Reviewed by Daniel Mirkovic
Updated February 23, 2024
re·in·sur·ance | ˌrē-ən-ˈshu̇r-ən(t)s
Definition: Insurance purchased by an insurance company to protect against major claims events.
Following the earthquake, the insurance company’s reinsurance helped pay for the significant losses.
Reinsurance is a special type of insurance that insurance companies buy. It’s a layer of extra protection from unexpected or exceptional claim events.
Insurance companies need to pay claims—that’s the reason they exist. Accordingly, they need to have a certain amount of money in the bank at any given time. There’s a lot of number crunching involved, but basically: insurers predict how much money they’ll need to cover their customers’ claims in the upcoming months.
Assuming their predictions are correct, all is well. They collect premiums, pay out claims, and pay their staff, with a little money left over in reserve.
But what happens when their predictions are wrong?
Major loss events, like floods or wildfires, can cause billions of dollars in damage. Even spread amongst many insurers, that’s a huge amount of money. Insurance companies can’t afford to keep hundreds of millions of dollars sitting in the bank waiting for a natural disaster. They’d have to charge premiums so high that their customers couldn’t afford them.
That’s where reinsurance comes in.
Reinsurance exists so that insurance companies don’t have to hoard money for major loss events that are not as likely to happen—like a once-in-a-century wildfire or ice storm. When such an event does happen, the insurance company’s reinsurance kicks in to help pay for the claims.
There are other reasons that insurance companies buy reinsurance as well.
Reinsurance allows insurance providers to take on greater risks than they could without it. That can mean offering policies with higher coverage limits or insuring higher-risk customers.
Insurance companies can also use reinsurance to help them expand. If an insurer is growing rapidly, they may not have enough reserves built up to cover their new customers’ claims—reinsurance can help with that.
Basically, there are many reasons an insurer would seek reinsurance.
Almost every insurance company buys reinsurance in some form or another. And that means that part of the payment for every insurance policy eventually finds its way to a reinsurance company.
Reinsurance companies are some of the biggest insurance companies there are. The largest reinsurance providers collect tens of billions of dollars in annual premiums. In turn, they also pay out tens of billions of dollars in response to large claims.
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There are many types of reinsurance, but they generally work the same way. An insurance company pays a reinsurer an agreed-upon amount of money. In return the reinsurer jumps in to help cover agreed-upon costs.
However, the amounts of money and the things reinsurance covers depend on the type of reinsurance. There are two main types of reinsurance.
Reinsurance policies are either proportional, or non-proportional. This refers to how the insurance company pays their premiums, and which losses the reinsurer covers.
Under proportional reinsurance, a reinsurance company takes on a percentage of the risk for each policy the insurer sells. They also receive a percentage of the premiums paid for that policy.
Alpha Insurance Company has a reinsurance policy from Zeta Reinsurance. When Alpha sells an insurance policy, Zeta takes on 25% of the risk and receives 25% of the premiums.
Alpha sells a policy with a limit of $100,000, for which their customer pays $100 in annual premiums. From that $100, Zeta receives $25.
Later, the customer makes a claim for $50,000, which is covered. Alpha pays the customer their entire claim of $50,000, and Zeta then reimburses Alpha the 25% ($12,500) that was agreed to under their reinsurance policy.
That’s an oversimplification, but you get the idea. There could be all sorts of conditions within the agreement. For example: maybe Alpha covers the first $100,000 of each policy and Zeta only covers 25% of amounts above that.
In any case, Alpha’s customer only ever deals with Alpha—they aren’t involved in the reinsurance transactions that happen behind the scenes.
Proportional reinsurance contrasts with non-proportional reinsurance.
Under a non-proportional agreement, the reinsurer will only pay out if losses top a certain number in a given time period or for a specific event. This is the type of reinsurance that helps insurance providers cover costs following a major catastrophe. It’s also known as a reinsurance treaty.
Beta Home Insurance Company has a non-proportional reinsurance agreement with Zeta Reinsurance.
Beta is prepared to cover up to $10 million in losses from any single event. They’ve purchased reinsurance from Zeta for up to $40 million above that. Beta pays a set premium in exchange for this coverage, regardless of whether they need to use it.
Following a major storm, Beta’s customers suffered a combined $25 million in losses, all of which is covered by their insurance policies.
In this case, Beta pays their customers the full $25 million, and their reinsurance from Zeta reimburses Beta $15 million (the full amount of the loss, minus the first $10 million that Beta agreed to cover on their own).
That’s the basic version of how non-proportional reinsurance works.
However, insurers can also buy per-policy non-proportional reinsurance. That means they can buy reinsurance for one specific policy, which will cover losses over a certain amount for that policy only. This is known as facultative reinsurance.
Alpha Insurance Company has agreed to insure a new office building. They normally limit individual policies to $10 million, but this building needs $15 million in coverage.
Alpha can buy reinsurance for this single policy to cover the gap. With a $5 million reinsurance policy plus their standard $10 million, they can sell the office a $15 million policy.
Any claims the building’s owner makes that are under $10 million will be paid entirely by Alpha. Claim amounts above $10 million will be covered by their reinsurer—but only up to the reinsurance limit.
The math in this example is similar to math above about proportional reinsurance. However, proportional reinsurance is part of an ongoing agreement wherein the reinsurer covers a portion of many (or all) policies. Facultative reinsurance is on a policy-by-policy basis.
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About the expert: Daniel Mirkovic
A co-founder of Square One with 25 years of experience in the insurance industry, Daniel was previously vice president of the insurance and travel divisions at the British Columbia Automobile Association. Daniel has a bachelor of commerce and a Master of Business Administration (MBA) from the Sauder School of Business at the University of British Columbia. He holds a Canadian Accredited Insurance Broker (CAIB) designation and a general insurance license level 3 in BC, Alberta, Saskatchewan, Manitoba and Ontario.
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