What is reinsurance and how does it work?

Reinsurance allows a primary carrier to pass, or cede, a portion of its liabilities onto another company.

The Insurance Information Institute noted reinsurance can be broken into two primary categories; treaty and facultative. Treaty reinsurance covers broad groups of policies, such as all of a primary carrier’s auto policies, while facultative contracts cover individual policies that are generally high in value or risk. Credit: Shutterstock

Editor’s note: This column is part of PropertyCasualty360’s Foundations of P&C Insurance series, which aims to bring new insurance professionals up to speed, while keeping industry veterans sharp. On Fridays, PC360 will offer up fresh content covering the nitty-gritty details of P&C insurance, tips for professional development, articles looking at the industry’s more niche concepts, and the history of certain lines and programs.

Reinsurance is in essence insurance for insurance companies, or the business of insuring insurance companies, as the FC&S Coverage Experts insurance dictionary puts it.

Insurers are responsible for paying the costs of claims against the policies they issue and are required by law to have sufficient capital to ensure they can pay all potential future claims. The Insurance Information Institute (Triple-I) explained this protects consumers, but it also limits the amount of business an insurer can write.

Reinsurance allows a primary carrier to pass, or cede, a portion of its liabilities onto another company, in turn lowering the amount of capital needed to meet regulation, while ensuring good financial health and the ability to pay future claims.

According to the National Association of Insurance Commissioners (NAIC), other common reasons an insurance company might seek reinsurance include:

The basics of reinsurance contracts

Triple-I noted reinsurance can be broken into two primary categories; treaty and facultative.

Treaty reinsurance covers broad groups of policies, such as all of a primary carrier’s auto policies, while facultative contracts cover individual policies that are generally high in value or risk. Facultative contracts also give reinsurers the ability to accept or reject all or parts of an insurance policy.

Reinsurance can be structured as proportional or “excess-of-loss” agreements, Triple-I reported.

Under propositional agreements, reinsurers get a prorated share of the premiums sold by the primary insurer. If claims are filed, reinsurers bear a portion of the losses based on the proposition of the risk they cover.

In excess-of-loss agreements, reinsurers are only liable if the primary insurer’s losses surpass a specific amount, called the priority or retention limit, according to Investopedia, which noted these types of contacts are typically applied to catastrophic events.

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