Insurance is based upon a simple premise – sharing a risk. At the policyholder level, at its most basic, insurers calculate the risk of a loss, and the cost of that loss, and average that cost out across all the policyholders. Insurance companies are required by laws (which vary from place to place) to have a certain amount of liquid assets available to cover a percentage of their potential risks, For example, if the company is required to have 25% of their potential losses covered, and they insure one billion dollars in assets (cars, homes, etc), then they must have 250 million dollars at hand to cover claims costs.
But what if the worst case scenario happened and more than 25% of their policy holders submitted claims at once? What if half, or more did? The insurance company may not have the liquid assets to pay out the claims. Policy holders would be left in the lurch, and the insurer may end up going bankrupt to cover all the liabilities from the outstanding claims, jeopardizing any payments.
Reinsurance was developed to cover such worst case scenarios, deemed in the insurance biz as ‘catastrophic losses’. Almost all insurers participate in some sort of reinsurance coverage, and in some countries and areas, it is required. Sometimes the liquidity requirement is reduced if the company has a significant amount of reinsurance.
For example, lets say fictitional insurance company ABC Insurance has 10,000 auto policy holders in a storm prone area like the US Midwest. A severe hailstorm comes along and causes damages to 90% of the vehicles, at an average claim cost of $2000 each. This adds up to $18 million in claims, just from one incident! This is on top of all the everyday claims that it pays out to policy holders across the US. Even if ABC Insurance has the cash on hand to pay these claims, it would put a serious dent in their cash flow. Costs to the insurer are then passed on to the policy holders, so these policy holders may find their insurance premiums skyrocketing.
This is where reinsurance comes in. In this scenario, lets assume ABC Insurance has a reinsurance policy with fictitious reinsurance provider 123 Reinsurance. Terms of the policy vary, but for this case, lets say that their policy states that, for catastrophic losses, 123 Reinsurance will pay 80% of the losses to ABC Insurance. This significantly reduces the impact on ABC Insurance, and allows all the claims to be paid out without jeopardizing the financial liquidity of the insurance company.
How does this benefit the policy holders? For starters, their claims get paid. The second benefit is in keeping premiums low. Keeping in mind that premiums are always based on the risk of potential losses, if ABC Insurance has a reinsurance policy in place to keep their ultimate payout down, the actual cost of risk that goes into the calculation is the costs of the reinsurance premium, not the total dollar loss.
Without reinsurance, people with a potential for catastrophic losses, such as those that live in storm zones, flood plains, earthquake zones, etc, would be either unable to obtain or certainly unable to afford property damage insurance. Reinsurance is not just about property damage, however. Liability insurance, life insurance, business insurance – all of these can be reinsured. Business with potential for huge losses (although risk of such an event may be low) such as commercial airlines, certainly benefit from such a plan. While the risk for a catastrophic crash is very low, claims against an airliner and their insurer for a high loss of life can amount to staggering sums of money. Without the ability for the insurer to reinsure such a risk, airlines would simply not be able to function. The cost of liability premiums would be so prohibitive, and it passing on that cost to the consumer, would make air travel far to expensive to generate enough business to be profitable.
Reinsurance is simply another aspect of sharing the risk and thus reducing the impact of a loss on the policy holder. And the ultimate beneficiary is always the consumer.