Reinsurance, known as the insurance for insurance companies, is insurance that an insurer purchases to protect itself against exposure to large risks. The reinsurance process helps insurance companies spread and share risk against catastrophic loss. By spreading risk, reinsurance allows the insurance industry to function more efficiently. Reinsurance allows insurance companies to write larger amounts of insurance, protects against large losses, helps insurers protect their internal business against swings in business cycles and stabilizes their year to year operations, and helps provide underwriting expertise for new lines of insurance or new markets.

Buyers and Sellers

Most reinsurance occurs with specialist reinsurers, like earthquake and hurricane reinsurers, that operate on a global basis. The insurance company that buys the reinsurance is known as the as the ceding insurer, and the company that sells the reinsurance is known as the reinsurer. Most reinsurance transactions involve numerous reinsurers sharing risk. Because reinsurance is an indemnification contract, the reinsurance is payable only after the ceding insurer pays losses under its own insurance or reinsurance contracts.

Catastrophic Losses

Reinsurance works just like insurance, but on a bigger scale. For example, say a fire burns down one house, but not 500 others. For regular insurance, the premium paid by the 500 policyholders would cover the cost of rebuilding the house that burned down. However, if a catastrophe, like a hurricane, destroyed all the homes in a certain county, the premium paid by the 500 policyholders would not be enough to cover all the destroyed homes. Reinsurance protects against that situation in that there would likely not have been a catastrophe in another county. In other words, the year there is a hurricane in Florida, there isn't an earthquake in California, and the risk for either of the potential catastrophes can be shared.

Types of Reinsurance

There are two types of reinsurance: proportional basis reinsurance and excess of loss reinsurance. A proportional basis reinsurance contract, used frequently in property reinsurance, prorates all premiums and losses between the ceding insurer and the reinsurer on a pre-arranged basis. With an excess of loss reinsurance contract, the ceding insurer keeps all of its losses up to a certain level, and the reinsurer covers the ceding insurer for any losses above that level, up to the contract limits.

Types of Reinsurance Contracts

There are also two types of reinsurance contracts: facultative reinsurance and treaty reinsurance, and both types may be written on a proportional or excess of loss basis, or a combination of both bases. Facultative reinsurance is for a specific risk of the ceding insurer. It is generally used to cover catastrophic risks. It covers underlying, individual policies and it is written on a policy-specific basis. The parties negotiate the terms and conditions in each individual contract. The reinsurer is offered an individual risk by the ceding insurer, and it can either accept or reject the risk. Reinsurance treaties, on the other hand, are broad contracts that cover a block of the ceding company's book of business. For instance, the treaty insurance may cover the ceding insurer's entire property book of business. The reinsurance treaty automatically covers all the risks of the ceding insurer that are within the specified business class, unless those risks are specifically excluded. Although reinsurers are not required to review each individual risk associated with the reinsurance treaty, they should be aware of the overall business and underwriting policies of the ceding insurer.

Insurance for Reinsurers

Finally, reinsurers can also purchase their own reinsurance, known as a retrocession. The reinsurers purchasing the reinsurance become known as retrocessionaires, and the reinsurers selling the reinsurance to other reinsurers become known as retrocedents. Retrocessions further spread the risk of reinsurance, and it is quite common for a reinsurer to buy reinsurance protection from other reinsurers. Reinsurers providing proportional basis reinsurance may need to protect their own exposure to catastrophes, or reinsurers providing excess of loss reinsurance protection may need to protect themselves against accumulated losses.

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