Reinsurance occurs when multiple insurance companies share risk by purchasing insurance policies from other insurers to limit their own total loss in case of disaster. Described as "insurance for insurance companies" by the Reinsurance Association of America, the idea is that no insurance company has too much exposure to a particularly large event or disaster.

Key Takeaways

  • Reinsurance occurs when multiple insurance companies share risk by purchasing insurance policies from other insurers to limit their own total loss in case of disaster. 
  • By spreading risk, an insurance company takes on clients whose coverage would be too great of a burden for the single insurance company to handle alone. 
  • Premiums paid by the insured is typically shared by all of the insurance companies involved.
  • U.S. regulations require reinsurers to be financially solvent so they can meet their obligations to ceding insurers.

The Beginnings of Reinsurance

The Reinsurance Association of America states that the roots of reinsurance can be traced back to the 14th century when it was used for marine and fire insurance. Since then, it has grown to cover every aspect of the modern insurance market. There are companies that specialize in selling reinsurance in the United States, there are reinsurance departments in U.S. primary insurance companies, and there are reinsurers outside the United States that are not licensed in the United States. A ceding purchases reinsurance directly from a reinsurer or through a broker or reinsurance intermediary.

How Reinsurance Works

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.

If one company assumes the risk on its own, the cost could bankrupt or financially ruin the insurance company and possibly not cover the loss for the original company that paid the insurance premium.

For example, consider a massive hurricane that makes landfall in Florida and causes billions of dollars in damage. If one company sold all the homeowners insurance, the chance of it being able to cover the losses would be unlikely. Instead, the retail insurance company spreads parts of the coverage to other insurance companies (reinsurance), thereby spreading the cost of risk among many insurance companies.

Insurers purchase reinsurance for four reasons: To limit liability on a specific risk, to stabilize loss experience, to protect themselves and the insured against catastrophes, and to increase their capacity.  But reinsurance can help a company by providing the following:

  1. Risk Transfer: Companies can share or transfer specific risks with other companies.
  2. Arbitrage: Additional profits can be garnered by purchasing insurance elsewhere for less than the premium the company collects from policyholders.
  3. Capital Management: Companies can avoid having to absorb large losses by passing risk; this frees up additional capital.
  4. Solvency Margins: The purchase of surplus relief insurance allows companies to accept new clients and avoid the need to raise additional capital.
  5. Expertise: The expertise of another insurer can help a company obtain a higher rating and premium.

Reinsurance Regulation

U.S. reinsurers are regulated on a state-by-state basis. Regulations are designed to ensure solvency, proper market conduct, fair contract terms, rates, and to provide consumer protection. Specifically, regulations require the reinsurer to be financially solvent so that it can meet its obligations to ceding insurers.

Advisor Insight

Peter J. Creedon, CFP®, ChFC®, CLU®
Crystal Brook Advisors, New York, NY

Reinsurance is a way a company lowers its risk or exposure to an untoward event. The idea is that no insurance company has too much exposure to a particular large event/disaster. If one company assumed the risk on its own, the 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 in damage. If one company had sold all the homeowners insurance, the chance of covering the losses would be unlikely. 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.