding the insurer’s retention limit. This contract is usually used for catastrophic events and provides coverage to the insurer either on a per-occurrence basis or for the total losses within a set period.
All claims established during the set period are covered under risk-attaching reinsurance. Even if the losses occur outside the coverage period, risk-attaching reinsurance will still cover them. However, there is no coverage provided for claims that originated from outside the set coverage period regardless of whether the losses occurred while the contract was still in effect.
Understanding Reinsurance Companies
An insurance company providing insurance policies to individuals or businesses transfers its risk to a reinsurance company through a process known as cession. Just like individuals who pay premiums to insurance companies, they also pay premiums to reinsurance companies. The prices of these premiums depends on the amount of risk, like it is with the price of insurance. Reinsurers generally have the word “Re” in their names. For example: Allianz Re, Swiss Re, etc.
Reinsurance companies help spread out the risk of natural disasters like hurricanes or earthquakes. These catastrophic events can result in more claims than usual and it can get difficult for a primary insurer to pay these claims without going bankrupt. These claims would not only be expensive for the company to pay but will also be around the same time period which can lead to financial stump for insurance companies. At times like these, reinsurance companies come to the help of insurance companies and help them spread out the risk.
The risk is spread out by transferring portions of the risk of insuring, including a part of the premiums, against these events to various different reinsurers. This way individuals and businesses can continue to file their claims and insurance companies can continue to pay these claims without going completely bankrupt. There have been many instances in history where insurance companies struggled to pay the claims in the event of a natural disaster just because they were not solvent enough to be able to manage paying out the insurance on their own policies. One example of such is given above about Hurricane Andrew.
Reinsurance can be a large business. In 2018, the top 10 reinsurance companies in the world made up two-thirds of premiums in the insurance market, that is if you exclude life insurance. That is how large the reinsurance business can be. The two largest reinsurance companies in the world are Munich Re (MURGF) and Swiss Re (SSREF) which accounted for 30 percent of the two thirds of written premiums in the reinsurance market.
Speaking generally, the main reason insurance companies tend to purchase reinsurance is to grow the insurance company’s business and bring stability to the underwritten policy. The capital is also raised via financing and there is catastrophe protection. There is also a divestiture from a specific type of insurance business where they gain expertise and distribute their risks.
How Reinsurance Companies Work
It is not easy for reinsurance transactions to be made. This is because there are many factors to consider when a reinsurance company is selected. For instance, it is difficult to select one reinsurer as rating agencies tend not to treat all reinsurers the same. Their capital models can vary based on the reinsurer’s financial strength ratings.
The best way to buy reinsurance is through a risk charge based on the reinsurance company’s credit quality, ceding company’s risk level reinsured to the reinsurer and a mortality risk exposure. Often times reinsurance companies choose to buy reinsurance themselves. This is known as retrocession.
Many policies are generally spread amongst multiple reinsurers instead of one. In cases like this, the transactions involve a lead reinsurer that negotiates the terms of the policy. Other reinsurers then participate in this negotiation. The terms and any modifications to be done after signing are set by the lead reinsurer. However, it is not necessary for them to take on the largest portion of the risk. The other reinsurers helping in the negotiation and involved in the entire process are known as followers.
Reinsurers tend to deal in the most complex and largest risks in the insurance system. These are the same risks that normal insurance companies do not want or are not able to deal with. These risks are often international in nature such as, war, commodity market problems or severe recession. This is the main reason reinsurance companies tend to have a global presence. It can allow the reinsurer to spread risk across larger areas leading to less risk cumulation for each reinsurer.
Reinsurance companies also don’t deal with other insurers only. They may also write policies for multinational companies, banks or financial intermediaries. However, the majority of the clients for any reinsurance company are primary insurance companies.
Thus, to conclude, now that we know what a reinsurance company is, we can see that without reinsurance, the insurance industry today would be more vulnerable to risk. They would have to likely charge higher prices on all of their policies in order to compensate for any potential loss they might have. This is why reinsurance can be so important for the insurance companies and even the individuals and businesses that buy insurance policies from these companies. If there was no reinsurance, the prices of these policies would be too high to afford which will harm the individual and businesses as they would not be able to purchase coverage for anything, as well as insurance companies that would go out of business in a month. So calling reinsurance the backbone of the entire insurance industry would not be too much of a stretch.