Put simply, reinsurance is insurance for insurance companies. It works when the reinsurer enters into an agreement with the insurance company (known as the ceding party or agent) to transfer a portion of their risk portfolio. This helps the insurance company reduce its chance of paying out a large insurance claim.
There are two main types of reinsurance – facultative reinsurance and a reinsurance treaty. Facultative reinsurance is when the reinsurer shields the insurance company from an individual or specified risk. If there are a few different types of separate risks that need reinsuring, these must be negotiated separately and the reinsurer can choose whether to accept or deny a proposed risk.
In contrast to this, under a reinsurance treaty, the reinsurer is obligated to take on all types of risks over a set period.
How did reinsurance start?
The reinsurance sector started in Germany in 1842, after the Great Fire of Hamburg, which forced local insurers to pay out enormous claims. The first dedicated and independent reinsurance company was Cologne Re, but it took them four years to become fully licenced and they only signed their first reinsurance business in 1852.
After that, the reinsurance sector quickly escalated, mainly because reinsurers were relatively inexpensive to set up and run. They were also able to spread risk on an international scale, and were active in most or all lines of business known at the time. They did, however, struggle to advertise, relying solely on the word of their clients or brokers and were charged excessive fees by insurers, who generally offloaded their worst risks to them.
The Swiss Reinsurance Company, established in Zurich in 1863, helped to discipline the sector with a set of proper and strict underwriting regulations that let the industry flourish.
Soon after, Münchener Rückversicherungsgesellschaft Reinsurance (Munich Re) set up in 1880 in Germany and Lloyd’s underwriter, which also operates with reinsurance set up in London. In America, reinsurance companies started towards the end of the 1900s.
Today some of the biggest reinsurance companies include Berkshire Hathaway, PartnerRe, Everest Re Group, SCOR S.E and Hannover Rück SE as well as Swiss Re. Munich Re and Lloyd’s.
The industry is not as regulated as the insurance sector, because the insurers who purchase reinsurance are considered sophisticated buyers. Just like insurers, reinsurers also have to submit financial statements to regulators who monitor their financial health.
How does reinsurance help the insurance industry?
Without reinsurers, insurance companies would not be able to survive financially. Reinsurers essentially provide insurers with predictability in a generally unpredictable market. Their business is based on the theory that two or more catastrophic events would hardly occur within the same period and in one single place, let alone the possibility of occurring at the same time in any two parts of the world.
By transferring their risk, insurers are able to underwrite more policies with even higher limits. In principle, the insurer is taking on more risk, but this makes them far more appealing to a broader clientele.
Reinsurers use their own models to evaluate the riskiness of policies and in some cases, may charge the insurer a lower rate than what the insurer charges its clients. This is beneficial to the insurer as they receive more value on their risk.
Spreading their high-risk insurance liabilities insulates an insurer from paying out potentially large losses from unexpected natural disasters, for example. In the past, pay-outs from earthquakes and hurricanes have caused abnormally high claims, which can potentially bankrupt an insurance company.
By shifting part of the insurance liabilities to reinsurers, insurance companies are able to remain afloat in such extreme events and are in a better position to predict their income.
As the chance of paying out a huge claim is low, insurers do not need to keep as much capital on hand and any additional capital can be invested elsewhere in order to generate even more revenue.
The most famous claims
Reinsurers started paying out huge claims as early as the 1900s. Over 70 different insurers and reinsurers covered various parts of The Titanic, including the likes of Swiss Re.
The owners only insured the vessel for half its value. After it sank in April 1912, the insurance payout was in excess of £12 million, one of the largest marine losses ever recorded.
British insurers were the most affected by the disaster, as well as a few American life insurers, who had to pay out several million dollars for some of the richest American men who died. The disaster forced many insurers to become realists and as a result, many were reluctant to insure the Olympic, The Titanic’s sister ship a few years later.
In the last three decades, reinsurers have had to pay out large claims for major catastrophes like $1.2 billion for the Chernobyl Disaster in 1986, $4 billion for the 2004 Indonesian tsunami and $40 billion for the 9/11 terrorist attack in New York.
The 9/11 attack was particularly significant to the reinsurance business. Before this, reinsurers had only accounted for natural catastrophe insurance that paid out for like of Hurricane Andrew, the most costly disaster prior to September 11. Terrorism insurance was in short supply and this forced many insurers to relook their product offering.
One of the biggest and most recent pay-outs was for the 2008 financial crisis, seen as the worst financial crisis since the Great Depression. In excess of $21 trillion was paid out for massive bailouts and policies that were triggered to prevent a collapse of the financial system.
Some insurance providers like AIG, the world’s largest insurer, nearly went bankrupt due to the debt obligations it had made during the crisis. Other insurers had to freeze paying out money after fearing that they would end up with not enough to cover their own obligations.
The effects of the Covid-19 pandemic
Like all other industries, the impact on the insurance and reinsurance sector will be unprecedented, but most insurers seem to have taken little action in the interim to prepare for it.
This is probably because basic policies do not cover communicable diseases like the Coronavirus. Similarly, it has been a common market practice to exclude the risk of a pandemic outbreak from the property-casualty segment, including business interruption insurance cover.
French reinsurer SCOR has already suggested that the pandemic will not affect life insurance in 2020 and Moody’s estimates that there will be limited impact on global and European reinsurers.
However, those insurers and reinsurers who have a stake in major events will face significant repercussions. Munich Re, for example, has significant exposure to the Olympic Games, in the region of hundreds of millions of Euros.
Other big losses are also likely to occur because of the economic downturn. Some reinsurers, like Hiscox, are already preparing for this eventuality by paying out reduced dividends to shareholders.
It’s clear that the virus will affect most industries negatively, but not always in the way we think it will.