What is reinsurance?
Reinsurance is a way a company lowers their risk or exposure to an untoward event. The thought is, no insurance company has too much exposure to a particular large event/ disaster that if one company assumed the risk on their own, and the event happened, the insurance company cost would bankrupt or financially ruin the insurance company and possibly not cover the loss for the original company that paid the insurance premium. As an example, a large hurricane makes landfall in Florida and causes billions of dollars of damage. If one company had sold all the homeowners insurance, the chance of covering the losses would not be likely. Instead, the retail insurance company spreads parts of the coverage to other insurance companies (reinsurance), thereby spreading the cost of risk to many insurance companies. A benefit of reinsurance is a retail company can can service more people in an area because they only keep/are responsible/exposed to a portion of the total coverage.
Reinsurance occurs when multiple insurance companies share risk by purchasing insurance policies from other insurers to limit the total loss the original insurer would experience in case of disaster. By spreading risk, an individual insurance company can take on clients whose coverage would be too great of a burden for the single insurance company to handle alone. When reinsurance occurs, the premium paid by the insured is typically shared by all of the insurance companies involved.
Reinsurance can help a company by providing:
- Risk Transfer - Companies can share or transfer of specific risks with other companies
- Arbitrage - Additional profits can be garnered by purchasing insurance elsewhere for less than the premium the company collects from policyholders.
- Capital Management - Companies can avoid having to absorb large losses by passing risk; this frees up additional capital.
- Solvency Margins - The purchase of surplus relief insurance allows companies to accept new clients and avoid the need to raise additional capital.
- Expertise - The expertise of another insurer can help a company obtain a proper rating and premium.
(For more on this topic, read When Things Go Awry, Insurers Get Reinsured.)
This question was answered by Steven Merkel.
Reinsurers work behind the scenes to share the risk with frontline carriers. For example, you may buy buy a policy from Prudential or MetLife, but a reinsurer may share the cost of insuring you.
This arrangement helps insurance companies take on more risks, so more people can buy the policies they need for their families and businesses. It's not always an equal relationship. Frequently, reinsurers will exercise veto power as to whether or not the insurance company can take on the risk in the first place. They typically do this for solid financial reasons, such as concerns about credit or reserves.
At the same time, insurance companies have what's called retention. This means that they will insure people up to a certain maximum without having to bring in a reinsurer. This allows them to potentially take on more risks than they would if they had to involve the reinsurer.