Reinsurance is simply insurance for insurers. It allows them to pass on risks that they cannot, or do not wish, to absorb themselves.
Insurance companies typically insure some (but not all) of the risks that they are exposed to with specialist reinsurers. The insurer can then recover a part of the claims they pay out from the reinsurer. This reduces the risk of the failure of the insurer in the event of a catastrophic event, such as a natural disaster, that may produce a very high level of claims.
Reinsurance companies are usually very large, well funded and have a wide spread of operations.
Risk measures such as solvency margin are adjusted for the level of reinsurance cover.
There are two types basic types of reinsurance arrangement, facultative reinsurance and treaty reinsurance.
This is the arrangement of separate reinsurance for each risk that the insurer underwrites. This is normally part of an on-going arrangement and the insurer continually offers policies to the reinsurer, and the reinsurer decides whether to accept each or not individually. Obviously this requires a lot of work and is now generally regarded as too expensive in human resources to be practical.
Treaty reinsurance is arranged for a block an insurer's underwritten policies. The reinsurer reinsurers a whole large chunk of the insurer's business. This means that the reinsurer does not need to scrutinise each policy individually and the insurer does not have the added workload of providing the reinsurer details of each and every risk it underwrites.
Reinsurance may be agreed on a pro rata basis or a stop loss basis:
- Pro rata basis: the reinsurer gets a fixed proportion of the premium on the risks covered, and in return pays out a fixed proportion of the claims made.
- Stop loss basis: the insurer will absorb losses up to a limit (the retention), and reinsurer will absorb almost all losses above that limit.
Reinsurnace may also cover only individual risks of above a certain size or losses above a specified excess.