THE MEANING OF REINSURANCE
Reinsurance is the process by which an insurance company shares the risk that it assumes when it issues an insurance policy. For example, an insurance company that issues a $1 million life insurance policy may reinsure or have other insurers assume $900,000 of the risk. The insurance company issuing the policy thus “cedes” most of the risk to one or more reinsurers.
There are numerous variations of reinsurance. Insurers and reinsurers may enter into treaty reinsurance agreements or facultative reinsurance agreements. Treaty reinsurance agreements provide that the insurer ceding some portion of the risk agrees in advance with one or more reinsurers that particular percentages of coverages will be sold to the reinsurers in return for a portion of the premiums paid for the insurance. Facultative reinsurance agreements are made policy-by-policy between insurers and reinsurers on particular risks.
For example, a treaty reinsurance agreement between an insurer and reinsurers may cover all of the accounting malpractice policies issued by the insurer. A facultative reinsurance agreement may cover ceding of risks incurred by the insurer in issuing a policy covering occurrences at a particular office building.
Under either treaty or facultative agreements, reinsurers may agree to pay either a percentage of the loss in return for a percentage of the premium (pro-rata) or the reinsurers may agree to pay losses above a certain amount (excess of loss).
Reinsurance allows insurance companies to spread their risk and thereby offer more alternatives to policyholders. In turn, policyholders do not have to rely solely upon the financial health of a single insurer. This can be an important consideration when evaluating policy proposals on large risks.