What Is Reinsurance? Reinsurance is when insurance companies purchase insurance policies from other insurance companies to reduce their total loss in the event of a disaster. The Reinsurance Association of America calls it “insurance of insurance businesses”. It is the concept that insurance companies cannot be too exposed to large events or catastrophes.
Reinsurance: The Beginnings
According to The Reinsurance Association of America, reinsurance’s roots can be traced back as far back as the 14th century when it was used to ensure marine and fire risks. It has expanded to include all aspects of modern insurance markets. Some companies specialize in selling reinsurance in America, there are reinsurance departments in U.S. primary insurers, and there is a global network of reinsurers that are licensed outside the United States. Ceding buys reinsurance direct from a reinsurer, or through a broker.
How Reinsurance Works
Spreading risk allows an insurance company to take on clients that are too difficult for one company to manage. Reinsurance is where the insured pays a premium that is shared with all the other insurance companies.
If an insurance company takes on the risk, it could bankrupt the company or cause financial ruin. The insurance company may not be able to pay the premium.
Consider a hurricane that hits Florida, causing billions in damages. It is unlikely that all homeowners insurance would be sold by one company. Instead, the retail insurer spreads a portion of the coverage to other insurance agencies (reinsurance), spreading the risk among multiple insurance companies.
Reinsurance is purchased by insurers for four reasons. To limit their liability on a particular risk, to stabilize loss experience, and to protect themselves and they’re insured against catastrophic events. Reinsurance can be a benefit to a company in the following ways:
- Risk transfer: Companies may share or transfer certain risks with other businesses.
- Arbitrage: You can make additional profits by buying insurance elsewhere at a lower price than what the company collects from policyholders.
- Capital Management: This allows companies to avoid large losses and free up capital.
- Solvency Margins: Companies can purchase surplus relief insurance to accept new clients without having to raise additional capital.
- Expertise: A company can benefit from the expertise of another insurer to obtain a higher rating or a premium.
Reinsurance Regulation
Reinsurance companies in the United States are regulated state-by-state. The regulations are intended to protect consumers and ensure market conduct, solvency, fair contract terms and rates, fair market conduct, market conduct, fair contract conditions, rates, and consumer protection. Particularly, regulations require that the reinsurer be financially solvent to meet its obligation to ceding insurance.
ADVISOR INSIGHT
Reinsurance allows a company to reduce its exposure or risk of an unfortunate event. Insurance companies mustn’t be too exposed to large events or disasters. The risk would be too high for one company to assume it on its own and bankrupt or financially ruin them.
A large hurricane can cause billions of dollars worth of damage in Florida, for example. The possibility of recouping the losses would not be possible if all homeowners insurance was sold by one company. Instead, the retail insurer spreads a portion of the coverage to other insurance firms (reinsurance), spreading the risk among many insurance companies.
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