What Is Reinsurance?
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Reinsurance is insurance for insurance companies — it ensures that those who provide insurance for thousands of individuals and businesses are insured themselves. Reinsurance companies (also called reinsurers) help insurance companies hedge some of their risks, freeing their financial reserves and allowing them to underwrite more policies.
An insurer will want to ensure that they are covered just like their customers. This reinsurance guide breaks down the basics of reinsurance and how it works.
Reinsurance Definition & Example
Reinsurance is insurance that insurance companies buy to help insure against high-cost claims. The party being reinsured is typically called the ceding company.
Reinsurance often comes into play when a specific area is affected by a disaster, spiking the number of claims. Since the total costs can be offset by spreading financial liability to the reinsurer up to a limit, reinsurance is sometimes called stop-loss insurance.
Here's an example of reinsurance:
Let's say your city was devastated by a hurricane. You and nearly every neighborhood in your city filed a claim for flood damage and the damages totaled $100 billion. For one insurance company to handle even 5% of those damages, they would need to pay out $5 billion. To help manage some of these costs, a portion of payments on approved claims would be handled by the reinsurance company.
How Reinsurance Works
Similar to traditional insurance, the ceding insurer pays a premium to the reinsurer to gain coverage on certain claims over a period. Reinsurance helps mitigate the blow of high-cost claims so that insurance companies can fulfill their financial responsibilities to their customers.
Reinsurance also helps insurers underwrite policies otherwise impossible without reinsurance. For example, let's say the insurance company wants to underwrite a policy for $20 million but can only take on $15 million in liability — this limit is often called retention. If the insurance company can get reinsured for the remaining $5 million, they can then sell that policy.
Keep in mind that a primary insurer may be reinsured by multiple companies, even on a single policy. In the example above, the $5 million could be reinsured by one company or five or more.
Types of Reinsurance
When a reinsurance company agrees to reinsure a ceding company, they enter into a reinsurance contract. There are two types: facultative and treaty.
Facultative reinsurance: The reinsurer agrees to take on specific claims, but has the ability, or "faculty," to reject an insurance policy. The scope of policies is typically more focused than treaty insurance — typically high-cost or high-volume policyholders (e.g., hospitals) or claims related to specific perils (e.g., natural disasters).
Treaty reinsurance: The reinsurer covers multiple types of policies and claims, such as auto or flood claims. After determining the insurance company's risk exposure, the reinsurer will automatically cover predetermined types of policies. Unlike a facultative agreement, the reinsurer must accept all policies under the agreement.
Proportional vs. Non-Proportional Reinsurance
Proportional (pro rata)
Non-proportional (excess of loss)
Both the insurance company and reinsurance company share the premium from policyholders and potential losses. The reinsurer's gains and losses are based on a predetermined percentage.
The insurance company retains a predetermined amount of liability for losses. The insurance company must pay a fee to the reinsurance company for any losses over that threshold, up to a limit.
|✓ Mitigate payouts during declared disasters||✓ Free up capital|
|✓ Underwrite more policies||✓ Helps small insurers compete|
Mitigate payouts during disasters
Reinsurers provide catastrophe insurance against claims that spike within a short period due to emergencies and natural disasters. By delegating a portion of those costs to the reinsurer, the insurance company can meet its financial obligations to its policyholders.
Free up capital
Reinsurance can help an insurance company's cash reserves become more liquid. Since a portion of financial liability is handled by the reinsurer, insurers have more wiggle-room to reinvest their capital in revenue-generating opportunities.
Underwrite more policies
With financial risk mitigated by the reinsurer, the insurance company has more freedom to sell more policies — just be sure to balance the premiums you accept with the claims you can fulfill (even with reinsurance).
Helps small insurers become more competitive
Small insurers with reinsurance arrangements can mitigate risk, free up capital and underwrite more policies. These benefits help small insurers succeed and go toe-to-toe with other insurance companies because they can set competitive rates and accept more customers.
The reinsurance industry is subject to both state and federal regulations.
States set requirements on a reinsurance company's financial solvency — an entity's ability to meet its financial obligations — so that it could carry out any arrangements with ceding insurance companies. The state also imposes rules, sometimes indirectly, on market conduct, rates and terms and consumer protections.
At the federal level, several regulation entities were established under the Dodd-Frank Act of 2010, which created legislative implications for reinsurance companies. The Federal insurance Office, for example, looks for issues or gaps in the insurance industry that could contribute to a domestic financial crisis.
Are You Insured?
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