The reason insurance companies can take on the risk that we may not be able to handle comfortably, or perhaps not even at all, is that they spread the risk they take on among many clients.

The impact of a risk is going to always be relative to one’s own capital, so with an individual or even a company, major losses, such as losing a building to a fire, is going to usually represent too large of a percentage of their capital to be comfortable with.

So let’s say there’s 1 chance in 100 this will happen during any given year, but if it does happen, you will be out $100,000, to keep the numbers simple. So it costs you $1500 a year to protect yourself against this, and even though by the time this is likely to happen it will cost you more in the long run, the impact of having it happen with you unprotected leaves you in an unacceptable position.

For an uninsured individual, this would usually mean having to still make mortgage payments while still needing to find a place to live for instance. While they would likely end up defaulting on the mortgage, whatever equity they have built up on the property over the years would be lost, including the whole thing if it’s free and clear.

So say an insurance company insures 100 such homes in a neighborhood, and they therefore take in $150,000 a year in premiums, and their expected losses will average out to $100,000 from the one home that’s expected to be lost. They are making enough to cover that, and will have built up enough of a cushion to handle situations where 2 or 3 of these homes burn down.

In reality they will be insuring many more homes than 100, and the law of large numbers will put them in a very comfortable position to manage this risk, and will have significant reserves which they invest which adds to the profits and the extent of their capital.

Insurance Companies Need Protection Too Though

What if a natural disaster hits our neighborhood, a wildfire we’ll say, and all 100 of the homes burn down at the same time. Now, the $150,000 they take in per year is just a drop in the bucket compared to the $10 million this will cost to cover the claims.

Some natural disasters can claim many more homes than this, and while they may feel comfortable with the normal distribution of risk, the risks in these situations may be too great for them to bear themselves, just like our own one home may be too much for us to bear losing.

The same principle applies in both cases, it’s that the risk would comprise too much of our capital and the bigger risks of many claims from disasters may also comprise too much of an insurance company’s capital. So what can insurance companies do here?

Well insurance involves spreading risk and insurance companies can spread some of this risk, share it in essence, with other insurance companies, ones that specialize in stepping in and providing insurance to insurers. They are called reinsurers.

Reinsurers play an essential role in the insurance business, because without them, without the ability of insurance companies to reassign part of their risks to reinsurers, they would not be able to offer certain forms of coverage to their clients.

So if you wanted to buy insurance against certain natural disasters, well some insurance companies may already be hesitant to offer certain coverages, but without reinsurance you probably would never be able to get these coverages from anyone.

It’s not a matter of the risk being too great, for instance if you live in a flood plain you may not be able to get flood insurance merely because of the specific risk, but we’re not talking about that here. We’re speaking of the cumulative risk of these events since they result in many claims being brought when they do happen. The claims can run into the billions of dollars in total.

Now insurance companies could take on a select number of clients, as many as they could manage themselves, but there’s only so many insurance companies in the market and this would likely leave most people out in the cold, after the maximum amount was allotted.

The Huge Reinsurance Market

Reinsurance is a huge industry, with over half a trillion dollars in reserve at any given time, called the float, to cover future claims. While insurance companies do invest their float, it’s of a shorter term nature, while reinsurance companies deal more with massive claims that happen far less often and therefore tend to hold a higher percentage of their premiums in reserve.

This does allow reinsurance companies to make significant gains over time from the investment of their float, all the while providing necessary security to insurance companies that they insure. Warren Buffet made a great deal of his fortune investing the float of Berkshire Hathaway, which he built up to be one of the world’s largest reinsurance companies.

Buffet is considered the father of the modern reinsurance business, and his wise investments of the massive amount of float that he’s had access to over the past few decades has propelled his company into what is now the third largest company in the world by market value, only behind Microsoft and Alphabet, the parent company of Google.

So that’s how big reinsurance is, and Berkshire Hathaway is just one of several huge reinsurance companies in the market, and in fact are only in fifth place by volume of business. So this tells us that a great deal of insurance risk gets reassigned to reinsurers, and this is definitely the case.

Most people aren’t even aware of the reinsurance market, as they operate completely behind the scenes, even though many of the world’s largest insurance companies either don’t offer insurance directly or most of their business is through reinsurance.

How Reinsurance Works

Reinsurance basically offers insurance companies the ability to write more insurance, which will always be limited to the amount of risk that they are exposed to. So in other words the money they collect will yield a certain float which will limit how much risk they can take on.

By reassigning some of this risk to reinsurers, they can focus even more on their specialty, which is to manage risk in bulk, where the total risk taken on can be easily managed through the law of large numbers. So this isn’t unlike a casino setting limits on the size of wagers, as if the wagers are kept from getting too large, they can really take on an unlimited amount of them.

If a casino were to take on bets of a size that they weren’t comfortable with, then the casino itself may be at risk, if these huge bettors had too much luck for instance. An extreme example of this would be a very wealthy person betting the value of the entire casino on a coin toss. This would not be acceptable at all to the casino. Casinos manage this through setting betting limits, but insurance companies don’t have this luxury, but they have another way.

So the biggest effect of reinsurance is to increase the capacity of retail insurance companies, so that they can satisfy the demand of the retail insurance market. Reinsurance also adds stability to the holdings of insurance companies, and both of these are benefits to retail clients, by not only keeping premiums down by not requiring insurance companies to maintain much larger floats, but by also better ensuring that their claims will be paid out if a major catastrophe occurs.

Reinsurance companies are happy to do this because on their end they get to make money off of the premiums they charge, and this is the major way that these companies make their profits.

Reinsurers offer two main services to insurers. They will either enter into contracts to cover losses from specific events, where the losses may be huge, or they may enter into treaties with insurance companies to cover a certain percentage of their losses overall.

The specific contracts allow insurance companies to maintain stability in the face of excessive risk, while treaties allow them to write more insurance and expand their business without having to worry about increasing their total risk exposure beyond what they are comfortable with.

Both of these types do allow insurance companies to better serve the needs of their clients though, and it’s certainly not healthy to have your insurance company exposed to too much risk, because they are the ones that we rely on and pay to manage this risk for us.

Within these two main categories are a variety of arrangements that can be made between reinsurers and insurers, all designed to help insurance companies manage the risks that they take on. Like insurance, reinsurance is tailored to the particular needs and risks of the client, only this time insurance companies are the clients, not the public.

The reinsurance market has really tightened up though over the last few years, primarily due to the lower interest rate environment that we’re in now, and even Warren Buffet has lightened his holdings in the market due to this. Still though, it’s still a mammoth industry, but it’s become a lot more competitive over the last few years, which itself will drive down return on investment.

So reinsurance has become an essential component of the insurance market that we know today, and serves to solidify and make more efficient the business of taking on the risks of others for a fee.