Understanding the Reinsurance Business Model: Risk Management for Insurers

Key Takeaways

• Reinsurance is insurance for insurers, transferring and sharing risks between companies.
• Treaty reinsurance provides broad coverage for all of an insurer’s policies.
• Facultative reinsurance covers specific risks or blocks of risks individually.
• Reinsurers handle complex and catastrophic risks that insurers avoid.
• Reinsurers must comply with regulatory and financial conditions to operate globally.

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Insurance companies commonly want the same kind of financial protection they offer to their customers, and they can find such protections in the reinsurance market. Reinsurance companies provide insurance against loss for other insurance companies, especially losses related to catastrophic risks such as hurricanes. Reinsurance allows insurance companies to spread risk and protect themselves financially. Their role is important in international risk management.

Treaty reinsurance involves one insurer buying broad coverage from a dedicated reinsurance issuer that covers all the insured company’s policies. Facultative reinsurance covers a single risk or a block of risks in the primary insurer’s book.

Understanding Different Reinsurance Products

Treaty reinsurance is a type of contract where the reinsurer is bound to accept all of the policies, or an entire class of policies from the reinsured, including those that have yet to be written. Facultative reinsurance can cover single individual policies, such as reinsuring the excess insurance on a company or large building, or cover different parts with several policies pooled together.

Reinsurance may or may not be considered proportional. Under proportional reinsurance, the reinsurer receives a prorated share of all policy premiums sold by the insurer. For a claim, the reinsurer bears a portion of the losses based on a pre-negotiated percentage. The reinsurer also reimburses the insurer for processing, business acquisition, and writing costs.

With non-proportional reinsurance, the reinsurer is liable if the insurer’s losses exceed a specified amount, known as the priority or retention limit. The reinsurer does not have a proportional share in the insurer’s premiums and losses. The priority or retention limit is based on one type of risk or an entire risk category. Excess-of-loss reinsurance is a type of non-proportional coverage in which the reinsurer covers the losses exceeding the insurer’s retained limit. This contract is typically applied to catastrophic events and covers the insurer either on a per-occurrence basis or for the cumulative losses within a set period.

Comparing Reinsurers with Standard Insurance Providers

Like any other form of insurance, the reinsurance customer is charged a premium in exchange for the insurer’s promise to pay future claims in accordance with the policy coverage. Reinsurance companies employ risk managers and modelers to price their contracts, just as normal insurance companies do.

However, reinsurance companies target a different customer base and tend to work in wider jurisdictions that involve different, or even competing, legal systems. Standard insurance companies openly advertise their products to the public and compete over the same market segments. Reinsurance companies operate in the background of the financial world. These companies don’t buy mass direct-to-consumer advertising, they have small workforces and they commonly develop strong niche roles with a few large competitors.

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Navigating Reinsurance Contracts and Regulations

Reinsurance contracts are between the ceding insurer, the insurance company seeking insurance, and the assuming insurer, or the reinsurer. The reinsurer indemnifies the ceding insurer for losses under specific policies written by the ceding insurer to its customers.

Unlike the standard insurance contract, a reinsurance contract is not regulated as to form and content because both parties are considered equally knowledgeable about the industry and have equal bargaining power under the law. Reinsurance companies are regulated based on which states they file their incorporation documents with and the states in which they transact.

Reinsurers can operate in the United States without a specific license, though most jurisdictions require licensure to establish offices or conduct business transactions. Many reinsurers provide qualifying collateral to ceding insurers as a gesture of legitimacy and good faith. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires unauthorized reinsurers to provide 100% collateral of their gross liabilities to a ceding insurer for the ceding insurer to receive a financial statement of credit for the reinsurance. Reinsurers certified to have acceptable financial strength can reduce collateral according to their ratings.

What Claims Do Reinsurers Handle That Normal Insurance Companies Do Not?

Reinsurers primarily deal with the most complex risks in the insurance system. These are the risks that normal insurance companies do not want or cannot internalize.

Do Reinsurance Companies Only Write Policies for Other Insurers?

Reinsurance companies don’t always deal solely with other insurers. Many also write policies for financial intermediaries, multinational corporations, or banks. However, the majority of reinsurance clients are primary insurance companies.

Do Reinsurers Handle Global Claims?

These sorts of risks tend to be international in nature: war, severe recession, or problems in the commodity markets. For this reason, reinsurance companies tend to have a global presence. A global presence also allows the reinsurer to spread risk across larger areas.

The Bottom Line

Reinsurance companies must meet regulatory and financial conditions to operate with provisions included in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. They provide insurance to other insurance companies against catastrophic loss. Reinsurers deal with the greatest risks in the insurance system, stabilizing the financial industry globally by providing coverage for catastrophic events.