Reinsurance is essentially insurance for insurance companies. Here’s how it works:
- Protecting Primary Insurers:
- Risk Sharing: Primary insurers (the ones who sell policies directly to individuals and businesses) spread their risk by purchasing reinsurance.
- Catastrophic Events: Reinsurance allows primary insurers to handle major losses from events like hurricanes, earthquakes, or large liability claims.
- How Reinsurance Functions:
- Ceding Company: The primary insurer transfers (cedes) part of their risk to a reinsurance company.
- Reinsurer: The company accepting the risk shares in the premiums and pays a portion of any claims on the ceded policies.
- Treaties vs. Facultative:
- Treaties: Reinsurance agreements covering a whole block of policies (like all of an insurer’s homeowners policies in a certain state).
- Facultative: Reinsurance purchased for a specific high-value policy (like on a skyscraper or a huge cargo ship).
- Why Reinsurance is Essential:
- Stabilizes Insurance Markets: Allows primary insurers to take on bigger risks and offer more coverage options.
- Catastrophe Protection: Protects insurers from going bankrupt due to a massive disaster.
- Spreads Risk Globally: Large reinsurers are often global companies, diversifying risk geographically.
Types of Reinsurance:
- Proportional: Reinsurer shares a percentage of premiums and losses.
- Non-Proportional: Reinsurer pays for losses above a certain threshold (e.g., hurricane damage exceeding the primary insurer’s limit).
Example:
A primary insurer sells a giant liability policy to a corporation. They purchase reinsurance to cover a significant portion of their potential risk on that policy so a major claim won’t devastate their company.