> For the complete documentation index, see [llms.txt](https://docs.re.xyz/llms.txt). Markdown versions of documentation pages are available by appending `.md` to page URLs; this page is available as [Markdown](https://docs.re.xyz/how-reinsurance-works/reinsurance-101.md). # Reinsurance 101 ## Insurer vs. Reinsurer ### What is insurance? You know of insurance; you probably pay for some of it yourself. But what if you were asked to define insurance, what would you say? On a basic level, insurance allows an entity (be that individual, a company, or even a government) to turn uncertain financial outcomes into more predictable ones by paying a premium to an insurer. Let’s take a common example: workers’ compensation. If your workplace is generally safe, it’s possible that the premiums your employer pays will total more than the cost of the injuries that actually occur in a given year. But what if a serious accident happens? Let’s say an employee is badly injured on the job. Without workers’ compensation insurance, the employer would be responsible for paying medical bills and lost wages out of pocket. The costs would amount to far more than the total premiums. Now imagine it’s a catastrophic injury – surgeries, long-term rehabilitation, or permanent disability – or even injuries to multiple workers from a major accident. In that case, the total cost could reach well into the millions of dollars. For a small business, that cost could be major. In that scenario, insurance is also accomplishing an important associated purpose: protecting the employer from extreme outcomes that could inflict severe financial harm. So that’s insurance. What is reinsurance? Insurers provide insurance directly to the customer. Reinsurance provides insurance for insurers. Insurers pay premiums to reinsurers in exchange for protection from extreme losses of their own. Though insurance companies are often major multinational entities – many of them even traded on the stock market – that doesn’t mean they have unlimited money. And the more insurance they sell, the more they’re exposed to potential losses. Let’s say an insurance company faces a perfect storm in a given year: for example, a severe hurricane season creates an enormous volume of claims. If the company is unshielded by reinsurance, then that one year could severely strain the company financially. Insurers pay reinsurance companies to take on some of their risk. If that perfect storm hits, then the insurer is protected and can remain financially healthy into the next year. An inherent benefit is reducing financial volatility: by lessening the impact of extreme outcomes, reinsurers help insurers maintain more consistent and more predictable year-to-year financial results in the long term. No insurer wants a wildly fluctuating balance sheet, and they gladly surrender some potential profit to reinsurers in order to ensure a more consistent bottom line. ## Premiums, Claims, and Expenses The process of pricing and writing reinsurance policies is known as underwriting. The underwriting profits for an insurer in any given year come down to a simple equation: premiums minus claims and expenses. #### Premiums Premiums are payments from insurance companies to reinsurers in exchange for coverage. They compose the revenue side of the equation. In concept, they’re similar to the premiums you may pay for automotive, medical, or homeowners insurance. In practice, when and if they’re paid out can be different (more on that later). #### Claims Claims are payments made from reinsurers to insurers if losses covered by the reinsurance agreement happen. The amount of money a reinsurer pays out in claims on a given policy can vary widely based on the volume of covered events that occur. #### Expenses In this context, expenses refers to the costs of operating a business. Running a business costs money, and reinsurance is no exception. These costs can range from ubiquitous expenditures such as salaries, rent, and facility upkeep to more insurance-specific expenses such as claims investigation costs or broker commissions. ## The Combined Ratio The combined ratio is the industry-standard method of evaluating a reinsurer’s annual profitability. It’s calculated by adding together the amount spent by the insurer on claims and expenses and dividing that sum by the amount earned by the insurer in premiums, then multiplying the product by 100. Or: `100 * ((Claims + expenses) / premiums)` If a reinsurer’s combined ratio in a given year is less than 100, then the reinsurer made a profit on its policies. If it’s greater than 100, then the reinsurer operated at an underwriting loss. For example, a 90% combined ratio indicates that 90% of a reinsurer’s premiums were allocated to claims and expenses. That would be a good year! ## Why Reinsurance Exists Here’s where it gets more complicated! There are three major reasons. We’ve already gone over the first two (in less detail). #### Risk Transfer This is the “insurance for insurers” part. Insurers buy reinsurance to protect themselves from extreme outcomes by turning uncertainty into predictable premiums. Reinsurance protects them from worst-case scenarios in given coverage categories, therefore keeping a single bad year from turning into a financial disaster that could threaten the company’s solvency. #### Stabilization The variable nature of claims – that is, the frequency of covered events – means that insurance profits and losses can vary a great deal from year to year. For example, insurers that traffic heavily in hurricane insurance policies might see an extreme tropical storm season in one year followed by a very quiet one in the next. Even if an insurer has the ability to absorb enormous losses, a wildly fluctuating balance sheet would remain a major operational obstacle. The function of reinsurance in converting the possibility of major financial losses into predictable premium payments allows insurers to maintain a more stable balance sheet from year to year. #### Capital Relief US state laws require insurers to maintain a surplus of assets known as regulatory capital, which acts as a mandated buffer to ensure that claims can be paid out even in a worst-case scenario. The amount of required regulatory capital increases based on the dollar value of policies that an insurer has written, and it can amount to a very considerable sum. Transferring risk to a reinsurer lessens regulatory capital requirements, therefore freeing up some of that capital for use on growth through writing more policies, on increasing investments, or by otherwise returning better profits to shareholders. In practice, this utility often trumps the actual risk transfer itself in importance to an insurer. *** *For educational and informational purposes only. Nothing on this Site is investment, financial, legal, or tax advice, or an offer, solicitation, or recommendation to buy, sell, or hold any digital asset, including reUSD and reUSDe. Yields are not guaranteed and all figures are illustrative, not a promise of return; past performance is not a reliable indicator of future results. Digital assets involve significant risk, including total loss of principal — the Tokens are not bank deposits and are not insured by any government agency. The Tokens are available only to eligible non-U.S. persons in permitted jurisdictions and are subject to KYC/AML requirements. The binding terms of the applicable agreements govern and prevail over this summary. See our full* [*Disclosures*](https://re.xyz/disclosure) *for important additional information.*