May 1, 2025
Bad things happen. Cars crash, fires break out, crime occurs. Insurers take on the risk of bad things happening through the form of insurance policies. They insure cars against accidents, homes against accidental damage, and lives against untimely death. Through these insurance policies, insurers are responsible for paying insureds for valid claims. For those risks and promises to pay valid claims, the insurance companies receive premiums. Ideally, insurers are able to charge premiums to insureds and then cover claims and costs while making an appropriate profit for their efforts.
Although insurance providers are in the business of risk management, insurers have risks of their own that they need to manage. Insurance companies attempt to manage the risk they take on for each policy through underwriting and obtaining as much information as possible about the risk associated with the insured. Some risks are too great for insurers to accept at allowed premium levels. We have seen this cause the exodus of insurance carriers in the California property and casualty insurance market due to recent fire and claim activity.
When risks become too great for insurers, they also have the option of integrating reinsurance into their business model. When pricing insurance policy premiums, insurers utilize actuarial science to develop estimates of what the ultimate cost of claims will most likely be. Although these estimates are generally reliable, unanticipated events or unidentified underwriting risks can drive claims to be higher than these estimates. If an insurance company were to have claims in excess of their estimates, the solvency of the insurance company could come into question.
In order to protect against insolvency, excess risk associated with insurance policies can be ceded to reinsurers via indemnity reinsurance or assumption reinsurance. Indemnity reinsurance is when a portion of the risk associated with insurance policies is transferred to the reinsurer, with the original insurer transferring a portion of premiums to the reinsurer to take on that risk. However, all obligations to the insured remain with the original insurer. The original insurer is still responsible to fulfill claims and the obligations of the policy. The reinsurer has the obligation to the insurer based on the reinsurance agreement. Assumption reinsurance is when the original insurer essentially sells policies to a reinsurers and all obligations transfer to the reinsurer. Policyholders must approve assumption reinsurance transactions as they are essentially getting a new insurance company to fulfill the obligations of the policy.
Using reinsurance as part of a risk management strategy eases the minds of insurance companies and provides a backstop for worst case scenarios. Risk is shared between insurers and reinsurers in order to provide stability and meet the risk tolerance of all parties involved. If reinsurers have reached too high of risk for their tolerance then another level of reinsurance can be obtained with retrocession. Risks continue to be shared amongst various insurers, reinsurers and subsequent retrocession until all parties are satisfied with the risk that remains with them. Proper reinsurance transactions share the risk of the insured and meet the insured’s goal of mitigating their risk.