By definition, reinsurance is insurance for insurance companies. It's a bit of a tongue-twister. But it’s a valuable product that just about every insurance company buys regularly.
You may be wondering, “Insurance companies sell insurance; why would they buy insurance?”
This article will clear that up for you. We’ll look at what reinsurance is, why insurance companies buy it, how it works, the different types of reinsurance, and more. Read on for a peek at another way insurance companies turn a tidy profit.
Insurance companies buy reinsurance to lower their financial risk, much like you buy all types of insurance to lower yours.
We all know that an accident, disability, or death can occur at any time and cause financial hardship for our families. It’s a risk everyone is exposed to every day, and it’s why we buy automobile insurance, long term disability insurance, and life insurance. We share our risks with insurance companies.
The same holds true for insurance companies of all kinds: property and casualty insurers, disability insurance carriers, and life and health insurance companies. They can only assume so much financial risk without being in danger of becoming insolvent.
For example, when Hurricane Andrew struck the coast of Florida in 1992 and moved across the state, it caused over $15 billion in damage. Because of this, eight property insurance companies that had sold homeowner’s insurance in that area went under — they were unable to pay all of the claims filed because of the disaster:
- Florida Fire
- Great Republic
- Ocean Casualty
- Nova Southern
- Insurance Company of Florida
These were generally small insurers (at least two companies were family-owned).
However, some larger property and casualty insurers (i.e., State Farm, Allstate, Progressive) had purchased reinsurance for just such an event. As a result, their losses were limited. They had paid other insurance companies to assume some of the risk they took on when they sold policies to people owning property in Florida.
They anticipated that a catastrophic weather event, like a hurricane, could once again strike the Florida coast, potentially causing them to pay out more in claims than the cash they had on hand (also known as “reserves”).
Insurance companies are legally required to have enough money in reserves to pay all potential claims related to policies they’ve issued. This protects consumers because it all but guarantees their losses will be covered.
To ensure they can survive, insurers purchase reinsurance, which allows them to reduce the amount of capital they’re required to maintain in reserves. This frees up money for them to invest in their growth and increase profitability through improved technology, increased staff, new buildings, etc.
Life insurance companies also use reinsurance to lower their risk. For example, a life insurer that sells a policy with a $10 million face amount will very likely share that risk with one or more reinsurance companies.
Without reinsurance, insurance companies would only be able to write a limited number of policies and would have to turn away people looking for coverage. This would drive insurance premiums beyond the reach of many people and make insurance coverage a valuable commodity (supply and demand).
There are two types of reinsurance: treaty and facultative.
- Treaty reinsurance covers all or part of an insurance company’s risks for a certain period of time. For example, a reinsurance company may only share in the risk of a life insurance policy for a performer while they’re on tour, but not after the tour ends.
- Facultative reinsurance insures against a specific risk. Underwriters evaluate the individual risk involved and issue a policy accordingly. For example, a reinsurer may cover the death of a trapeze artist due to natural causes, but not if they died while performing.
Treaty and facultative reinsurance can be proportional or nonproportional.
Proportional reinsurance is also known as “pro-rata” reinsurance. It obligates the reinsurer to pay a portion of any loss for which it received a prorated share of the premiums it was paid by the original insurer.
For example, if Standard Life Insurance Co. sells a life insurance policy with a $5 million death benefit for $2,000 per month in premiums and shares 50% of that premium with a reinsurance company, the reinsurer will be responsible for paying 50% of the death benefit ($2.5 million).
Nonproportional reinsurance is also known as “excess of loss” reinsurance. A reinsurer becomes liable for payment when the primary insurer’s losses exceed a set amount.
For example, an insurance company specializing in earthquake insurance could seek a reinsurance agreement to cover all losses caused by an earthquake over $1 billion.
According to A.M. Best, who has been ranking and rating insurance companies since 1899, the ten largest reinsurance companies in 2021 ranked by gross premiums collected were:
- Munich Reinsurance Company ($45.8 billion)
- Swiss Re Ltd. ($36.5 billion)
- Hannover Ruck SE ($30.4 billion)
- SCOR S.E ($20.1 billion)
- Berkshire Hathaway Inc. ($19.1 billion)
- China Reinsurance Group Corp ($16.6 billion)
- Lloyd’s ($16.5 billion)
- Canada Life Re ($14.5 billion)
- Reinsurance Group of America Inc. ($12.5 billion)
- Korean Reinsurance Company ($7.7 billion)
In addition to collecting premiums from insurance companies looking to share their risk, reinsurance companies generate revenue in other ways.
First, reinsurers sometimes profit by assuming the entire risk a primary insurer brings them because they believe the individual to be insured isn’t as great a risk as the original insurance company does.
For example, a reinsurer might be approached by an insurance company to assume partial liability on an insurance policy for a $6000 yearly premium. After examining the proposal, the reinsurer might offer to take on the entire risk for an annual premium of $8000, creating additional revenue they wouldn’t have otherwise realized.
Reinsurers also generate revenue by investing the premiums they collect, just as other insurance companies do. Warren Buffet and Berkshire Hathaway’s property and casualty reinsurance group are famous for generating tremendous profits by doing this. The group’s pre-tax profits in the first quarter of 2022 were $405 million, up significantly from $166 million in the first quarter of 2021.
You may not see ads for reinsurance companies or know their names, but they play an important role in providing people across the globe with financial security they otherwise wouldn’t have.
The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.