What is Reinsurance?
This is a risk management tool used by insurance companies, where a portion of the risk is transferred to another party in order to limit pay-out obligations on claims. Simply put, reinsurance is insurance for insurance companies.
An insurance company provides a policy to the insured party in exchange for a premium. However, some risks such as natural calamities may be hard to predict and thus the timing and the amount of the pay-out is difficult to quantify. If a large claim comes in that isn’t covered by the premiums, the insurance company runs the risk of going insolvent.
To protect against insolvency and huge losses, the insurance company insures part of the policies which may have large unpredictable claims. This is known as ceding reinsurance. The company looking for such protection is known as the ceding party and the protection provider is known as the reinsurer.
Key Learning Points
- Reinsurance is a type of insurance for insurers and is used as a risk management tool
- Reinsurance provides protection for insurance companies against incurring significant and unexpected expenses
- Although reinsurance can be used by all insurance companies, it is most important for companies that provide policies with exposure to natural catastrophic events, as the timing and risk levels of these events are hard to predict
- Reinsurance can be proportional where the insurance company pays a certain portion of policy received to the reinsurance company and receives the same portion of reinsurance protection
- Reinsurance can also be non-proportional which can be excess of loss, where individual claims are covered above a certain level, or stop loss where a portfolio of claims are covered beyond a certain level
Types of reinsurance
Reinsurance can be done in two ways. Proportional reinsurance is where the ceding company pays a proportion of the premiums they receive to the reinsurance company who covers them for the same proportion of any claims. Non-proportional reinsurance allows the ceding company to pay a fixed amount of premium and the reinsurance company then covers claims beyond a specific amount. This can cover individual claims that are higher than a certain threshold which is known as an excess of loss reinsurance. Non-proportional reinsurance can also be where portfolio claims exceed a certain level, which is known as stop-loss reinsurance.
Purpose of reinsurance
The main reason insurance companies use reinsurance is to allow them to reduce their overall risk. Although reinsurance is commonly used within all types of insurance, it is particularly important for insurance companies exposed to natural calamities such as earthquakes, storms, or floods. These events can have exceptionally high claims, and their timings cannot be easily predicted.
Reinsurance gives the ceding (insurance) company greater security when they take on the financial burden of unpredictable events. The insurance company can thus provide cover for these events, without charging the customer extremely high premiums.
Download the accompanying excel exercise sheets to test your knowledge of reinsurance.