Reinsurance is insurance that insurers themselves buy — a primary insurer transfers a portion of its risk to a reinsurer in exchange for a share of premium, so no single catastrophic event can threaten the primary insurer's solvency.
Why It Matters
Reinsurance is what lets a regional insurer write a $50M property policy without betting the company on a single hurricane — it's the mechanism that makes the entire insurance industry's risk-bearing capacity scalable beyond any one balance sheet. Reinsurance pricing and capacity also directly drive primary insurance rates, especially in catastrophe-exposed property lines.
How It Works in Practice
- 1Treaty reinsurance covers an entire category of business automatically (e.g., all homeowners' policies in a state); facultative reinsurance is negotiated policy-by-policy for unusually large or unusual risks
- 2Quota share treaties split every policy's premium and losses by a fixed percentage; excess-of-loss treaties only pay once losses exceed an agreed threshold
- 3Reinsurers themselves often buy retrocession — reinsurance for reinsurers — to further spread catastrophic exposure
- 4Reinsurance recoverables (amounts owed by reinsurers) are tracked as an asset on the primary insurer's balance sheet and carry their own counterparty credit risk
Common Pitfalls
Reinsurance recoverables are only as good as the reinsurer's ability to pay — concentration with a single reinsurer, or with a weakly-capitalized one, is a real counterparty risk
Reinsurance capacity and pricing are cyclical; a 'hard market' after major catastrophes can leave primary insurers unable to buy the coverage they modeled their pricing around
Basis risk between what a primary insurer's reinsurance actually covers and what its underlying policies actually pay out can leave unexpected gaps