In a traditional insurance arrangement, the risk of loss is spread among many different policyholders, each of whom pays a premium to the insurer in exchange for the insurer's protection against some uncertain potential event. It is a business model that works whenever the sum of received premiums from all members exceeds the amount paid out on insurance claims against the policies. There are times, however, when the amount paid out in claims by the insurer exceeds the sum of money received from policyholder premiums. In such instances, it is the insurer who faces the greatest risk of loss.
This is where reinsurance companies come into play. Reinsurance companies offer insurance to other insurers, safeguarding against circumstances when the traditional insurer does not have enough money to pay out all of the claims against its written policies. One of the highest-profile reinsurance companies is the Berkshire Hathaway Reinsurance Group, a subsidiary of Berkshire Hathaway Inc. (BRK-A). which offers insurance to other property/casualty insurers and reinsurers.
In effect, a standard insurance provider can spread its own risk of loss out even further by entering into a reinsurance contract. A reinsurance contract takes place between the reinsurer, or assuming company, and the reinsured, or ceding company. There are two basic forms: reinsurance treaties and facultative reinsurance.
Treaty reinsurance occurs whenever the ceding company agrees to cede all risks within a specific class of insurance policies to the reinsurance company. In turn, the reinsurance company agrees to indemnify the ceding company of all risks therein, even though the reinsurance company has not performed individual underwriting for each policy. Often, the reinsurance applies even to those policies that have not yet been written. so long as they pertain to the pre-agreed class.
The most important characteristic of a treaty agreement is the lack of individual underwriting on behalf of the assuming insurer. This structure transfers underwriting risks from the ceding company to the assuming company, leaving the assuming company exposed to the possibility that the initial underwriting process did not adequately evaluate the risks to be insured.
There are different kinds of treaty agreements. The most common are called proportional treaties, in which a percentage of the ceding insurer's original policies is reinsured, up to a limit. Any policies written in excess of the limit are not be covered by the reinsurance treaty.
For example, one reinsurance company might agree to indemnify 75% of the original insurer's automobile policies, up to a $100 million limit. This means the ceding company is not indemnified for $25 million of the first $100 million in auto policies written under the agreement; that $25 million is known as the ceding company's "retention limit." If the ceding company writes $200 million worth of automobile insurance, it retains $25 million from the first $100 million and all of the subsequent $100 million, unless it arranges a surplus treaty. Generally speaking, reinsurance policy premiums are lower when retention limits are higher.
Facultative reinsurance occurs whenever the reinsurance company insists on performing its own underwriting for some or all the policies to be reinsured. Under these agreements, each facultatively underwritten policy is considered a single transaction, not lumped together by class. Such reinsurance contracts are usually less attractive to the ceding company, which may be forced to retain only the most risky policies.
That said, facultative reinsurance is usually the simplest way for an insurer to obtain reinsurance protection. These are also the easiest to tailor to specific circumstances. Suppose a standard insurance provider issues a policy on major commercial real estate, such as a large corporate office building. The policy is written for $35 million, meaning the original insurer faces a potential $35 million in liability if the building is badly damaged. Now suppose the insurer believes it cannot afford to pay out more