Everyone knows what companies like Geico, Allstate, StateFarm do. They provide life, health, auto, and other forms of insurance coverage for individuals like you and I. We buy insurance for protection from situations like car accidents that might cost too much to pay for ourselves. Insurance is a form of financial protection that smooths costs over a long period of time instead of having no costs for some periods followed by extremely high costs the next.
Insurance companies also seek this type of financial stability, and have it in the form reinsurance. They have a massive amount of liability, but generally keep enough reserves that allows them to handle a certain amount of claims at one time. It would be extremely rare that say, Geico would have so many of their auto coverages get into separate accidents that their reserves become depleted from the claims. However, say StateFarm has written a lot of home insurance policies in Florida. We know that Florida is very susceptible to hurricanes, which can cause extreme damage to homes. Well, StateFarm knows that there is money to be made in the Florida home insurance market, and they don’t want give that business up even though it is risky. What they will do is purchase reinsurance, which acts as a stabilizer for their business in Florida. They will pay an annual premium to a company like Munich Re, Swiss Re or Willis Re who will in return will provide relief in the event of a major loss. They are essentially selling a portion of their risk to a company that has a large amount of capital. In the event StateFarm experiences a hurricane, the reinsurer to whom they sold their risk, will pay for damages above a certain threshold.
Over time, a fair Reinsurance agreement would lead to an even outcome for both sides. The normal insurer would pay the same amount of premium as the reinsurer paid in damages. The reason that this is an attractive option for the insurer is that they are able to pay a consistent amount every year to ensure that one catastrophic event would not completely deplete their reserves, and ruin their business. Reinsurance allows insurance companies to operate in risky areas that are prone to natural disasters, where otherwise it might be too difficult for insurers to provide significant coverage to those living there. Without this secondary form of insurance, people in high risk areas like Florida would have to pay obscene premium for insurance policies, or may not be able to purchase insurance at all.
Reinsurance underwriting, like insurance underwriting, attempts to assess what the risk of insuring a policy would be, and what price would be required for the insurer to take on that risk. The interesting aspect of reinsurance underwriting is that reinsurers need to look at all of the policies that an insurer has written in an area, then look at what types of catastrophic risks that area faces and how likely those policies are to be impacted by potential catastrophic events. Using this information, they can determine the average loss per year from catastrophic events, and decide whether to take on that risk.
Reinsurance is much more complicated than I just made it out to be, but operates in this general sense on every level. For example, insurers can buy reinsurance for policies that cover extremely valuable homes. If an insurance company is covering a single home that is worth $50 million, then they might not want to be liable for the entire value of the home, but still want to write the policy. They can sell a portion of the risk of the home to a reinsurer who will cover a portion of the value of the house if it is damaged.
This is an extremely complex and widespread market, that many people have not heard about or understand. Hopefully this has helped you begin to understand this fascinating business.