Reinsurance

When life takes a swing at you, you’ll be glad you bet against yourself...with insurance.

Did you get into a car accident? Well...good thing you bet that you would. Now you get a car insurance payout. In the hospital? You won your own bet against yourself, because you win a health insurance payout.

The insurance industry makes these bets with us: they bet “ehh, you’ll be fine; I’ll collect those premiums in the meantime, thank you” while you’re betting that “life is a dangerous place, and I am a mere mortal meatbag.” From individuals to companies, insurance seems available for anyone to buy to bet against themselves. Everyone but the insurance companies.

But...who insures insurance companies? How can we trust they’ll be there with our payouts when we need them? What if they go under because other people’s payouts made their funds run dry?

Answer: insurance companies insure each other, i.e. “reinsurance.”

Take Ricky’s Insurance company. They cover a lot of people’s home in case of an earthquake. When the earthquake struck, Ricky’s Insurance company got lucky: it was big enough and making enough money from investing all those monthly premiums to make the promised payouts to the quake-stricken homeowners. There was only a few million dollars' worth of damage. Ricky took on all of that risk as an insurance company, and ended up dodging a bullet. Phew. But just down the road, Ricky’s brethren "Roman’s" didn’t fare so well. Roman’s Insurance company, also in the quake-insurance biz, had to make big payouts after the town was shaken up. Roman’s insurance company insured 300 free-standing homes, all of which were completely decimated. Roman’s was left with a cool 382 million dollars to pay, which they did not have on hand. Rut-roh. Roman’s had no choice but to close up shop and declare bankruptcy, leaving all those homeowners with quake-n-shake insurance from Roman’s insurance company...up a creek. You know which one.

While this situation is obviously not so great for Roman, it’s also not so great for the entire insurance industry. How can people be sure their insurance company will be able to pay? Without a guaranteed payout as agreed upon in the initial insurance contract during the insured’s time of need, it becomes too risky for your average Joe to be paying monthly premiums. What’s the point of paying every month if you’re not even sure your insurance company will be able to cover you when you need them?

Alas, a new era was born in the insurance industry. Insurance companies banded together as frenemies, spreading risk among themselves, keeping each other (and therefore, their whole industry) afloat. People no longer had to worry about being left high and dry by their insurance company, because...like them…their insurance company was insured. So in order to manage the risk of complete company death, the world of reinsurance began to be a thing.

In the reinsurance biz, there’s the “ceded” company (the one getting insured) and the “reinsurer” (the one taking on some risk for the other insurance company). As with your insurance, your insurance company (if they’re reinsured) pays premiums to the reinsurance company in exchange for a “come rescue me when I need you” ticket.

There are two main types of reinsurance contracts: treaty reinsurance and facultative reinsurance. Treaty reinsurance is more broad, covering an area of an insurance company’s risk. For instance, treaty insurance might cover a company’s earthquake insurance contracts, but not flood and fire contracts. While treaty reinsurance is more “general insurance” for insurance companies, facultative reinsurance is the emergency insurance. It’s pretty specific, covering more unusual situations that might occur. Facultative reinsurance is there to cover everything that treaty reinsurance doesn’t.

So yeah...that’s reinsurance. For Ricky’s and Roman’s, it’s sort of an “I’ve got your back, you’ve got mine,” situation. Comes in handy when one of them has an itch.