What Is a Reinsurance Contract Called?
Explore the various names and structures of reinsurance contracts that allow insurance companies to manage and transfer risk effectively.
Reinsurance is a fundamental practice within the insurance industry, allowing one insurance company to transfer a portion of its risk to another. This helps primary insurers manage financial exposure and protect themselves from large losses, contributing to overall market stability.
Understanding Reinsurance
Reinsurance is often described as “insurance for insurance companies.” It involves a primary insurer, known as the “ceding insurer” or “cedent,” transferring some of its insurance liabilities to another company, called the “reinsurer.” This transfer allows the ceding insurer to reduce its net liability and gain protection against large or multiple losses.
The core purpose of reinsurance is to enable insurers to underwrite more policies than their capital base might otherwise permit. By ceding a portion of the risk, the primary insurer can free up capital for new business or market expansion. This mechanism also protects insurers from unexpected claim frequencies or intensities, ensuring they remain solvent after major events like natural disasters. Reinsurance contributes significantly to the overall stability of the insurance market by diversifying risk across multiple entities.
Key Types of Reinsurance Agreements
Reinsurance contracts are categorized primarily by how risks are transferred and how premiums and losses are shared. Two overarching methods dictate how these agreements are structured: facultative and treaty reinsurance. These foundational types then branch into proportional and non-proportional arrangements, which define the financial mechanics of the risk transfer.
Facultative reinsurance involves negotiating coverage on a case-by-case basis for individual risks or specific policies. The reinsurer has the option to accept or reject each risk presented, allowing for a thorough assessment of unique or high-value exposures. This method is often used for risks that do not fit within standard reinsurance agreements due to their size, complexity, or specific characteristics.
Treaty reinsurance, in contrast, covers a predefined portfolio or book of business over a specific period through an ongoing agreement. The ceding insurer agrees to transfer, and the reinsurer agrees to accept, all risks that fall within the terms of the treaty. This approach is less transactional and provides automatic coverage for a group of policies, making it efficient for managing consistent types of risks.
Within both facultative and treaty structures, reinsurance can be further classified as proportional or non-proportional, determining how financial responsibilities are shared. Proportional reinsurance means the reinsurer shares a percentage of both the premiums and losses with the ceding insurer. Common forms include quota share, where the reinsurer takes a fixed percentage of all policies within the treaty. Another form is surplus share, where the reinsurer covers the portion of risk that exceeds the ceding insurer’s retention limit.
Non-proportional reinsurance, often called excess of loss reinsurance, operates differently; the reinsurer only pays when losses exceed a certain predetermined threshold, known as the retention limit. The primary insurer bears all losses up to this retention, and the reinsurer covers the amount above it, up to a specified limit. This category includes excess of loss, where the reinsurer pays claims above a specific amount, often used for large, infrequent events. Another type is stop loss, which covers the ceding insurer when its aggregate losses for a period exceed a certain percentage of its premium income, providing protection against an accumulation of smaller losses.
The Mechanics of Reinsurance
The operational flow of a reinsurance arrangement begins when a policyholder purchases insurance from a primary insurer. This initial transaction establishes the direct insurance contract and the primary insurer’s liability for potential claims.
To manage this exposure, the primary insurer “cedes,” or transfers, a portion of its risk to a reinsurer. Along with the risk, a corresponding portion of the premium received from the policyholder is transferred to the reinsurer. This risk and premium transfer is formalized through a reinsurance contract, which outlines the specific terms and conditions of the agreement.
When a claim occurs, the policyholder files it directly with the primary insurer, who then pays the full amount of the claim to the policyholder. Subsequently, the reinsurer reimburses the primary insurer for its agreed-upon share of the loss, according to the terms of their reinsurance contract. This reimbursement process ensures the primary insurer’s financial stability and capital preservation, even in the face of significant payouts.
A common financial aspect of these arrangements is the “ceding commission,” a fee paid by the reinsurer to the primary insurer. This commission helps the primary insurer cover administrative costs, such as underwriting and policy issuance expenses, and can also serve as an incentive for transferring business. The ceding commission typically ranges from 15% to 35% of the ceded premium, depending on the type of business and market conditions.