What Is Reinsurance?

By Motley Fool Staff Markets Fool.com

Reinsurance is a form of insurance purchased by insurance companies in order to mitigate risk. Essentially, reinsurance can limit the amount of loss an insurer can potentially suffer. In other words, it protects insurance companies from financial ruin, thereby protecting the companies' customers from uncovered losses.

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What is reinsurance?

The simple explanation is that reinsurance is insurance for insurance companies. Reinsurance is the mechanism that insurance companies use to lower their risk or reduce their exposure to a specific catastrophic event.

Reinsurance can prevent an insurer's losses from getting out of control. Image source: Getty Images.

If an insurer has too much exposure to a potentially costly event, then that event could cause the company to go bankrupt or even shut down if it's unable to cover the loss. For example, when Hurricane Andrew caused $15.5 billion in damage in Florida in 1992, seven U.S. insurance companies became insolvent because they were unable to pay the claims resulting from the disaster.

As a simplified example, let's say you run a small auto insurance company and you've collected a total of $10,000 in premiums from your customers this year. However, if one of your customers gets into a serious accident, it could easily create a claim for which you would have to pay out several times that amount. So you use a portion of the premiums you receive to purchase a reinsurance contract that will pay out in the event of an exceptionally large loss.

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Reinsurance is a large and complex industry. In a recent year, reinsurers accounted for about 7% of total U.S. property/casualty insurance premiums written.

Insurers are legally required to have sufficient capital in reserves to pay all potential claims related to their issued policies. Thanks to this regulation, consumers' losses will be covered even if their insurance company goes under. However, reinsurance lowers an insurer's liability potential, and therefore it can reduce the amount of capital the insurer is required to maintain in reserves.

Two types of reinsurance

There are two main categories of reinsurance: treaty and facultative.

  • Treaty reinsurance agreements cover all or a portion of an insurer's risks, and they are effective for a certain time period.
  • Facultative coverage insures against a specific risk factor. The underwriter would evaluate the individual risk factor and write a policy accordingly.

Proportional vs. nonproportional reinsurance

Treaty and facultative reinsurance policies can be proportional or nonproportional in structure. A proportional reinsurance (also known as "pro rata" reinsurance) agreementobligates the reinsurer to bear a portion of the losses, for which it receives a prorated share of the insurer's premiums. For example, a proportional reinsurance agreement may require a reinsurer to cover 50% of losses.

Non-proportional reinsurance (also known as "excess of loss" reinsurance) agreements kick in when the insurer's losses exceed a set amount. For example, a windstorm insurance company could seek a reinsurance agreement that would cover all losses from a hurricane in excess of $1 billion.

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