What is Reinsurance?

In its simplest form, reinsurance is insurance for insurance companies. Reinsurance is a transaction between two insurance companies whereby one insurance company offers to provide coverage to another in exchange for the payment of premium (i.e. the cost of an insurance/reinsurance policy). The company who is offering the protection is referred to as the reinsurer or reinsurance company and the company who purchases the protection in exchange for the payment of premium is known as the ceding insurer (or primary insurer). Similar to how a person purchases an insurance policy to cover his/her motor vehicle against possible future losses or to cover their assets against possible liability claims, insurance companies purchase reinsurance to protect their solvency (i.e. their ability to meet future financial obligations).

Insurance companies are in the business of accepting risks from customers in exchange for a promise to pay for any losses that are covered under the terms of the insurance policies they provide. In accepting risks, and provided that the terms of the insurance policy are satisfied, insurance companies become responsible to their policyholders (i.e. customers who purchased insurance coverage from the insurer) to pay for any covered losses and to restore their policyholders to the same condition they would have enjoyed had the loss not taken place, this is known as the principle of indemnity.

Insurance companies accept vast volumes of different types of risk from their customers. All the risks that are accepted by an insurance company comprise the insurer’s portfolio of written business. The insurance company faces the risk that a large event, or the accumulation of small events, may cause losses to the risks in their portfolio to such a degree that the insurance company’s financial health may become impaired. The insurance company has to cover all the losses that satisfy the terms and conditions of the written insurance policies. Therefore; the insurance company’s liabilities to its policyholders may greatly exceed the insurance company’s ability to pay for those losses to indemnify customers. By purchasing reinsurance, insurance companies can share the risks with a reinsurance company. This means that, in exchange for the payment of a reinsurance premium, the reinsurance company will be responsible for indemnifying the insurer for a predetermined portion of the losses suffered. When structured properly, reinsurance coverage can reduce the insurance company’s total exposure to loss to a more manageable amount. Reinsurance can assist insurers by helping them to remain solvent after unfavorable claim periods.