Reinsurance is insurance for insurance companies. Similar to how insurance offers financial protection from adverse events for companies and individuals, reinsurance does the same for insurers. Imagine if. a natural disaster ripped through a single geographic area where one particular insurance provider has provided coverage to hundreds of customers. In such a situation, that one provider could face hundreds of claims that could bankrupt the company thanks to the amount of cash outflow that must be made at once.
Reinsurance allows insurers to share their risks and liability with other insurance companies. In this way, a single large claim or multiple related claims occurring simultaneously would not compromise one company’s future and ensure that all claims are paid out to the requisite customers on time.
How does reinsurance impact your premiums? Here's what you should know.
- The fundamentals of reinsurance
- Why is reinsurance important?
- The reinsurance process
- Types of reinsurance
- The impact of reinsurance on customer premiums
- FAQs about reinsurance
The fundamentals of reinsurance
Reinsurance can be a complicated process. In a typical transaction, a consumer or business buys a product such as home insurance or car insurance from an insurance organization. This organization is called the primary insurer. A reinsurance organization is the third party in this process that deals directly with the primary insurer, not you.
Similar to how you buy a policy from your primary insurer, the reinsurance company will structure an agreement with the primary insurer that transfers some of the risk the primary insurer has taken on. As part of the agreement, the primary insurer pays a defined sum of money in each time period, a percentage of the premiums that the customer pays, to the reinsurer. When this happens, the primary insurer is known as the ‘ceding company’.
Why is reinsurance important?
Reinsurance companies have a very important role to play in the entire end-to-end insurance process. Imagine a small insurance organization that underwrites home, auto, or life insurance policies. This small organization would likely collect premiums. However, the premiums wouldn’t be sufficient to cover a major event in which a high volume of claims are made in a short period of time.
To address that problem, federal policies mandate that an insurance company must have enough funds on hand at all times to fulfil the policies it underwrites. This is where reinsurance companies come in to share some of that risk and enable the insurance company to meet both its regulatory objectives and growth priorities.
The reinsurance process
Reinsurance has three main parties involved: (i) the customer who buys the insurance policy, (ii) the primary insurer who underwrites the policy, and (iii) the reinsurance provider that shares the risk of the policy with the primary insurer. The steps involved in the reinsurance process are listed below. For the purposes of this explanation, we have illustrated the reinsurance process for an auto insurance policy.
1. The customer buys a car
The first step in the process is when the customer buys a car. Under Canadian federal law, the customer must buy an insurance policy to drive on Canadian roads.
2. The customer buys a policy from an insurance company (primary insurer)
After reviewing various options, the customer will choose one insurance provider who will offer a stipulated amount of coverage in exchange for the customer paying a premium, usually on a monthly basis.
3. The primary insurer signs a reinsurance agreement
When the primary insurer underwrites a large number of auto insurance policies, particularly if they are in one geographic area that is prone to adverse events such as floods, they may feel overexposed to risk. In this case, they will sign an agreement with the reinsurer that transfers some of their portfolio's risks in exchange for a pro-rated share of the premiums made by the initial customer to the primary insurer.
4. An adverse event occurs
Once the customer has bought the insurance policy and starts paying premiums, they are eligible to receive coverage for a specified set of adverse events as defined in the insurance agreement. If any of these adverse events occur, customers can file a claim with the insurance provider to help mitigate their personal financial losses.
5. The reinsurance company steps in
Depending on how the reinsurance agreement is structured, the reinsurance company may step in immediately to cover claims or at a later stage when a certain threshold of losses has been breached.
Types of reinsurance
Not all reinsurance agreements are the same. There are two main types of reinsurance: (i) treaty reinsurance and (ii) facultative reinsurance.
Treaty reinsurance is an agreement between the primary insurer and the reinsurance company in which the two share certain risks. In this type of agreement, the reinsurance company will assume coverage over large policy groups, such as the insurer’s entire home insurance or auto insurance portfolio. These agreements are then valid for a set period of time, after which they need to be renewed.
A facultative reinsurance agreement is more specific in nature. In facultative reinsurance, each risk is underwritten on an individual or case-by-case basis. This type of reinsurance is usually undertaken when the underlying risk is of a larger magnitude, such as if the insurance policy provides natural disaster coverage for a high-rise commercial or residential building.
Types of facultative reinsurance
There are two main types of facultative reinsurance agreements: (i) proportional and (ii) non-proportional. A proportional agreement means that the primary insurer and the reinsurer will share in both the premiums and any losses incurred as a result of claims. In a non-proportional agreement, the primary insurer covers losses up to a certain threshold. Once the total claims exceed that threshold, the reinsurance provider must cover the remainder of the losses.
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The impact of reinsurance on customer premiums
The reinsurance industry is a key component of the overall industry ecosystem. Without reinsurers, insurance companies would not be able to underwrite as many policies. This is because they would need to keep huge sums of capital on hand to comply with government regulations.
By transferring some risk from the primary insurer to the reinsurance provider, the reinsurance company allows the insurance provider to underwrite more policies and cover a wider range of risks.
Reinsurance enables insurance companies to keep their premiums steady for customers. Reinsurers also closely follow catastrophes occurring around the world to determine the probability of various events, such as natural disasters. If they notice increased claims for a certain type of coverage, the costs of these claims will then be passed on to the primary insurers, which in turn will pass them on to customers via higher premiums.
FAQs about reinsurance
Reinsurance is insurance for insurance providers. Insurance providers will work with reinsurers to share some of the risks they assume when underwriting policies, which enables them to de-risk part of their portfolio and gives them the capacity to underwrite more policies.
Reinsurance companies receive part of the premiums that customers pay to the primary insurer. Depending on the reinsurance agreement, the reinsurance provider will receive a certain pro-rated share of premiums in exchange for the risk transfer.
Reinsurance is the contractual transfer of risk from the primary insurer to the reinsurer for a policy or group of policies. In return for a portion of the premiums collected from customers, the reinsurance company offers financial protection that prevents a single insurer from becoming financially overwhelmed by a large claim or number of claims at once.
The two types of reinsurance are treaty insurance (risk transfer for an entire portfolio of insurance business) and facultative reinsurance (risk transfer for single risks evaluated on a case-by-case basis).
The primary difference between reinsurance and insurance providers lies in who they work with. Insurance companies deal directly with the end-user (either individuals or organizations) whereas reinsurance companies deal exclusively with the insurance provider. The individual customer often has no visibility on who the reinsurance provider is, and interacts directly with the insurance company for premiums payments, claims, and any other customer support issues.
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About The Author: Arthur Dubois
Passionate about personal finance and financial technology, Arthur Dubois is a writer and SEO specialist at Hardbacon. Since his arrival in Canada, he’s built his credit score from nothing.
Arthur invests in the stock market but doesn’t pay any fees because he uses National Bank Direct Brokerage online broker and Wealthsimple’s robo-advisor. He pays for his subscriptions online with his KOHO prepaid card, and uses his Tangerine credit card for most of his in-store purchases. When he buys bitcoins, it’s with the BitBuy online platform. Of course it goes without saying that he uses the Hardbacon app so that he can manage all of his finances from one convenient place.
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