Reinsurance

Reinsurance: Definition, Types, and How It Works

Reinsurance is insurance purchased by an insurance company (the cedent) from another insurer (the reinsurer) to transfer part of its risk exposure. By sharing or ceding portions of policies, insurers reduce their liability for large or concentrated losses, stabilize financial results, and increase capacity to underwrite more business.

Key takeaways
* Reinsurance is “insurance for insurers,” used to manage risk, protect capital, and stabilize earnings.
* Two principal placement methods: facultative (per risk) and treaty (broad portfolio).
* Two principal pricing/settlement approaches: proportional (shares premiums and losses) and non-proportional (reinsurer pays only after a retention threshold).
* Common non-proportional forms include excess-of-loss and stop-loss coverages, often used for catastrophic protection.

How reinsurance works
* The cedent and reinsurer enter a contract specifying what risks are covered, how premiums and losses are shared, the duration, and other terms.
* Reinsurance can cover individual policies or whole books of business. Contracts may include clauses for insolvency, aggregate limits, or reinstatements after large events.
* Reinsurance reduces net liability on individual claims and on accumulations of claims from a single event (for example, a hurricane or major industrial loss).

Placement methods
* Facultative reinsurance: Negotiated and underwritten for a specific individual risk or policy. The reinsurer has the right to accept or decline each risk. Common for high-value or unusual exposures not covered under treaties.
* Treaty reinsurance: Covers a defined class or portfolio of policies for a fixed period. The reinsurer automatically accepts risks that fall within the treaty’s scope, simplifying placement and administration.

Proportional vs non-proportional arrangements
* Proportional reinsurance: The reinsurer receives a fixed percentage of premiums and pays the same percentage of losses. Variants include:
* Quota share — fixed percentage of every policy.
* Surplus share — reinsurer covers amounts above the cedent’s retention up to a limit.
The reinsurer typically also reimburses a share of acquisition and administrative costs.
* Non-proportional reinsurance: The reinsurer pays only when the cedent’s losses exceed a pre-agreed retention (priority). The reinsurer does not share premiums or routine losses below that threshold. Common forms:
* Excess-of-loss (per-occurrence) — covers losses above the cedent’s limit for a single event.
* Aggregate stop-loss — covers cumulative losses above a defined level over a period.

Benefits of reinsurance
* Capital protection and solvency support: Helps insurers meet regulatory reserve requirements and absorb large losses without jeopardizing financial stability.
* Capacity expansion: Enables insurers to underwrite larger or more policies than their balance sheets alone would allow.
* Earnings volatility reduction: Smooths results by sharing the impact of unusually heavy claim years.
* Expertise and market access: Reinsurers often provide underwriting guidance, risk modeling, and access to global capacity for catastrophic exposures.

Practical considerations
* Reinsurance contracts vary widely in scope, pricing, and complexity; careful negotiation and clear terms are critical.
* Regulatory and accounting rules can affect how ceded premiums and recoveries are treated on financial statements.
* Reinsurance markets can tighten or relax based on catastrophe experience, capital availability, and broader economic conditions.

Bottom line
Reinsurance is a foundational tool for risk management in the insurance industry. By transferring portions of risk to reinsurers, insurers protect capital, stabilize operations, and expand underwriting capacity—helping the overall market remain resilient to large or concentrated losses.