Understanding Reinsurance

by Aliza R. Writer

You count on your insurance company to cover your damages when the unexpected happens. Who does your insurance company count on?

Do insurance companies take out insurance policies of their own? Like any business, yes they do – insurance is a way of reducing the risk on all kinds of business assets, such as buildings that could be damaged by storms or fire. However many people don't realize that insurance companies will also take out insurance on the policies they themselves have issued. This is known as reinsurance.

To understand how this works it's important to remember that, to an insurance company, the policies it sells to its customers are a business asset. Just as a jeweler would insure their diamonds, or a car lot would insure against damage to its inventory of cars, an insurance company has to consider what would happen if it suddenly experienced major losses on all of its policies. That could spell disaster, and they want to insure against that eventuality. For that they turn to a reinsurance company.

A reinsurance company thus effectively offers to share in the risk another insurance company has taken on. There are two ways this can work: a company can take out reinsurance on specific, individuals policies or on all of its policies of a certain type.

Individual or “facultative” reinsurance is usually taken out on large, unique insurance policies. Alternately they may be taken out on amounts in excess of a certain threshold on a company's largest policies. These are cases where the amount of money the insurance company is liable to pay out is either so high or so unpredictable that it's worth the extra cost to write a one-off reinsurance contract.

Across the board or “treaty” reinsurance is taken out on a certain type of policy in bulk. Most often, this is a policy type that an insurance company no longer offers or is phasing out (“legacy policies”). Managing legacy policies can be costly for very little return, and it's often in a company's best interest to essentially outsource them entirely to a reinsurance company.

The work that a reinsurance company does is typically invisible to the end customer of the insurance policy, and it actually improves the insurance available – reinsurance helps insurance companies offer out policy types they otherwise couldn't and live up to their obligations with even the largest policies. While not well known, reinsurance is a crucial part of the industry.