Reinsurance – Everything you need to know

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Reinsurance lets insurance companies share financial risk in case of a major disaster. 

Insurance is a risky business. Companies take on the liability of the unknown, willingly offering to stand up and support when disaster strikes. What that disaster may be and its costs are anyone’s guess, but it’s all part of everyday life for the average insurer.

When Hurricane Andrew roared onto the Florida shore in 1992, it created catastrophic devastation to the tune of $15.5 billion. Seven U.S. insurance companies folded under the crippling financial weight, unable to pay the countless claims pouring in for untold damages.

These companies could not handle the simultaneous payout of all these claims arriving simultaneously, and so they became insolvent. 

That is where reinsurance can make all the difference. 

What is reinsurance?

Reinsurance helps insurance companies by allowing multiple insurers to group together and share the financial risk of their customer’s policies. 

If a catastrophe should occur, no single company is responsible for the damages when all of the companies collectively share the risk. By sharing the risk of consumer policies, insurers can help assure survival despite a sudden influx in claims. 

“If you have ever wondered how insurance companies can come up with a ton of money at a moment’s notice, this is one of the factors contributing to it,” explains Anthony Martin, licensed insurance agent and CEO of Choice Mutual. 

According to the Reinsurance Association of America, reinsurance has its roots in the 14th century as protection for fire and marine insurance. Today’s insurance market is far more expansive, and reinsurance has evolved to accommodate its growing needs.

How does reinsurance work?

Reinsurance, also known as stop-loss insurance, allows insurers to assign a portion of their portfolio risk to other companies. These ceding companies have the reassurance of additional support should extreme losses occur. When policyholders pay their regular premiums, the payments can be shared by the collective group of insurers. 

“Like any business, primary insurance carriers leverage existing capital and surplus to write much larger books of business,” explains Stacey Giulianti, co-founder and chief legal officer for Florida Insurance Company. “Should a large-scale loss occur – a hurricane, earthquake, or wildfire – a primary carrier simply won’t have the funds to pay every claim. Instead, carriers purchase reinsurance in order to transfer risk above and beyond their ability to pay claims to much larger, often international, reinsurance entities.”

The party that assumes the ceding company’s risk is known as the reinsurer, which is another insurance company. To be eligible for reinsurance, a primary insurer must be financially solvent to ensure it can handle the additional liability. 

Reasons why a reinsurer may want to purchase reinsurance include:

• Risk transfer spreads the liability among several parties, so no one party assumes all the risk.
• This shared risk allows insurers to take on new business, thus keeping the industry moving.
• Reinsurers can earn additional profits through arbitrage, which is when reinsurers purchase a company with the ability to make profits from existing premiums.
• Ceding companies receive additional support from reinsurers who can provide counsel and guidance based on their experience and success.

Given these benefits, reinsurance is understandably a widespread and potentially lucrative practice within the insurance industry today.  

What are the types of reinsurance?

Several types of reinsurance are available, with each designed toward a different goal. 

Some of the most common types of reinsurance available include: 

• Per risk: Facultative coverage doesn’t provide full coverage for a company’s entire risk portfolio. Instead, it’s more of an a la carte item that allows insurance companies to assume limited liability covering specific risks. The ceding company then has the choice to accept the offer or decline. 
• Per period: A reinsurance treaty can allow limited or full liability, but it’s restricted to a specific period. 
• Per premium: Proportional reinsurance gives reinsurers prorated policy premiums in return for the risk they assume. It includes a pre-negotiated percentage paid to the reinsurer, with shared liability for claims and losses. The reinsurer is also responsible for reimbursing processing, business acquisition, and writing costs to the ceding insurer. 
• Minimum-based liability: Non-proportional reinsurance is when a reinsurer limits liability by employing a priority or retention limit. This means the reinsurer only becomes involved when there’s a minimum of specified losses, thus forfeiting any share of the ceding insurer’s premiums or losses. A reinsurer may also choose specific risks for which it will cover.
• Maximum-only liability: Excess-of-loss reinsurance is also a form of non-proportional coverage, but this applies when a reinsurer only covers above a ceding company’s maximum limits. This might apply to only catastrophic events or a specific amount of losses above a certain threshold.  

Who needs reinsurance?

Reinsurance decreases net liability for large claims while also enabling insurance companies to increase underwriting abilities given the lower risk.  

“Since insurance companies are required by law to keep enough cash to pay out their policies, reinsurers allow insurance companies to free up some risk so they can sign up more insurance accounts,” says Minesh Patel, founder of The Patel Firm.

Nate Tsang, founder & CEO of WallStreetZen, says you can’t have too much insurance for certain assets and events. 

“Think about a major financial disaster, like a flood — potentially billions in lost or destroyed property and belongings. That’s far more than one insurer can cover,” Tsang says. “When insurance companies need to mitigate risk and provide more coverage than they can on their own, they collaborate with other insurance companies to offer policies.”

Why is reinsurance important?

Reinsurance is an added security for insurance companies in an unpredictable world.  

 “Reinsurance works in two ways. It lessens the financial burden on the insurer providing coverage to customers, and it stabilizes the market for individual insurance,” Martin says. 

It’s expensive to be an insurance company. That’s why insurance companies use reinsurance to band together to support one another and the industry in which they serve.

“Reinsurance is most often used when companies take on insurance policies that would leave them in significant financial trouble if they repaid the insurance in full,” says Cliff Auerswald, president of California’s veteran-owned All Reverse Mortgage. “Insurance companies take policies to additional companies and apply for their own policies, occasionally sharing the premiums with each other.”

What is a reinsurance company?

It’s a common enough practice that reinsurance companies account for about 7% of national property and casualty insurance premiums. However, that doesn’t mean that just anyone can become a reinsurance company. 

Reinsurers are subject to regulation, which is handled on a state-by-state basis. The Insurance Information Institute explains that these regulations are in place to provide multiple assurances:

• Financial solvency
• Appropriate market conduct
• Fair contract terms
• Rates
• Consumer protection

The main goal is to ensure that reinsurance companies are actually able to fulfill the financial obligations to which they commit. 

There are three types of ceding companies:

• U.S.-based companies that specialize in reinsurance
• U.S. primary insurance companies that maintain reinsurance departments
• International companies that aren’t licensed in the U.S. and require a direct purchase from a ceding company, broker, or intermediary.  

2021 Top reinsurance companies

AM Best released its 2020 annual ranking of Top 50 Global Reinsurance Groups. 

Here are the top reinsurance companies.

Insurance vs. reinsurance — What is the difference?

Insurance is a standard type of protection that consumers can purchase to protect some of the most important things in life, whether it is your home, car, or medical needs. To answer these needs, insurance companies offer many types of insurance, such as homeowners, renters, auto, health, and life insurance. 

When a loss occurs, your insurance company will pay for repair or replacement if it is a covered event covered in your policy.

Reinsurance is different. It’s not for consumers but instead for the insurance companies themselves.

“Reinsurance is an insurance company’s insurance,” explains Auerswald. “Reinsurance is essentially extra insurance on an object or contract.”

With reinsurance companies providing additional security to these insurance companies, it helps provide extra assurance so insurers can fulfill their obligations to policyholders, even if a major calamity occurs. In the case of Hurricane Andrew, reinsurance could have helped several insurers survive the extreme losses from the record-breaking storm. 

“Insurance covers a policyholder’s financial risk, while reinsurance covers the insurance company’s risk of that payout,” Patel says. 

How does reinsurance affect insurance rates? 

With the added financial security that reinsurers provide, insurance companies can provide more competitive pricing to their customers. The decreased liability means that insurance companies can pass savings to consumers because they pay less if there is a loss.  

“While reinsurers are garnered toward insurers, they affect other parties very positively,” explains Martin. “This is because reinsurers pay a part of every insurance payout. This lowers premiums and stabilizes them for insurance customers seeking coverage.”

He adds that the whole process increases affordability, “meaning that more people get their health and properties insured.”

Alternatively, reinsurance can also increase insurance rates, explains Jim Pendergast, senior vice president of altLINE by The Southern Bank Company. “Reinsurance forces a company to pay more money to insure property, so they often pass that on to their customers. Some insurers tack on an extra 5% or more to every contract that requires reinsurance.”

It’s just another reason to shop and compare insurance providers before you purchase or renew your insurance policy.

Lena Borrelli

Contributing Researcher

 

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Lena Borrelli is a freelance writer from sunny Tampa Bay who has worked with such leading industry titans as Gronk Fitness, Morgan Stanley, Wells Fargo and Simon Corporation. Her work has most recently been published on sites like TIME, Microsoft News, Bankrate, Investopedia, Fiscal Tiger, The Simple Dollar, ADT and Home Advisor.