Reinsurance Companies: What You Need to Know

If you've ever tried to read your insurance policy, you can appreciate just how complicated the industry can be. Yet reinsurance companies take insurance to a whole new level of complexity, offering their insurance company clients the ability to manage risk for catastrophic events like natural disasters. Interestingly, the reinsurance business typically behaves differently from what you might expect, thriving in the aftermath of big losses and then suffering from increased competition during more favorable loss periods. Below, you'll learn what you need to know about reinsurance companies in order to understand their role in the insurance industry.

Data source: S&P Global Market Intelligence. * Figures are for parent company rather than just the reinsurance unit. ** Includes Berkshire Hathaway Reinsurance Group and General Re.

How reinsurance companies work

The idea behind reinsurance is relatively simple. Insurance companies write policies covering their customers from potential losses. Yet those insurers have to take care to manage their risk effectively, or else they might leave themselves open to devastating losses that would jeopardize their business if an unlikely sequence of loss events happens. In particular, insurance companies that primarily serve a specific geographical area might find themselves with too much exposure in case of a localized catastrophic event, and an insurer that covers very specific types of risk could get overwhelmed if unfortunate circumstances lead to excessive losses.

Reinsurance companies help insurers spread out their risk exposure. Insurers pay part of the premiums that they collect from their policyholders to a reinsurance company, and in exchange, the reinsurance company agrees to cover losses above certain high limits. That puts a cap on the insurer's maximum possible loss, and it leaves the reinsurance company with the responsibility to figure out how to cover what can amount to massive losses if a major disaster does strike.

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Why reinsurance is profitable

Reinsurance companies make money in two ways. First, if reinsurers are smart about what they insure, reinsurance underwriting should generate profits. Yet equally important is the fact that reinsurance companies get to invest the premiums they receive, and earn income until they have to pay out losses. Berkshire Hathaway has used that model to perfection with its Berkshire Hathaway Reinsurance Group and its General Reinsurance units, and the reinsurance business gives Berkshire the most float of any of its insurance units.

However, the dynamics of those money-making opportunities change over time, and that in turn affects the competitive landscape in the reinsurance industry. When reinsurance companies have gone several years without major losses, new entrants come into the space and start to write reinsurance policies. That puts pressure on premiums, and the lower margins eat into profitability for all reinsurance companies. When an inevitable major loss occurs, undercapitalized reinsurance companies go out of business, and that improves the competitive picture for the survivors. Premiums go up following catastrophic events, and the healthy remaining reinsurers enjoy a period of larger profits until the cycle repeats.

To succeed, a reinsurance company has to adapt to changing conditions. For instance, Berkshire Hathaway in 2015 recognized the stresses that the reinsurance market was undergoing, and it therefore cut its stake in industry giant Munich Re by almost a fifth. Berkshire has also gotten more careful with its own reinsurance business, sticking to risks that it's comfortable taking and avoiding more perilous types of policies.

What to watch for

If you're looking at investing in reinsurance companies, you need to understand not just how reinsurance works but also how the industry rises and falls over time. That way, you can weather the inevitable storms that all insurance companies face -- and share in the profits that top reinsurers generate in the long run.