What is “Reinsurance” and How Does it Work?
Until I started my career in health care I had no idea what reinsurance was. That lack of knowledge bugged me because, what I found out, was that reinsurance is a very popular thing for insurance companies to take part in because it helps them lower their risk.
For the vast majority of people the word reinsurance won’t mean much, but if you are involved in an industry where the word is tossed around, it’s important to have a basic understanding of what reinsurance is and how it works.
Reinsurance, in it’s simplest form, is insurance that is purchased by an insurance company from one or more other insurance companies as a means of risk management. An easy way to think of reinsurance is “insurance for insurance.”
For example: When you purchase insurance for your home you are purchasing it from an insurance company. Let’s say that insurance company insures 10,000 homes. To manage their risk they may agree to pay another insurance company a set price to cover any catastrophic claims that exceed x dollars. The risk they are taking on with these 10,000 homes has now been reduced and allows them to set aside less reserves, keep less cash on hand, etc.
Another example is the recent health care reform bill in the United States. Because insurers are
forced to take on anyone who signs up for health insurance. they are taking on significant risk because those who sign up could have pent-up demand for expensive procedures. Additionally it is hard to forecast medical expense for a population that has little to no data available.
To protect insurers the United States government implemented reinsurance as part of health care reform. When an individual has more than $60,000 in claims for a given fiscal year, the reinsurance program will cover the claims past that point all the way up to $150,000, at which point the insurer becomes responsible again.
These two examples may have oversimplified how complicated reinsurance contracts are. Reinsurance can become complicated quickly, especially because the risk that the re-insurer is taking on can be difficult to quantify. For example, World Trade Center One, which replaced the Twin Towers, has reinsurance coverage. Can you imagine how long it took to draw up a contract and all the back and forth between the insurer and re-insurer that took place before a final deal was struck?
As far as who is involved in reinsurance, there are a number of major players who receive in excess of $1 Billion in revenue from reinsurance contracts. One such company is Lloyd’s or Lloyd’s of London. who received approximately $41 Billion in reinsurance revenue in 2012. The reinsurance industry is dominated by global companies.