Reinsurance means one insurance company purchasing coverage from a second insurance company for a risk that the first insurance company is insuring. The best way of explaining this is through an example. Big City Life Insurance Company has written a $10 million life insurance policy on the life of Mr. Moneybags, the industrial tycoon. Big City is concerned that Mr. Moneybags’s death would have a material impact on Big City’s profits from the $10 million claim. So, Big City buys coverage on the life of Mr. Moneybags from Country Cousin Mutual Insurance Company. Big City decides to buy $3 million of coverage from Country Cousin.

If Moneybags dies in a plane crash, Big City will have to pay his beneficiary $10 million, but Big City can in turn collect on the coverage it obtained from Country Cousin. The two insurance companies will share the loss, with Country Cousin bearing $3 million of the loss and Big City $7 million ($10 million paid to the beneficiary less the $3 million collected from Country Cousin). Of course, both companies share in the premiums and profits of the coverage as well as the losses.

In the above example, Country Cousin is called the reinsurer. Country Cousin is not the insurer that wrote the original coverage. They are instead standing behind the original insurer. Big City is called the ceding company or cedant (sometimes spelled cedent). Big City has ceded some of its life insurance business to Country Cousin through the reinsurance arrangement.

There are a wide variety of reinsurance coverages that Big City can purchase. For example, if Big City believes Mr. Moneybags’s health is fine, but is worried that he might die from an accident, they can purchase reinsurance coverage only for death via an accident. In that arrangement, if instead of a plane crash Mr. Moneybags dies of a heart attack, Big City would still have to pay his beneficiary $10 million, but Country Cousin would not owe anything to Big City. Naturally, Big City would pay less premium to Country Cousin for accidental death reinsurance coverage than for comprehensive life reinsurance coverage.

Rather than Big City buying reinsurance only for accidents, Big City and Country Cousin can agree to more of a partnership reinsurance arrangement. Country Cousin could agree to pay half of any and all deaths Big City covers, in exchange for half of the premiums Big City collects.

Any reinsurance arrangement Big City and Country Cousin make does not affect the insurance policies that Big City writes for its policyholders. Mr. Moneybags will most likely not even be aware that Country Cousin has reinsured a portion of his coverage from Big City. Big City is still liable to pay its policyholders for insured losses regardless of the reinsurance coverage.

Reinsurance allows the insurance industry to spread its losses among more companies, lessening the impact of claims on any one company. This helps assure that a few big claims will not affect the solvency of an insurance company. An example of the value of reinsurance is the destruction of the World Trade Center in New York. Many insurance companies will contribute a share of the losses because of the reinsurance agreements in place. If one insurance company had to pay the tens of billions of dollars in losses alone, it might face bankruptcy. There are many different reasons why insurance companies might choose to buy reinsurance, but spreading of losses is the primary reason.

In the past, reinsurance of life insurance policies was sometimes called reassurance, but the distinction is largely a matter of history and has no substantive significance today. Still, the term can be found in the names of several life reinsurance companies, including our own (Munich American Reassurance Company).