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Understanding Reinsurance

Reinsurance is insurance that an insurer purchases to protect itself against exposure to large risks. The reinsurance process helps insurance companies spread and share risk against catastrophic loss. By spreading risk, reinsurance allows the insurance industry to function more efficiently. Reinsurance protects against large losses, thereby allowing insurance companies to write larger amounts of insurance, which helps them to protect their internal business against swings in business cycles and stabilize their year to year operations. Reinsurance further helps to provide underwriting expertise for new lines of insurance or new markets.
 
Buyers and Sellers
 
Most reinsurance occurs with specialist reinsurers, like earthquake and hurricane reinsurers, that operate globally. The insurer that buys the reinsurance is known as the as the ceding insurer, and the company that sells the reinsurance is known as the reinsurer. Most reinsurance transactions involve numerous reinsurers sharing risk. Because reinsurance is an indemnification contract, the reinsurance is payable only after the ceding insurer pays losses under its own insurance or reinsurance contracts.
 
Catastrophic Losses
 
Reinsurance works just like insurance, but on a bigger scale. Take, for example, a situation in which a fire burns down one insured house, but not 500 others that are also insured. With regular insurance, the premium paid by the 500 policyholders would cover the cost of rebuilding the house that burned down. However, if a catastrophe, such as a hurricane, destroyed all the homes in a certain locale, the premium paid by the 500 policyholders would not be enough to cover all the destroyed homes. Reinsurance protects against that situation in that a catastrophe in another locale at the same time would be unlikely. In other words, in a year in which a hurricane hits Florida, California will not likely experience a major earthquake, and the risk for either of the potential catastrophes can be shared.
 
Types of Reinsurance
 
Two types of reinsurance exist: proportional basis reinsurance and excess of loss reinsurance. Frequently utilized in property reinsurance, a proportional basis reinsurance contract prorates all premiums and losses between the ceding insurer and the reinsurer on a pre-arranged basis. With an excess of loss reinsurance contract, the ceding insurer keeps all of its losses up to a certain level, and the reinsurer covers the ceding insurer for any losses above that level, up to the contract limits.
 
Types of Reinsurance Contracts
 
Reinsurance contracts consist of either facultative reinsurance or treaty reinsurance, and both types may be written on a proportional or excess of loss basis or a combination of both bases. Facultative reinsurance is for a specific risk of the ceding insurer and is generally used to cover catastrophic risks. It covers underlying, individual policies, and it is written on a policy-specific basis. The parties negotiate the terms and conditions in each individual contract. The reinsurer is offered an individual risk by the ceding insurer, and it can either accept or reject the risk. On the other hand, reinsurance treaties are broad contracts that cover a block of the ceding company's book of business. For instance, the treaty insurance may cover the ceding insurer's entire property book of business. The reinsurance treaty automatically covers all the risks of the ceding insurer that are within the specified business class, unless those risks are specifically excluded. Although reinsurers are not required to review each individual risk associated with the reinsurance treaty, they should be aware of the overall business and underwriting policies of the ceding insurer.
 
Insurance for Reinsurers
 
Finally, reinsurers can also purchase their own reinsurance, known as a retrocession. The reinsurers purchasing the reinsurance become known as retrocessionaires, and the reinsurers selling the reinsurance to other reinsurers become known as retrocedents. Retrocessions further spread the risk of reinsurance, and it is quite common for a reinsurer to buy reinsurance protection from other reinsurers. Reinsurers providing proportional basis reinsurance may need to protect their own exposure to catastrophes, or reinsurers providing excess of loss reinsurance protection may need to protect themselves against accumulated losses.