Most people have a fairly good idea of what insurance is, and how it works. People pay premiums, with a rate established by determining risk. This money is pooled, and used to pay claims for losses—whether that loss is a car accident, a house fire or items stolen from an apartment.

Fewer people are familiar with reinsurance, but it plays an important role in the ability of the insurance industry to function properly. As a result, it is worth learning about and understanding.

Insuring the insurer

At its most basic level, reinsurance is insurance for insurance companies. If there is a catastrophic event that affects many homeowners, like a hurricane or strong earthquake, those losses can be so staggering that paying claims could cause an insurance company to become insolvent.

Reinsurance redistributes risk across a wide range of insurance companies. It accomplishes this by enabling an insurance company (called the “cedent”) to purchase insurance from one or more insurance companies (called the “reinsurer”). By redistributing this risk among many companies, the cedent diversifies its risk in exchange for a premium paid to the reinsurer.

Why is reinsurance important to consumers?

This is a more arcane and complicated part of the insurance industry, but it helps to protect consumers. When very large and catastrophic events happen — such as the hurricanes and wildfires that destroyed many homes in 2017 — insurance companies have to make large payouts. All insurers are required to have sufficient capital held in reserve to cover potential claims. Depending on what an insurer’s customer base is, having reinsurance can reduce the risk exposure of the insurance company’s portfolio, which then reduces the amount that must be held in reserve.

Reinsurance exists to ensure that even after catastrophic events, consumers aren’t faced with trying to make claims with an insurance company that is no longer solvent, meaning it doesn’t have sufficient funds to pay its claims. Reinsurance can be a complex topic, and because it is typically not something that consumers have to deal with, it is not widely understood. That said, it is an important protection that exists to make sure that people can recover from even very large and very costly disasters.

How much did reinsurers and insurers lose in 2017?

Last year wasn’t kind to many policyholders in southeast coastal regions, southern Texas and California. Hurricanes Irma, Harvey and Maria destroyed many homes, as did the wildfires that swept through parts of California.

While policyholders in these areas have suffered greatly, their insurance companies and the reinsurers that covered those companies also took hits as a result of all the damages.

In total, the global insured losses from all disasters in 2017 are estimated by Sigma to be $136 billion, which would be the third highest total ever since Sigma records started in 1970. There is an estimated $306 billion in total economic losses for 2017.

Munich Re, the second-largest reinsurer in the world, is among the companies that suffered as a result of the 2017 disasters. The company saw an 85 percent decrease in full-year profit and announced March 15 that it planned to eliminate 900 jobs — half of those being in the United States.

Given the $136 billion that insurance companies had to pay out to policyholders, consumers can certainly expect premiums to climb in the coming year. While Clearsurance found 47 percent of U.S. consumers expected a 1 to 9 percent increase in homeowners insurance rates as a result of the 2017 natural disasters, some 2018 projections are as high as 20 percent.

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