Kathmandu. When Hurricane Katrina devastated the U.S. Gulf Coast in 2005, or the collapse of the World Trade Center towers on September 11, 2001, billions of dollars in claims were paid to insured. Those amounts were recouped not only by the insurer, but also by a largely invisible layer of the financial system known as reinsurance.
Foreign reinsurers alone covered more than 60% of the total loss payments from the 2005 hurricane season. Insurers across the United States risked a devastating wave of bankruptcies if reinsurers had not repaid.
At its core, reinsurance is an insurance service for insurance companies. When individuals and businesses purchase insurance policies to protect against risk, primary insurers mention that risk in their financial books. But there are certain limitations that insurers have to deal with before they can afford those risks — capital, risk appetite and the level or level of risk. To manage this, they purchase a reinsurance service, transferring a portion of their risk to specialized reinsurance companies in exchange for a portion of the premium. In this process, the original insured—a homeowner, airline or manufacturer—is never involved in either of these two types of insurer. For most people, reinsurers are completely invisible. Yet we know that without them, modern insurance wouldn’t work.
This mechanism works through a certain range of risk transfers. Individuals and organizations pay premiums to primary insurers for purchasing insurance policies. The insurer transfers both the risk and the premium to the reinsurer.
Insurers then spread out these risks based on geography and the nature of the risk. For example, reinsurance insurers that carry earthquake risk in Chile, hurricane risk in Florida, mortality portfolios in Europe, and aviation liability in Asia pass on a portion of their risk to reinsurance in those non-risk geographies. This global diversification provides reinsurers with the financial strength to absorb losses that no single insurer can afford alone.
In addition to simply paying claims, reinsurance performs three important functions for the broader economy. Its risk transfer function eases the volatility of the insurer’s income. The balance sheet is protected from catastrophic damage. and makes insurance companies more attractive to investors. Its capital relief work frees up self-capital that insurers would otherwise have to hold in reserve or arrangement. This makes it easier for them to issue more policies, reach more customers and expand the business. And its information function contributes deep underwriting expertise, pricing knowledge, and actuarial insights. This helps insurers to develop new products and create an environment to enter new markets with confidence.
The role of reinsurance in stabilizing the economy and protecting society is expected to increase as the frequency and severity of natural disasters increase due to climate change, rapid urbanization, and the increasing concentration of insured assets in disaster risk zones.
