Reinsurance Meant to Spread Risk

Maurice R. "Hank" Greenberg was forced out of AIG by the reinsurance probe. (Daniel Acker -- Bloomberg News)

Who insures the insurers?

That is a question not many people ask, but "reinsurance," the process of selling off to third parties risks that insurers have underwritten, is an enormous industry in the United States and worldwide. It plays a key role in the willingness and ability of insurers to write policies in disaster-prone areas and of life insurers to take on concentrated risks.

But it is also a murky and little-understood industry outside of insurance circles, a characteristic that may have allowed companies such as American International Group Inc. to shift risks and premiums back and forth in ways that made their own and others' finances look stronger than they otherwise would.

In essence, reinsurance is the purchase of insurance by an insurer, typically the one that wrote the original coverage. Those primary insurers write policies promising to pay claims if certain bad things happen. They then cede some or all of the risk they have taken on to reinsurers, along with a corresponding portion of the premiums from the business.

This mechanism spreads risk, allowing a company in, say, Florida, to write a lot of storm damage coverage and then sell much of it off to reinsurers so that the original company would not have to pay all the claims itself if a huge storm hit.

"If there's a loss, some of it goes somewhere else," said J. Robert Hunter, director of insurance at the Consumer Federation of America and former Texas insurance commissioner.

"An insurance company [buying reinsurance] wants to protect itself, not unlike a consumer would, from an infrequent but extreme event," said Franklin W. Nutter of the Reinsurance Association of America, an industry group.

A terrorist attack would be a classic example of such an event, and, in fact, of the $32 billion to $33 billion in insurance claims resulting from the World Trade Center attacks, some $20 billion was ultimately paid by reinsurers, Nutter said.

Reinsurance also allows primary insurers to write more policies than they otherwise could. Since regulators require insurers set aside reserves to pay claims, laying off risk to others frees reserves and allows the company to write more policies.

But the key element is "there has to be a transfer of risk," said Maine Insurance Superintendent Alessandro A. Iuppa.