Reinsurance is insurance. It’s as simple as that. It is coverage that insurance companies (known as the ‘ceding’ party) buy from one or more reinsurers as a means of risk management. What is the risk? The risk is the amount of coverage/exposure that the insurance company holds in its underwritten policies.
Theoretically, at any time an insurance company could be liable for any and all of the coverage enacted in its current policies. Almost all insurance companies buy reinsurance to cover their exposure to such risk. As a result, the initial insurer can write policies with higher limits than would normally be allowed, because it is backed by the reinsurance. Insurance companies implement reinsurance strategies in an effort to create a more manageable and profitable portfolio of insured risks.
Most reinsurance contracts are contracts of indemnity, which means that it only becomes effective when the insurer (ceding party) has made a payment to the original policyholder. Reinsurance saw a rise in popularity in the late 1990s/early 2000s due to large natural disasters and mass tort litigation which resulted in much larger payouts of claims by insurers.
Reinsurance contracts are typically either facultative or treaty based. Facultative reinsurance manages coverage on a case by case basis. It may cover all or part of the underlying policy depending on the reinsurer’s individual analysis of the situation. Treaty reinsurance (which is most common in property insurance) is used to cover all of a certain type of policy as opposed to one particular policy. These types of reinsurance policies are usually more general than facultative policies because the reinsurance decision is based on general, potential liability as opposed to a specific, enumerated risk.
There are two ways that coverage in reinsurance policies can be allotted between parties: proportionally (or percentage based) and non-proportionally. In proportional reinsurance the reinsured obtains coverage for only a portion (or percentage) of the potential loss (or risk) from the reinsurer, whereas non-proportional reinsurance covers a set amount of loss (or risk).