Reinsurance is insurance that is purchased by an insurance company (insurer) from a reinsurer as a means of risk management, to transfer risk from the insurer to the reinsurer. The reinsurer and the insurer enter into a reinsurance agreement which details the conditions upon which the reinsurer would pay the insurer's losses (in terms of excess of loss or proportional to loss). The reinsurer is paid a reinsurance premium by the insurer, and the insurer issues thousands of policies.
For example, assume an insurer sells one thousand policies, each with a $1 million policy limit. Theoretically, the insurer could lose $1 million on each policy – totaling to $1 billion. It may be better to pass some potential risk to a reinsurance company (reinsurer) as this will minimize the insurer's risk.
There are two basic methods of reinsurance:
1. Facultative Reinsurance is specific reinsurance covering a single risk. The reinsurer is reinsuring one insured on a specific policy. Each facultative risk is submitted by the insurer to the reinsurer.
2. Treaty Reinsurance is a method of reinsurance requiring the insurer and the reinsurer to formulate and execute a reinsurance contract. The reinsurer then covers all the insurance policies coming within the scope of that contract. There are two basic methods of treaty reinsurance:
-- Quota Share Treaty Reinsurance, and
-- Excess of Loss Treaty Reinsurance.
In the past 30 years there has been a major shift from Quota Share to Excess of Loss in the property and casualty fields.