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Understanding Reinsurance

When several insurance companies work together to share risk by purchasing insurance from other insurers in order to limit individual risk, it is called reinsurance.  The idea is that each entity diversifies their risk profile, so that no one entity would be fatally damaged by a major loss event.  It became popular in the late 90s due to tort litigation, natural disasters, and other events that caused insurance companies to have to make massive payments.

As impenetrable as they seem, even insurance conglomerates need to spread risk.

Even Insurance Companies need Insurance

Commonly referred to as insurance for insurance companies, though the third parties assume the risk, the also get to collect a portion of the premiums.  This is great for companies who are hoping to insure clients whose risk would normally be a huge burden for one insurer to handle alone.  The premium that a client pays is usually spread out across all of the insurance companies involved. Consider the insurance policy for the Olympic Games. Insuring against all of the risks involved would be too much for a single entity, but spread across insurers, the risks are manageable.

Another good example is in the case of natural disasters, where reinsurance is very important in providing financial management.

Parties Involved

In a reinsurance contract there are usually two parties: the reinsurer or assuming insurer, and the ceding insurer.  The first is the insurance company looking to indemnify (protect) against lost, and the latter is the company that is helping to spread out that risk.  They may do this against all or just part of the loss they expect to face.  They can choose to do so for specific risks, or for a more broad class of business.

Reinsurance happens in any risk concentration portfolio. Health insurance, life insurance, auto insurance and homeowners insurance, reinsurance helps the insurance companies maintain healthy portfolios. It isn’t a perfect process however, and therefore risk concentrations can be taken advantage of to find the lowest cost policy from a given insurance company. Be sure to compare insurance policies to find these opportunities.

Global Business

The basic principle by definition makes it a global business – being international helps to spread the risk and provide access to larger markets to help cover potential and actual losses.  Just a little less than 50% of American property-casualty reinsurance and closer to 2/3rds of property-catastrophe reinsurance programs are written by foreign companies, making it a huge global enterprise.

Some ways that reinsurance can be good for a company include helping out with:

  • Capital Management.  This allows companies to avoid absorbing outrageous losses by passing the risk on to others, freeing up capital as it does so.
  • Arbitrage.  Purchasing insurance from a new source for less than the premium that the company is collecting from policy holders helps to increase profits.
  • Solvency Margins.  Purchasing what is known as “surplus relief insurance” helps companies to be able to bring on new clients, and allows them to avoid the need to come up with more money to do so.
  • Risk Transfer.  Companies are able to share or transfer specific risks with other companies they are partnered with.

There are two basic types of reinsurance.  Those are facultative reinsurance and treaty reinsurance.

The modern Olympic games would not exist without reinsurance...

Facultative Reinsurance

Facultative is the type that deals with specific risks.  It allows examination of each risk and situation, looks at the facts, and decides whether to cover all or part of the risk.

Treaty Reinsurance

Treaty reinsurance is designed to cover a certain class of risk, such as property insurance or casualty insurance.  Rather than focusing on one policy, all policies in the treaty are covered by the insurer.  These are more general than facultative reinsurance programs because they focus on general liability, rather than specific risks.

There are two basic principles in reinsurance that most companies try to follow: “Good Faith” and “Follow the Fortunes.”  Good faith is pretty self explanatory, requiring that the provider be honest and fair in assessment of the risks and all details of the policies.  Follow the fortunes stipulates that, assuming that the payments have been made by the insured, the insurer will promise to pay out as is required.

Reinsurance enables insurers to diversify their portfolios, thereby reducing their concentration of risk. The lower their risk profiles, the lower the premiums. Additionally, this collaborative insurance practice allows for the insurance of risks that would otherwise be unsustainable by a single insurer.

While reinsurance is seldom transparent to consumers, understanding the practice helps to educate the public on insurance practices; knowledge is power and power means added peace of mind.

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