Sometimes insurance companies want the same kind of financial protection that they offer to their own customers, and they can find such protections in the so-called reinsurance market. Reinsurance companies provide insurance against loss for other insurance companies, especially losses related to catastrophic risks, such as hurricanes or the global financial crisis of 2008-2009.

Without reinsurance, today's insurance industry would be more vulnerable to risk and would likely have to charge higher prices on all of their policies to compensate for potential loss.

Key Takeaways

  • Reinsurance, or insurance for insurers, is the practice of risk-transfer and risk-sharing between and amongst insurance companies.
  • Treaty resinsurance involves one insurer buying broad coverage from a dedicated reinsurance issuer that covers all of the insured company's policies.
  • Facultative reinsurance covers a single risk or a block of risks held in the primary insurer's book of business.
  • Reinsurers handle complex risks and must meet certain regulatory and financial conditions in order to operate.

Basics of the Business Model

Reinsurance companies typically offer two kinds of products.

  1. The first is known as treaty reinsurance, which is a type of contract where the reinsurer is bound to accept all of the policies, or an entire class of policies from the reinsured, including those that have yet to be written.
  2. The second type is facultative reinsurance, which is much more specific. These can cover single individual policies, such as reinsuring the excess insurance on a company or large building, or they may cover different parts with several policies pooled together.

In addition to these categories, reinsurance may be considered proportional or not. Under proportional reinsurance, the reinsurer receives a prorated share of all policy premiums sold by the insurer. For a claim, the reinsurer bears a portion of the losses based on a pre-negotiated percentage. The reinsurer also reimburses the insurer for processing, business acquisition, and writing costs.

With non-proportional reinsurance, the reinsurer is liable if the insurer's losses exceed a specified amount, known as the priority or retention limit. As a result, the reinsurer does not have a proportional share in the insurer's premiums and losses. The priority or retention limit is based on one type of risk or an entire risk category. Excess-of-loss reinsurance is a type of non-proportional coverage in which the reinsurer covers the losses exceeding the insurer's retained limit. This contract is typically applied to catastrophic events and covers the insurer either on a per-occurrence basis or for the cumulative losses within a set period.

Reinsurers primarily deal in the largest and most complex risks in the insurance system. These are the kinds of risks that normal insurance companies do not want or are not able to internalize. These sorts of risks tend to be international in nature: war, severe recession, or problems in the commodity markets. For this reason, reinsurance companies tend to have a global presence. A global presence also allows the reinsurer to spread risk across larger areas.

Reinsurance companies don't always deal solely with other insurers. Many also write policies for financial intermediaries, multinational corporations or banks. However, the majority of reinsurance clients are primary insurance companies.

Differences and Similarities With Insurance Companies

Like any other form of insurance, reinsurance boils down to a system wherein the insurance customer is charged a premium in exchange for the insurer's promise to pay future claims in accordance with the policy coverage. Reinsurance companies employ risk managers and modelers to price their contracts, just as normal insurance companies do.

However, reinsurance companies target a very different customer base than normal insurance companies, and they also tend to work in wider jurisdictions that involve different, or even competing, legal systems.

Another serious difference is the relative mystery in which reinsurance companies operate. Standard insurance companies openly advertise their products to the public at large and often compete intensely over the same market segments. Reinsurance companies, on the other hand, operate in the background of the financial world. These companies don't buy mass direct-to-consumer advertising, they have small work forces and they normally develop strong niche roles with a few large competitors.

Contract of Reinsurance

Reinsurance contracts act as an agreement between the ceding insurer, which is the insurance company seeking insurance, and the assuming insurer, or the reinsurer. In a normal contract, the reinsurer indemnifies the ceding insurer for losses under specific policies written by the ceding insurer to its customers.

Unlike the standard insurance contract between you and your insurance company, a reinsurance contract is not regulated as to form and content because both parties are considered equally knowledgeable about the industry and have equal bargaining power under the law.

Collateral and Other Regulations

Like standard insurers, reinsurance companies are regulated based on which states they file their incorporation documents with, as well as other states in which they transact.

Reinsurers can operate in the United States without a specific license, though most jurisdictions require some form of licensure to establish offices or conduct business transactions. In lieu of more specific financial regulation, many reinsurers provide qualifying collateral to ceding insurers as a gesture of legitimacy and good faith.

There are provisions inside the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that pertain to reinsurance companies, including that unauthorized reinsurers must provide 100% collateral of their gross liabilities to a ceding insurer in order for the ceding insurer to receive a financial statement of credit for the reinsurance. Reinsurers certified to have acceptable financial strength can have their collateral requirements reduced according to their ratings. In order to comply with the National Association of Insurance Commissioners (NAIC), all states must have set requirements by 2019.