How does reinsurance work

Stock Advisor will renew at the then current list price. Average returns of all recommendations since inception. Cost basis and return based on previous market day close. Investing Best Accounts. Stock Market Basics. Stock Market. Industries to Invest In. Getting Started. Planning for Retirement. Retired: What Now? Personal Finance. Credit Cards. Commercial banks and other lenders have been securitizing mortgages for years, freeing up capital to expand their mortgage business.

Insurers and reinsurers issue catastrophe bonds to the securities market through an issuer known as a special purpose reinsurance vehicle SPRV set up specifically for this purpose. These bonds have complicated structures and are typically created offshore, where tax and regulatory treatment may be more favorable.

SPRVs collect the premium from the insurance or reinsurance company and the principal from investors and hold them in a trust in the form of U. Treasuries or other highly rated assets, using the investment income to pay interest on the principal.

Bonds may be issued for a one-year term or multiple years, often three. Increasingly, catastrophe bonds are being developed for residual market government entities and state-backed wind pools. In addition, the California State Compensation Insurance Fund issued a bond to cover workers compensation losses in the event of a catastrophic earthquake. Other bonds have been created to cover extreme mortality and medical benefit claim levels.

The catastrophe bond market, which was largely pioneered by reinsurers, has begun to change. In , for the first time, primary insurance companies were sponsors of the majority of bond issues—about 60 percent. Industry observers say primary companies are increasingly integrating cat bonds into their core reinsurance programs as a way to diversify and increase flexibility.

Whereas traditional reinsurance is mostly purchased on an annual basis, cat bonds generally provide multiyear coverage and may be structured in tranches that mature in successive years. Of the many new ways of financing catastrophe risk that have been developed over the past decade or two, catastrophe bonds are best known outside the insurance industry.

One lesser-known alternative is the industry loss warranty contract ILW. Another recent innovation is the side-car. These are relatively simple agreements that allow a reinsurer to transfer to another reinsurer or group of investors, such as hedge funds, a limited and specific risk, such as the risk of an earthquake or hurricane in a given geographic area over a specific period of time. Side-car deals are much smaller and less complex than catastrophe bonds and are usually privately placed rather than tradable securities.

In side-cars, investors share in the profit or loss the business produces along with the reinsurer. While a catastrophe bond could be considered excess of loss reinsurance, assuming the higher layers of loss for an infrequent but potentially highly destructive event, side-cars are similar to reinsurance treaties where the reinsurer and primary insurer share in the results.

When catastrophe bonds were first issued after Hurricane Andrew, they were expected to gain industrywide acceptance as an alternative to traditional catastrophe reinsurance, which was then in short supply, but they still represent a small, albeit growing, portion of the worldwide catastrophe reinsurance market.

Several of the first attempts at true securitization were withdrawn because of time constraints — the hurricane season had begun before work on the transaction could be completed, for example — and lack of sufficient interest on the part of investors. The first deals were consummated in December , one by a U. This was the first large transaction in which insurance risk was sold to the public markets. The company said that it did not need to finance hailstorm damage in this way but sold the bonds to test the market for securitizing insurance risks.

Six months later there was strong investor interest in a bond offering that provided USAA with catastrophe reinsurance to pay homeowners losses arising from a single hurricane in eastern coastal states, proving for the first time that insurance risk could be sold to institutional investors on a large scale. The field has gradually evolved to the point where some investors and insurance company issuers are beginning to feel comfortable with the concept, with some coming back to the capital markets each year.

In addition to the high interest rates catastrophe bonds pay, their attraction to investors is that they diversify investment portfolio risk, thus reducing the volatility of returns. The returns on most other securities are tied to economic activity rather than natural disasters.

Equities are considered riskier under formulas that dictate how much capital must be set aside to support various liabilities. Without reinsurance, today's insurance industry would be more vulnerable to risk and would likely have to charge higher prices on all of their policies to compensate for potential loss. Reinsurance companies typically offer two kinds of products. In addition to these categories, reinsurance may be considered proportional or not. Under proportional reinsurance, the reinsurer receives a prorated share of all policy premiums sold by the insurer.

For a claim, the reinsurer bears a portion of the losses based on a pre-negotiated percentage. The reinsurer also reimburses the insurer for processing, business acquisition, and writing costs.

With non-proportional reinsurance, the reinsurer is liable if the insurer's losses exceed a specified amount, known as the priority or retention limit. As a result, the reinsurer does not have a proportional share in the insurer's premiums and losses. The priority or retention limit is based on one type of risk or an entire risk category. Excess-of-loss reinsurance is a type of non-proportional coverage in which the reinsurer covers the losses exceeding the insurer's retained limit.

This contract is typically applied to catastrophic events and covers the insurer either on a per-occurrence basis or for the cumulative losses within a set period. Reinsurers primarily deal in the largest and most complex risks in the insurance system. These are the kinds of risks that normal insurance companies do not want or are not able to internalize. These sorts of risks tend to be international in nature: war, severe recession, or problems in the commodity markets.

For this reason, reinsurance companies tend to have a global presence. A global presence also allows the reinsurer to spread risk across larger areas. Reinsurance companies don't always deal solely with other insurers. Many also write policies for financial intermediaries, multinational corporations or banks.

However, the majority of reinsurance clients are primary insurance companies. Like any other form of insurance, reinsurance boils down to a system wherein the insurance customer is charged a premium in exchange for the insurer's promise to pay future claims in accordance with the policy coverage.

Reinsurance companies employ risk managers and modelers to price their contracts, just as normal insurance companies do. Popular Courses. Personal Finance Insurance. Key Takeaways Reinsurance occurs when multiple insurance companies share risk by purchasing insurance policies from other insurers to limit their own total loss in case of disaster. By spreading risk, an insurance company takes on clients whose coverage would be too great of a burden for the single insurance company to handle alone.

Premiums paid by the insured are typically shared by all of the insurance companies involved. Advisor Insight Peter J. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate.

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This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Articles. Partner Links. Related Terms Reinsurer A reinsurer is a company that provides financial protection to insurance companies, handling risks too large for them to handle alone.