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Reinsurance is insurance for insurance companies. It’s a way of transferring some of the financial risk insurance companies assume in insuring cars, homes and businesses to another insurance company, the reinsurer.

When an insurance company issues an insurance policy, an auto insurance policy, for example, it assumes responsibility for paying for the cost of any accidents that occur, within the parameters set out in the policy. By law, an insurer must have sufficient capital to ensure it will be able to pay all potential future claims related to the policies it issues. This requirement protects consumers but limits the amount of business an insurer can take on. However, if the insurer can reduce its responsibility, or liability, for these claims by transferring a part of the liability to another insurer, it can lower the amount of capital it must maintain to satisfy regulators that it is in good financial health and will be able to pay the claims of its policyholders. Capital freed up in this way can support more or larger insurance policies. The company that issues the policy initially is known as the primary insurer. The company that assumes liability from the primary insurer is known as the reinsurer. Primary companies are said to “cede” business to a reinsurer.

The reinsurance business is evolving. Traditionally, reinsurance transactions were between two insurance entities: the primary insurer that sold the original insurance policies and the reinsurer. Most still are. Primary insurers and reinsurers can share both the premiums and losses, or reinsurers may assume the primary company’s losses above a certain dollar limit in return for a fee. However, risks of various kinds, particularly of natural disasters, are now being sold by insurers and reinsurers to institutional investors in the form of catastrophe bonds and other alternative risk-spreading mechanisms. Increasingly, new products reflect a gradual blending of reinsurance and investment banking.

Types of Reinsurance:

Reinsurance can be divided into two basic categories: treaty and facultative. Treaties are agreements that cover broad groups of policies such as all of a primary insurer’s auto business. Facultative covers specific individual, generally high-value or hazardous risks, such as a hospital, that would not be accepted under a treaty.

In most treaty agreements, once the terms of the contract, including the categories of risks covered, have been established, all policies that fall within those terms – in many cases both new and existing business—are covered, usually automatically, until the agreement is cancelled.

With facultative reinsurance, the reinsurer must underwrite the individual “risk,” say a hospital, just as a primary company would, looking at all aspects of the operation and the hospital’s attitude to and record on safety. In addition, the reinsurer would also consider the attitude and management of the primary insurer seeking reinsurance coverage. This type of reinsurance is called facultative because the reinsurer has the power or “faculty” to accept or reject all or a part of any policy offered to it in contrast to treaty reinsurance, under which it must accept all applicable policies once the agreement is signed.

Treaty and facultative reinsurance agreements can be structured on a “pro rata” (proportional) or “excess-of-loss” (non-proportional) basis, depending on the arrangement by which losses are apportioned between the two insurers.

In a proportional agreement, most often applied to property coverages, the reinsurer and the primary company share both the premium from the policyholder and the potential losses.

In an excess of loss agreement, the primary company retains a certain amount of liability for losses (known as the ceding company’s retention) and pays a fee to the reinsurer for coverage above that amount, generally subject to a fixed upper limit. Excess of loss agreements may apply to individual policies, to an event such as a hurricane that affects many policyholders or to the primary insurer’s aggregate losses above a certain amount, per policy or per year.

A primary company’s reinsurance program can be very complex. Simply put, if it were diagrammed, it might look like a pyramid with ascending dollar levels of coverage for increasingly remote events, split among a number of reinsurance companies each assuming a portion. It would include layers of proportional and excess of loss treaties and possibly a facultative excess of loss layer at the top.


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