An Intro to Reinsurance: How It Works and How It Benefits You

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min read
Updated: 13 June 2023
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Insuranceopedia Staff
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Key Takeaways

  • Reinsurance allows insurance companies to provide more secure coverage with higher limits.

Let's say you're a contractor working in construction. You find a big ticket job and start working through the numbers. It will net you a lot of money and some steady work for a while. But there's just one problem: there's no way you can finish the job on time by yourself, and some of it is too complicated and would require specialist training. Do you step down from the job and let someone else get that paycheck? Of course not. Instead, you hire sub-contractors to handle the work you can't do and you see to it that the work gets done.

The same kind of thing happens in the world of insurance. Like a contractor hiring sub-contractors, when an insurance company wants to insure a risk they don't have the resources to back fully, they reach out to a reinsurer. By partnering with the reinsurer, the two parties insure the risk jointly (to learn more about risk and insurability, see A Look at Uninsurable Risk).

Many insurance consumers are unfamiliar with the concept of reinsurance, but it's often working behind the scenes for them. This article will provide an overview of reinsurance and how it helps keep you protected.

How Reinsurance Works

Insurance companies are subject to regulations that mandate them to have a certain amount of capital on hand for all the insurance they provide. The higher the risk, the more capital they need to have access to. These regulations ensure that the company will have money available to pay the compensation they owe the insured when they file claims (find out How to File a Claim that Gets Paid Sooner).

The purpose of this regulation is to ensure that the company will have the money available to pay their insureds in the event of a claim. However, requiring the insurance carriers to maintain a specific capital to risk ratio means that, in some cases, high-risk insureds would cause the company to exceed its capital. Instead of declining to offer coverage to the insured, the insurance company enlists the assistance of a reinsurer.

The two parties team up to share the risk. In exchange for a pre-determined amount of the client’s premium, the reinsurer agrees to cover a portion of the insured’s loss if they file a claim. Essentially, the insurance carrier is selling part of the consumer’s insurance to the reinsurer.

Types of Reinsurance

There are two main types of reinsurance: facultative reinsurance and treaty reinsurance.

Facultative Reinsurance

In a facultative reinsurance situation, the carrier and the reinsurer negotiate each policy on a case-by-case basis.

Individually negotiating each policy means the carrier and the reinsurer customize every single coverage and rate. The reinsurer has the right to evaluate each contract and decide whether they are willing to accept the risk. The individual attention to each case also means that they can provide a more accurate picture when it comes to pricing the risk.

Treaty Reinsurance

With treaty reinsurance, the insurance carrier and the reinsurer create a contract that sets the guidelines for all policies that the carrier needs to reinsure.

One standard facet of the treaty is that the reinsurer agrees to accept any of the risks that the insurance company cedes to them. The other terms of the treaty, such as whether the carrier will send policies over after they reach a certain threshold or on a pick and choose basis, may vary depending on the agreement between the two companies.

Why Insurance Companies Reinsure Risks

There are good reasons for insurance companies to partner with reinsurers.

Backing Larger Risks

As we touched on earlier, one of the biggest reasons is that the insurance carrier doesn't have the capital to take on some of those larger risks by themselves. By reinsuring a portion of the risk, insurance companies can offer higher policy limits and accept risks that they otherwise could not (learn How an Insurance Company Decides to Insure You).


Another important reason is that reinsurance provides security for the insurance carrier. If a group of policyholders suffer a catastrophic loss, reinsurance means the insurer doesn't have to take on the entire burden of compensating them for it. By sharing the risk, they substantially decrease their risk of financial insolvency.

Better Serving Their Customers

As a policyholder, you benefit if your insurance company enlists the help of a reinsurer. First, because it allows them to cover more risks, you can take advantage of higher coverage limits. But, more importantly, if you pay your premiums faithfully and then suffer a loss, the last thing you want is to find out that your insurer went bankrupt and won't be able to refund you (get advice on How to Choose an Insurance Company that Won't Go Out of Business).

Reinsurers are also quite practiced at pricing high-risk clients. Their experience allows them to assess premiums more accurately than the insurance company could on its own. Allowing the reinsurer to set the rates might just sound like an excuse to charge clients more money, but being able to price accurately is fundamental element in ensuring the most stable rates possible for every insured.


Reinsurance allows carriers to offer coverage to a broader range of consumers and to provide greater levels of coverage. For high-risk insureds, reinsurance makes it easier and more affordable to get the type of coverage they need. So, while you might not have been aware of it, you might be benefiting from your insurance company's reinsurance.

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