# Reinsurance Definition, Types, and How It Works

![Reinsurance: Insurance for insurers.](https://www.investopedia.com/thmb/fDAjzbyl6E5at7Im33PK6Tbm00U=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/reinsurance.asp-final-da298221a9b342d58efb513d1eb48803.png)

*— Investopedia / Theresa Chiechi*

## What Is Reinsurance?

Reinsurance serves as a crucial risk management tool for insurance companies by allowing them to transfer some of their policy risks to another company, the reinsurer. This relationship is established through a formal contract, in which the primary insurer, or cedent, passes portions of its liability to the reinsurer.

By doing so, the primary insurer can safeguard its financial stability while enhancing its ability to underwrite more policies. Reinsurance thus plays a significant role in maintaining equilibrium within the insurance market as it helps insurers manage large-scale natural disasters and major claims without overwhelming their financial resources.

### Key Takeaways

*   Reinsurance is commonly known as "insurance for insurance companies," where an insurer transfers some of its risk to a reinsurer to reduce liability and enhance financial stability.
*   There are two main types of reinsurance: facultative, which covers specific individual risks, and treaty, which covers broad categories of policies.
*   Reinsurance helps insurers diversify their risk, stabilize their financial results, and enhance their underwriting capacity by covering potential large or catastrophic losses.
*   Through reinsurance, insurers can maintain required reserves and manage larger volumes of risk without significantly increasing administrative costs.
*   Non-proportional reinsurance, unlike proportional reinsurance, only involves the reinsurer in claims after the insurer's losses exceed a predetermined threshold.

## Understanding the Mechanisms of Reinsurance

[Reinsurance](https://www.investopedia.com/ask/answers/08/reinsurance.asp) helps insurers stay financially stable by recouping some or all payments made to claimants. Reinsurance reduces the net liability on individual risks and catastrophe protection from large or multiple losses.

Reinsurance gives [ceding companies](https://www.investopedia.com/terms/c/ceding-company.asp), or those seeking reinsurance, the opportunity to take on more and bigger risks. Ceding companies are insurance companies that pass their risk on to another insurer.

## Advantages of Utilizing Reinsurance

Reinsurance protects insurers from accumulated liabilities, providing more security and helping them handle financial pressure during major events.

> **Important**
>
> Insurers are legally required to maintain sufficient reserves to pay all potential claims from issued policies.

Reinsurance allows insurers to cover more risks without significantly increasing administrative costs to maintain solvency. In addition, reinsurance makes substantial [liquid assets](https://www.investopedia.com/terms/u/underwriting-risk.asp) available to insurers in the event of exceptional losses.

## Exploring Different Reinsurance Types

[Facultative](https://www.investopedia.com/terms/f/facultative-reinsurance.asp) coverage protects an insurer for a specific individual risk or contract. If several risks or contracts need reinsurance, they are renegotiated separately. The reinsurer holds all rights for accepting or denying a facultative reinsurance proposal.

A [reinsurance treaty](https://www.investopedia.com/terms/t/treaty-reinsurance.asp) is for a set period rather than on a per-risk or contract basis. The reinsurer covers all or part of the risks that the insurer may incur.

### Breaking Down the Concept of Reinsurance

Under proportional reinsurance, the reinsurer receives a prorated [share of all policy premiums](https://www.investopedia.com/terms/g/gross-net-written-premium-income.asp) sold by the insurer. For a claim, the reinsurer bears a portion of the losses based on a pre-negotiated percentage. The reinsurer also reimburses the insurer for processing, business acquisition, and writing costs.

> **Fast Fact**
>
> With non-proportional reinsurance, the reinsurer is liable if the insurer's losses exceed a specified amount, known as the priority or retention limit.

In the case of non-proportional reinsurance, the reinsurer doesn't have a proportional share in the insurer's premiums and losses. The priority or retention limit is based either on one type of risk or an entire risk category.

[Excess-of-loss reinsurance](https://www.investopedia.com/terms/e/excess-loss-reinsurance.asp) is non-proportional coverage where the reinsurer covers losses [above the insurer's limit](https://www.investopedia.com/terms/e/excess-limits-premium.asp). This contract is typically applied to [catastrophic events](https://www.investopedia.com/terms/c/catastrophe-excess-reinsurance.asp) and covers the insurer either on a per-occurrence basis or for the cumulative losses within a set period.

Risk-attaching reinsurance covers all claims made during the contract, even if the losses happened outside the effective period. No coverage is provided for claims originating outside the coverage period, even if the losses occurred while the contract was in effect.

## What Is Reinsurance?

Reinsurance is insurance for insurance companies. It’s a way of transferring some of the financial risks that insurance companies assume when insuring cars, homes, people, and businesses to another company, the reinsurer. Contracts between ceding companies and reinsurers can be complex and might include [special clauses](https://www.investopedia.com/terms/c/cutthrough-clause.asp) if one party becomes insolvent.

## Why Should Insurance Companies Have Reinsurance?

Insurers use reinsurance to expand capacity, stabilize results, finance, protect against catastrophes, spread risk, and gain expertise.

## What Types of Reinsurance Are There?

Reinsurance has two basic categories: treaty and facultative. Treaties cover broad groups of policies, such as a primary insurer’s auto business. Facultative covers specific individual, generally high-value or hazardous risks, such as a hospital, that wouldn't be acceptable under a treaty.

## The Bottom Line

Reinsurance, often called "insurance for insurance companies," results from a contract between a reinsurer and an insurer. In it, the insurance company—known as the ceding party or cedent—transfers some of its insured risk to the reinsurance company. As a result, the reinsurance company assumes some or all of the insurance policies issued by the ceding party. Having reinsurance transfers risk to another company to reduce the likelihood of being exposed to large payouts for one or more claims.

> **Article Sources**
>
> 1.  National Association of Insurance Commissioners. "[Reinsurance](https://content.naic.org/cipr-topics/reinsurance)."
>     
> 2.  Cornell University. "[Life Insurance Reserves](https://www.law.cornell.edu/cfr/text/26/1.801-4)."
>     
> 3.  Healthcare.gov. "[Reinsurance](https://www.healthcare.gov/glossary/reinsurance/)."
>     
> 4.  National Association of Insurance Commissioners. "[Glossary: Falcultative Coverage](https://content.naic.org/consumer_glossary#F)."
>     
> 5.  International Monetary Fund. “[Insurance Transactions and Positions, and Pension Schemes](https://www.imf.org/external/pubs/ft/bop/2014/pdf/BPM6_A2F.pdf),” Pages 340-342.
>     
> 6.  International Association of Insurance Supervisors. “[Core Curriculum for Insurance Supervisors](http://casact.org/sites/default/files/2021-05/6I_IAIS_CC_5.5.1.pdf),” Pages 16-17.
>     
> 7.  International Risk Management Institute. “[Understanding the Business-Covered Clause in a Reinsurance Contract](https://www.irmi.com/articles/expert-commentary/understanding-the-business-covered-clause).”