Insurance and reinsurance are both financial protection against the possibility of losses. While they are similar in concept, they are quite different in terms of how they are used and who uses them. You purchase insurance to protect against possible property losses. Who protects the insurance company from possible property losses? For smaller losses, the company is probably self-insured. But, as a hedge against large losses, they purchase reinsurance.
Definition of Insurance
Insurance is a contract purchased by individuals and companies to manage their risk of loss of life, home, auto, property or whatever the insurance was purchased to cover. Purchasers pay a fee (premium) for a policy/contract while the insurance company agrees to reimburse the purchaser for a financial loss due to one of the circumstances covered by the policy.
Definition of Reinsurance
Reinsurance is insurance purchased by an insurance company from other insurance companies to manage their risk. It protects against significantly large claims or disasters, allowing the insurance company to cover more individuals without fear of bankruptcy should a disaster occur, resulting in multiple policyholders filing claims at one time. For example, if there is widespread flooding that affects a specific area, where many residents are making claims, insurance companies may need to rely on their reinsurance to cover the claims. In some reinsurance arrangements, several insurance providers pool their policies and divide the risk among a number of insurance providers, sometimes globally.
How They Are Similar
Insurance and reinsurance are similar in many ways. Insurance is purchased to provide protection from covered losses; reinsurance guards the insurance company from too many losses. They both contractually transfer the cost of the loss to the company issuing the policy. They both have deductibles. For an insurance policy covering a home from fire, it might be $1,500. For a reinsurance policy covering an insurance company from a wildfire destroying hundreds of homes, it might be $45 million.
How They Differ
State insurance commissioners regulate both insurance and reinsurance. However, insurance policies are typically bought from companies that are allowed to offer policies in one state, while reinsurance policies are often purchased across state lines or even international borders. Reinsurance companies may be special divisions of large insurance conglomerates or companies that undertake only the reinsurance business. Ordinary insurance policies can be purchased to cover a variety of needs such as home, auto, life or disability.
Reinsurance policies fall into two types: treaty, which covers a pool of policies from either one or several insurers over a long term, and facultative, which covers a specific risk and is priced and purchased separately from the insurer’s other reinsurance policies. Think of facultative as a separate reinsurance policy purchased for something that the treaty wouldn’t cover, usually because the potential loss is much higher. For example, a maritime insurer may have treaty reinsurance over most of the ships it covers, but negotiate facultative policies on an extremely expensive vessel.
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