Insurance companies are exposed to loss due to risks. There was a time when some insurance companies received claims that needed huge amounts of money to pay due to natural disasters like hurricanes, which they were not prepared for and as a result some of them became insolvent. There was need for insurers therefore, to spread their risk of loss by buying insurance from large insurers known as reinsurance companies. This would cover them when a catastrophe occurs which requires huge payments like terrorism.
Buying insurance for insurance companies is therefore known as reinsurance. The insurance company enters an agreement with the reinsurer known as a reinsurance agreement and a policy is signed between the two parties. The insurer may purchase insurance from one reinsurer or many reinsurers. It pays insurance premiums to the reinsurer depending on the contract. Reinsurance companies also buy insurance from other reinsurance companies to protect themselves from losses beyond them.
When an insurance company is reinsured the two parties agree whether the reinsurer will assume all the risks or only part of the risks of the insurance company. Before underwriting reinsurance many reinsurers visit the insurance companies and review as many details as possible which include claims, financial statements, the risks and how much they would cost. They engage actuaries who are highly qualified to calculate risks using modern computer technology and mathematical models.
The reinsurance contract is between the reinsurer company and the insurance company. In this case the original policyholder does not have a right against the reinsurer. In case of a loss, the insurance company pays the original policyholder and makes a claim to the reinsurer for reimbursement. The language in the policy can be altered and require the reinsurer to pay the original policyholder directly especially when there is insolvency.
There are different types of reinsurance and the terms depend on the policy. The reinsurer can cover a proportion of the risks in which case the insurer will pay the proportionate or percentage of premium to the reinsurer. On the other hand the reinsurer will pay the proportionate loss when an event in the policy occurs. Insurers can also buy insurance for non-proportionate coverage. A base amount or level is set and when loss arises the reinsurer will pay only the amount above that base regardless of the premiums paid.
Reinsurance policies can either cover particular classes of individual risks or they can cover a block of risks. When an individual risk of loss is covered the insurer can choose to cover that particular loss or not depending on the risk. This type of reinsurance is taken for unusual risks or large risks i.e. war, terrorism. The risk is covered in one policy on its own. This involves underwriting that particular risk separately involving more cost and paperwork. This is known as facultative reinsurance. Treaty reinsurance on the other hand covers a wide range of risks within one contract. They cover many risks i.e. fire, theft, fraud in one contract.