It is an established fact that insurance companies are primarily saddled with the responsibility of mitigating the losses or risks involved in businesses and other live endeavors. The question most people ask is “since companies are insured with insurance companies how then, do insurance companies insure their own businesses? We will carefully examine the concepts of reinsurance.
What is Reinsurance?
The practice of insurers transferring portions of risk portfolios to other parties by some form of agreement in order to reduce the likelihood of having to pay a large obligation resulting from an insurance claim. The intent of reinsurance is for an insurance company to reduce the risks associated with underwritten policies by spreading risks across alternative institutions. Also known as “insurance for insurers” or “stop-loss insurance”.
Most of the time, companies will either self-insure or purchase a policy from another company to provide financial protection if the headquarters is destroyed by fire or a natural disaster, or if the business suffers from a break-in or vandalism. When it comes to protecting themselves from losses due to legitimately filed claims, insurance companies purchase policies on what is known as the reinsurance market. Reinsurers can be specialist reinsurance companies that only undertake reinsurance business, while other times they are traditional insurance companies. Because insurance companies have outstanding policies that can add up to millions or even billions of dollars’ worth of risk, they will often take out several reinsurance policies to protect themselves from having too much risk.
Protecting themselves from risk isn’t the only reason insurance companies spend millions every year on this type of policy; reinsurance coverage also makes good business sense. By purchasing reinsurance coverage, insurance companies can reduce the amount of capital needed to underwrite policies while at the same time enabling them to absorb larger losses. Having reinsurance coverage can also help insurance companies grow. If an insurer can get coverage for less than it sells policies for, it will make a profit, even if it has to pay out claims. Not to mention, the coverage is legally required in most states. There are actually laws that prohibit insurance companies from writing policies worth more than 10 percent of the company’s net value unless they carry reinsurance coverage.
Overall, the reinsurance company receives pieces of a larger potential obligation in exchange for some of the money the original insurer received to accept the obligation.
The party that diversifies its insurance portfolio is known as the ceding party. The party that accepts a portion of the potential obligation in exchange for a share of the insurance premium is known as the reinsurer.”
There are two basic types of reinsurance policies on the market: proportional and non-proportional.
1. Proportional Reinsurance
One or more re-insurers will take on a set percentage of the risks from policies written by insurers. The reinsurers’ profits and risks are divided according to this percentage. The original insurer will usually get a percentage of the policies as a commission to cover their expenses.
The reinsurance only comes into effect if the insurer’s losses are over a certain set amount. This is the equivalent of the insurance company having a deductible and basically caps the insurer’s exposure at the agreed-upon limit. Anything above that limit is paid for by the reinsurance company. In the past 30 years, there has been a major shift from proportional to non-proportional reinsurance in the property and casualty fields.
Another way insurance companies can mitigate their risk is by actually investing in a reinsurance pool. Pooling arrangements permit participating companies to rely on the capacity of the entire pool’s capital and surplus rather than just on its own capital and surplus. Under such arrangements, the members share all insurance business that is written and allocate the combined premiums, losses, and expenses. Reinsurers may insure insurance companies but usually insurance companies “self-insure” or set aside reserves to cover any expected payouts under the policies. Here’s how it works:
Sometimes insurance companies hold all the risk from underwriting policies. Sometimes insurers buy insurance from reinsurers for part of the risk. Insurers almost never lay off all such risk to others.
Reinsurance companies take a pool of portions of insurance policies underwritten by insurance companies in exchange for a fee. The reinsurer insures that pool of partial policies. The reinsurer may hold all or part of this risk and pass on some or all of the risk to another reinsurer.
I order to cover up their tracks and mitigate their own losses while mitigating the losses of the businesses, insurance companies opt for the option of reinsuring their own organizations.