Reinsurance is a form of insurance taken out by insurance companies to mitigate risk. Essentially, reinsurance can limit the number of losses that an insurer can potentially suffer. In other words, it protects insurance companies from financial ruin, thereby protecting business customers from uncovered losses.
Insurance companies work by charging clients a fee known as an insurance premium and aggregating those premiums – when a client suffers a loss, money is taken from the pool to compensate. Reinsurers work the same way, but their customers are the insurance companies themselves.
An insurance company (called a cedant in this context) chooses to pay premiums to a reinsurer (usually a fraction of the premium it receives from its customers). In return, the reinsurer undertakes to reimburse part of the cedant’s obligations in the event of a claim. As with regular insurance, reinsurance is often purchased through a broker.
Reinsurance helps insurers reduce the impacts of major claims and, in turn, allows them to help more customers than they normally could.
Consider how a small auto insurance company operates. Due to its size, it is unlikely to charge a high amount of premiums. Regulations require the business to have enough cash to comply with the policies it has written, but if the business faces a series of substantial losses in a very short period, it may struggle to pay all claims.
A reinsurance policy reduces the individual risk of an insurance company. In a reinsurance contract, a reinsurer assumes part of the risk that the primary insurer has assumed through the policies it has taken out. When your auto or home insurer pays a reinsurer to assume part of your risk, the primary insurer is called the ceding company. These agreements are put together in different ways, which you can read in more detail below.
Types of Reinsurance
A reinsurance treaty is a type of reinsurance in which an insurer (called a cedant) agrees with one or more reinsurers to assign them a portfolio of risks, as defined in the respective reinsurance agreement or treaty. In said agreement, the ceding company undertakes to cede and the reinsurers undertake to accept all risks written by the ceding company which fall under the terms of the treaty, subject to the limits specified therein. Conventional reinsurance can take the form of proportional or non-proportional conventional reinsurance. Simply put, proportional treaties aim to provide capacity, while non-proportional treaties aim to protect the risks retained by the reinsured entity. The most common forms of proportional treaties include share treaties, surplus treaties, and mandatory optional treaties. For non-proportional rates, the main rates include those treated as excess risk loss, excessive catastrophe loss, and overall excess loss.
Facultative reinsurance is often the easiest way for an insurer to obtain reinsurance protection. These policies are also the easiest to adapt to specific circumstances.
Facultative reinsurance is reinsurance purchased by an insurer for a single risk or a defined set of risks. Typically, a one-time transaction occurs when the reinsurance company insists on making its underwriting for some or all of the policies to be reinsured. Under these agreements, each policy possibly taken out is considered as a single transaction, not grouped by class. These reinsurance contracts tend to be less attractive to the ceding company, which may be forced to retain only the riskiest policies.
Proportional vs. nonproportional reinsurance
Treaty and facultative reinsurance policies can have a proportional or non-proportional structure. A proportional reinsurance contract (also called “pro-rata” reinsurance) obliges the reinsurer to bear part of the losses, thereby receiving a pro-rata share of the insurer’s premiums. For example, a proportional reinsurance contract may require a reinsurer to cover 50% of losses.
Non-proportional reinsurance arrangements (also known as “excess of loss” reinsurance) take effect when the insurer’s losses exceed a specified amount. For example, a windstorm insurance company might seek a reinsurance deal covering all losses from a hurricane over $ 1 billion.