(This is just a matter of personal interest - I’m not professionally involved in the insurance industry, nor do I have any disputes or problem with insurance companies running.)
I understand the basic concept of re-insurance - an insurance company gets an insurance policy, so that the primary insurer who pays the insurance sum in case of a loss will get that money back from the re-insurer.
What I don’t get is why this is profitable; the primary insurer will most likely try to pay less in premiums to the re-insurer than (the primary insurer) it itself collects from its customer, so there ought to be an incentive for the re-insurer to cut out the middleman and take the risk on its own in the first place.
I guess one can think of it as similar to the relationship between wholesale and retail. Wholesale companies choose not to maintain the infrastructure and service capacities which retail trade requires, so they sell their goods in bulks to retailers. Retailers sell these goods to customers who buy smaller quantities each, which increases costs per item, so they charge higher prices than they paid in wholesale. We all know this concept.
This might account for insurers to get bulk re-insurance for a large number of smaller policies, but it seems to me that re-insurance is also common in cases of large single risks, such as oil tankers or whatever. What is it that makes it profitable for re-insurers to insure other insurance companies instead of the risk itself?
I think it’s just a matter of each company doing what they do best. The re-insurer’s expertise is insurance (evaluating the risk). The ‘insurance’ company’s expertise is sales and marketing of insurance products.
It’s not uncommon for the ‘producer’ of a product to leave the sales and marketing to someone else. Cutting out the middle man sounds good in theory but it assumes you will sell just as much. Not likely if you aren’t a consumer sales-oriented company.
Isn’t it spreading the risk? You insure with the primary insurer and they reinsure 5% with reinsurer A, 10% with reinsurer B, etc. That’s how Lloyds of London works.
The aim is to spread the risk both ways: no single insurer is hit with a single massive claim; and no policy-holder is significantly hit by the failure of any one insurer.
Quartz is right – the re-insurer does not re-insure the entire liability of the primary insurer, only a portion of it. The purpose of re-insurance is so the primary insurer hurts less when a major, un-anticipated payout occurs (natural disasters, terrorist attacks, etc.)
This isn’t necessarily, or even usually true, unless the reinsurer is covering a self-insured group lacking its own expertise. In the health insurance world, a reinsurer may contract with a health insurance company to pick up the cost for only those members/patients whose claims in a certain time period exceed a substantial threshold - often $100,000 per year or higher. The contracts are usually very specific regarding which types of claims do and do not count toward the total - for instance, some reinsurance deals exclude specialty pharmacy costs. Therefore Quartz’s explanation is closer to the truth.
Reinsurers sometimes even get involved in “steerage” issues, such as being able to influence where tremendously expensive procedures like transplants are performed. All contracts are different and I am not implying that this is typical.
This is profitable (or not) for the same reason that any other insurance product is/is not - the reinsurer is gambling that their costs will be less than the premium they receive from the primary insurance company. That’s why good actuaries get the big bucks.
ooops… I have more than 5 minutes of edits to make to the above, which the hamsters don’t allow.
The other point I wanted to make is that smaller insurance companies typically must have reinsurance so that they don’t have the possibility of a catastrophic claim depleting their capital reserves so much that their state regulators will shut them down. The big national health insurance companies have far less need for this, while employers who self-insure usually have a HUGE need for reinsurance.