How does reinsurance work?

Reinsurance is a fundamental concept in the insurance industry that allows insurance companies to manage their risk exposure more effectively. By purchasing insurance from other insurers, primary insurers can mitigate the financial impact of claims that might arise from catastrophic events or unusually high claims. This practice enables them to protect their capital base and ensure they can meet their obligations to policyholders.

When an insurance company faces a potential loss that exceeds its risk capacity, it can transfer a portion of that risk to a reinsurer. This allows the primary insurer to stabilize its financial position and maintain the ability to cover claims without jeopardizing its overall financial health. Reinsurers assume some of the risk in exchange for a portion of the premiums collected from policyholders, which creates a more sustainable model for insurance operations.

Other choices do not accurately describe how reinsurance functions. Sharing claims with policyholders deviates from the concept, as reinsurance is concerned with the relationship between insurers, not between insurers and the individuals or entities they insure. Pooling premium resources is more about collaborative risk-sharing arrangements than the specific transaction of reinsurance. Additionally, limiting reinsurance to exclusive coverage for natural disaster claims is too narrow, as reinsurance can encompass a wide range of risks, including those from general liability, property,