Insurance and reinsurance may seem like the same thing to the layman but they are in fact, two different words and mean different things.

Insurance and reinsurance both provide financial protection to individuals and businesses against common risks and allow the transfer of potential loss from one entity to another for a fee or premium. However, while they both provide risk protection, they do it in different ways.

Insurance

Businesses and individuals purchase insurance to manage the risk of loss. When a business or individual buys an insurance policy, the insurer or insurance provider takes responsibility for financial loss that occurs when the event insured against happens. The limit of financial responsibility is usually contained in the policy’s terms of service.

Individuals usually buy insurance covers ranging from life insurance to vehicle insurance, property insurance, health insurance, and so on. While businesses buy workers compensation insurance, commercial vehicle insurance, general liability insurance, business interruption insurance, and so on.

The insurance holder pays a fee known as a premium for the policy or contract and the insurer agrees to provide compensation for financial loss should any event covered by the insurance policy occur.

Reinsurance

If individuals and businesses buy insurance to protect against certain events that can result in financial loss, who carries the risk for the insurance companies and protect them from losses? The insurance company is probably self-insured for smaller losses, but when it comes to large risks, they buy reinsurance.

Reinsurance is the insurance insurers buy from other insurance companies to protect them against financial loss from large risks. This insurance is designed to protect the insurance company against financial loss from extremely large insurance claims or other disasters so that the insurance company can provide more coverage without fear of going bankrupt. For example, if wildfire affects businesses and homes in a particular area, resulting in many insurance holders making claims at the same time, the insurance companies will simply fall back on their own reinsurance to cover the claims, thereby lessening the financial burden.

In some cases, many insurance companies come together to buy joint policies thereby dividing the risk among themselves.

As you can see, insurance and reinsurance are rather similar in a number of ways. Both are purchased to provide protection and cover for financial losses. Insurance provides cover for the individual or business, while reinsurance provides cover for the insurance company.

At the same time, they both transfer the cost of loss from the insured to the company providing the insurance, so that the responsibility for compensation rests with the insurer. They also both have deductibles but on a very different scale. For example, a homeowners insurance against a house fire may have a deductible of $2000, but for a reinsurance policy, cover for wildfire destroying lots of homes can be as much as $50 million.

Reasons for reinsurance

The following are some of the main reasons why insurance companies reinsure:

Minimization of risk: The basic idea behind insurance is to minimize risk so that it doesn’t lead to heavy financial losses, either for the insured individual or for the business. This is also the main reason behind reinsurance for insurance providers. If an insurance company is hit with simultaneous heavy claims, it can affect its financial fortunes so that they go bankrupt. But leveraging on another insurance company means that there will always be a way to meet their financial responsibilities without putting the fortunes of the primary insurer at risk.

Flexibility: Where there is no reinsurance, insurance companies will be limited in the number of covers they can sell or risk they can carry. In other words, they will not be able to accept a risk that is bigger than the resources of their business, this means losing a high number of potential policyholders.

Reinsurance gives insurance providers the flexibility to accept the risk that is beyond their financial resources, as they know that they can always fall back on their reinsurance policy should they be faced with a heavy-claim situation. According to Steve Pfeiffer of Talisman Casualty Reinsurance, this leaves the insurance community with the freedom and peace of mind to handle the different risks in their portfolio regardless of what the value per single risk is.

Growth and development: Just like every other business, the growth of an insurance company is dependent on the number of customers it has, it's financial standing and its profit-earning potential. Unfortunately, there can be little or no customers or profit if the insurance company cannot sustain its business or meet the claims placed by insurance holders.

Reinsurance makes it possible for insurance providers to meet claims regardless of their size. This stabilizes the business and makes it a good carrier for potential insurance holders. This, in turn, permits the insurance company to meet and even exceed its growth projections.