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The basics of reinsurance

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Sunday, October 15, 2017

The 2017 hurricane season has been one of the worst in recent memory. As we have all witnessed on the news, hurricanes Harvey, Irma, and Maria wrought devastation to the U.S. mainland, Puerto Rico, and other Caribbean islands.

Many, many people undoubtedly will depend on their insurance companies to help rebuild their lives and, as a result, insurers will incur enormous expenditures as they repair and replace the homes, businesses, and other property destroyed by the hurricanes.

What many people do not realize is that, just as individuals purchase insurance to protect their property, insurance companies also obtain insurance protection from other insurers by purchasing reinsurance. Insurers depend on reinsurance, especially during times of catastrophe and, given its importance to the insurance marketplace, the average individual may find it useful to learn a little more about the basics of reinsurance.

From a fundamental perspective, reinsurance can be viewed as an arrangement between two parties — the primary insurance company and the reinsurance company. The primary insurance company is the company that initially writes the insurance coverage and promises to indemnify a property owner in the event that property is damaged or destroyed.

The primary insurer then negotiates a contract with the reinsurance company whereby the reinsurer agrees to pay for part of all of the losses payable by the primary insurer due to a given peril, in a given line of business, in a given geographic location. In this way, reinsurers provide a significant amount of protection to primary insurers in times of catastrophe and help ensure that primary insurers can remain solvent and pay all promised claims.

There are two basic types of reinsurance arrangements — facultative reinsurance and treaty reinsurance. Both arrangements ensure that the primary insurer will recover part or all of a given loss from the reinsurer. However, facultative reinsurance arrangements are made on a case-by-case basis and are generally used when a primary insurer needs a large amount of reinsurance for a particular loss exposure.

On the other hand, in a treaty reinsurance arrangement, the reinsurer agrees to automatically reinsure the primary insurer’s business that falls within the parameters of the reinsurance treaty.

There are also different ways by which a primary insurer and reinsurer share losses after an event occurs. For example, the primary insurer and the reinsurer may agree to share losses proportionally.

Another arrangement, referred to as excess-of-loss reinsurance, requires the reinsurance company to pay for losses incurred by the primary insurer that are in excess of a predetermined limit. This type of reinsurance arrangement is often used to provide primary insurers protection against a catastrophic loss.

Of course, reinsurance arrangements are used for many reasons and not just to provide protection against catastrophic loss. For example, reinsurance allows primary insurers to increase their capacity to write new business, stabilize fluctuations in financial profitability, or obtain underwriting expertise from the reinsurer.

However, given the magnitude of the damage caused by the recent hurricanes, insurers are undoubtedly grateful for the existence of the reinsurance market, as reinsurers ultimately will pay a large portion of the cost to repair or replace the property damaged by natural disasters.

J. Bradley Karl is an assistant professor in the Department of Finance in the College of Business at East Carolina University.

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