Reinsurance is a process in which other companies take over some of the risk that insurance companies have taken on, in exchange for payment. It is commonly called insurance for insurance companies.
Companies issuing insurance policies run the risk of having to pay out a lot of money (perhaps more than they can get their hands on) if circumstances bring a widespread disaster, like Hurricane Katrina in 2005, that inflicts massive damage on the people and property they have insured. Here's a small-scale example: To manage risk, a company wants to insure homes dotted along Maple, Elm, and Oak streets. It doesn't want to insure all the houses on Maple Street, because a fire that hits one could spread and destroy them all.
One way insurance companies reduce their exposure is through "reinsurance" -- paying other companies to take on some of their risk. The reinsurance companies then invest the money to make more money. And, of course, hope they don't have to pay out a lot to cover claims. They also do lots of research to help them pick what appear to be low-risk endeavors.
Reinsurance is an international business and the trade group Reinsurance Association of America provides information about it.
Reinsurance companies operate in different ways and employ their own unique balance of risk and reward. A well-known example of such a firm is General Re Corp., owned by Warren Buffett's Berkshire Hathaway. (The "Re" stands for reinsurance and is in the names of several reinsurance companies.)
Related Fool Articles
- Understanding an Insurer's Balance Sheet
- The Next Great Reinsurer
- Insurance Industry Basics: Premiums