Simply put, reinsurance is insurance for insurers. It’s an industry safeguard that allows carriers to transfer some portion of their risk portfolio to specialized insurance entities called reinsurers that ultimately serve as backups should the cost of claims become too concentrated for any one carrier or sector.
This reallocation of risk helps insurance carriers better manage liability, maintain financial stability, and extend their ability to underwrite a wider range of policies.
How reinsurance works
Reinsurance redistributes risk from primary insurers to reinsurers, reducing the financial impact of large claims events. By sharing risks, carriers can ensure solvency and meet their obligations to policyholders, even during widespread catastrophic events.
Through contractual agreements, reinsurers take on specified risks in exchange for a portion of the premiums collected by the insurance carrier. This mechanism allows insurers to manage risks that might otherwise exceed their capacity, keeping the overall industry resilient while meeting the extensive needs of policyholders.
The two main types of reinsurance
Reinsurance is categorized into two main forms: treaty and facultative. The most important differences between the two are the number of policies and the amount of control that the reinsurer has in structuring the risk.
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Treaty reinsurance covers a broad portfolio of policies under an agreement that automatically includes qualifying risks. For example, it might cover all residential property policies within a region, or an insurer’s entire book of business. Treaty reinsurance is typically a long-term arrangement between carriers and reinsurers.
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Facultative reinsurance is negotiated on a case-by-case basis for individual high-value or unusual risks. Unlike treaty reinsurance, it is usually an isolated transaction, a one-off agreement in which the reinsurer holds greater autonomy in their decision to take on a specific risk. This form is commonly used to underwrite projects or assets with especially complex or unique risk profiles, such as major infrastructure developments.
Both treaty and facultative reinsurance can be structured as proportional, where premiums and losses are shared between insurer and reinsurer in a set ratio; or non-proportional, where the reinsurer covers losses exceeding a predetermined threshold (also known as excess-of-loss coverage).
The benefits and cost of reinsurance
Reinsurance enables carriers to expand their underwriting capacity by offering higher policy limits or by entering additional markets with higher risk. Reinsurance also promotes financial stability by limiting the impact of large claims, which makes loss costs more predictable and manageable. By leveraging reinsurance to reduce retained risks—the risks a business or individual might otherwise choose not to insure due to the high cost of insurance—carriers can extend the benefits of coverage at more affordable rates to more policyholders.
Reinsurance often comes at a high cost to insurers, and insurance companies face the same challenges sourcing an affordable policy as consumers. Like business owners and individuals evaluating their own insurance policies, insurers must decide whether a given risk, however small, justifies the expense of reinsurance. For cautious insurers mindful of their own retained risks, the answer is that it usually does.
On a global scale, reinsurance distributes risk across regions and markets, enabling the insurance industry to better manage major disasters, including natural disasters. Reinsurance is critical to carriers’ strategies for handling the growing zones of risk due to climate change, which has increased the frequency and severity of catastrophic events and tested carriers’ capacity to manage more routine surges of high-cost claims.
Reinsurance provides added protection to the overall insurance industry, enabling carriers to manage significant risks while maintaining financial stability.