The simple explanation is that reinsurance is insurance for insurance companies.It 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.
Reinsurance provides a way for the insurance company to protect itself from financial disaster and ruin by passing on the risk to other companies.
Types of reinsurance
The two basic types of reinsurance are:
- Treaty reinsurance:Treaty reinsurance agreements cover all or a portion of an insurer’s risks, and they are effective for a certain time period.Examples of classes covered by treaty reinsurance are all property insurance policies or all casualty insurance policies written by the reinsured.
Treaty reinsurance automatically passes the risk to the reinsurer for all policies that are covered by the treaty, not just one particular policy. Treaty policies are more general than facultative policies because the reinsurance decision is based on general potential liability rather than on a specific enumerated risk.
- Facultative reinsurance:coverage insures against a specific risk factor. The underwriter would evaluate the individual risk factor and write a policy accordingly.By deciding coverage case by case, the reinsurer can determine if it wants the risk associated with that particular policy.
Facultative reinsurance is used by the reinsured to reduce the chance of loss or risk associated with a certain policy.
Proportional vs. non-proportional reinsurance
Treaty and facultative reinsurance policies can be proportional or non-proportional in structure.
Proportional reinsurance (Treaty)
A proportional reinsurance (also known as “pro rata” reinsurance) agreement obligates 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 (Facultative)
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.
By covering the insurer against accumulated individual commitments, reinsurance gives the insurer more security for its equity and solvency by increasing its ability to withstand the financial burden when unusual and major events occur.