DEFINITION
A reinsurer steps in to help the original insurer pay claims.
Definition and Examples of Reinsurance
The purpose of insurance is to transfer and share risk—your auto policy allows you to share the risk of a potential auto accident with a large company. Direct insurers sell homeowner, auto, health, and life insurance policies directly to you, the consumer. Then, the direct insurer turns to a reinsurance company to help assume the risk of those policies, either partially or entirely. The direct insurer is called the “ceding” insurer.
As noted, insurance companies turn to reinsurance for their own coverage. So when you take out a homeowners policy, your insurance company insures your policy with a reinsurer. That reinsurer can even buy coverage with yet another reinsurer. The reinsurers help cover a claim, should it occur.
The major reinsurance companies include Lloyd’s of London, Munich RE, and Berkshire Hathaway.
How Reinsurance Works
Before offering you a policy and rate, an insurance company reviews your age, location, driving history, credit history, and other variables to determine how likely it is that you’ll cause an accident or otherwise be an expensive risk.
Similarly, a reinsurance company needs to evaluate how risky an insurance company’s policies will be to cover. Will the insurance company rack up repeated losses due to offering insurance in a hurricane-prone zone, for example? If so, the reinsurance pricing may go up in exchange for coverage.
Where homeowners insurance is concerned, reinsurers use computer-generated catastrophe models to determine the characteristics and probability of severe weather that could impact the insurance companies, including hurricanes, floods, and tornados. The models are generated using data from the National Centers for Environment Information (NCEI) such as cyclone tracking data, tornado and hail data, and temperature and precipitation data.
Types of Reinsurance
Much like a policy sold to you, a reinsurance contract is negotiated with the direct insurance company. Reinsurance is focused on transferring risk from the direct insurer to the reinsurer, so reinsurance contracts may differ by how risks are shared or passed along.
Treaty or Obligatory Contracts
With a treaty or obligatory reinsurance contract, certain classes of the insurer’s policies are covered, usually a large portfolio of similar risks. For instance, all of an insurance company’s policies concerning auto insurance in California.
Facultative
With a facultative reinsurance contract, only individual policies are reinsured on a case-by-case basis. For example, all of an insurance company’s auto insurance policies concerning California government vehicles. Facultative insurance can also help close coverage gaps after treaty reinsurance is negotiated. Insurance companies may use layers of treaty reinsurance and facultative reinsurance contracts to achieve their coverage goals.
There are two sub-categories within these contract types (treaty or facultative): Pro-rata/proportional and non-proportional.
Pro-Rata or Proportional
With a pro-rata reinsurance agreement, the reinsurer covers a portion of the losses and also accepts a portion of the insurer’s premiums. Proportional reinsurance prearranges premiums, losses, and expenses between reinsurer and insurer.
Non-Proportional
With this type of reinsurance, the reinsurer reimburses or covers costs above a certain cap (much like your deductible) up to a limit or ceiling. These policies could cover all losses over a certain amount or only for those in a particular risk category or portfolio.