It is a process whereby one entity (the reinsurer) takes on all or part of the risk covered under a policy issued by an insurance company in consideration of a premium payment. In other words, it is a form of an insurance cover for insurance companies.
Unlike co-insurance where several insurance companies come together to issue one single risk, reinsurers are typically the insurers of the last resort. The insurance business is based on laws of probability which presupposes that only a fraction of the policies issued would result in claims.
As a result, the total sum insured by an insurance company would be several times its net worth. It is based on this same probability of loss that insurance companies fix the insurance premium. The premiums are fixed in such a manner that the total premium collected would be enough to pay for the total claims incurred after providing for expenses.
However, there is a possibility that in a bad year, the total value of claims may be much more than the premium collected. If the losses are of a very large magnitude, there is a chance that the net worth of the company would be wiped out. It is to avoid such risks that insurance companies take out policies. Secondly, insurance companies take the support of reinsurers when they do not have the capacity to provide a cover on their own.
Broadly, reinsurance can be classified under two heads – treaty reinsurance and facultative reinsurance.