Re-insurance & Double Insurance in Business: Definition & Uses

Instructor: Nick Chandler
Disasters can result in huge payouts for insurance companies. This lesson looks at how reinsurance is used to reduce these huge payouts, as well as what happens when a person or company has double insurance.

Predicting The Unpredictable

Insurance companies or insurers are in the business of guaranteeing compensation to individuals and companies when certain events happen such as accidents, thefts, or natural disasters. They provide this compensation in return for a fee, called a premium. Insurers use factors like gender or location to guage the probability of events; in this way, they can charge varying fees in relation to increasing or decreasing risk.

However, there are some things you can't predict. Take, for example, natural disasters. A hurricane or tsunami can bring insurance companies to the brink of failure. So what can they do? Well, the answer lies in re-insurance, which is essentially a way of reducing risk by sharing it between many insurance companies. Let's look at reinsurance in more detail.

The Beginning Of Reinsurance

How did reinsurance get started? Natural disasters and large-scale accidents led to the need for reinsurance. For example, the first independent reinsurance company, called Cologne Re, was formed in 1852 following the Great Fire of Hamburg some years earlier. The San Francisco earthquake of 1906 also provided a big step forward for reinsurance as it showed that insurance companies could bear large losses as a result of such catastrophes.

Of course, the more frequent the natural disasters, the harder it is for insurers to bear the losses. This is why there were record losses in the reinsurance industry in 2011 following floods in Thailand, tornadoes in the U.S., and earthquakes in Japan and New Zealand.

Defining Reinsurance

Reinsurance refers to insurance that is purchased by one insurance company from one or more other insurers. The contract, called a policy, refers to the company which buys the insurance as the cedant. The company from which the cedant buys insurance is called the reinsurer. The cedant pays a premium to the reinsurer. In return, the reinsurer will pay a share of the compensation the cedant company pays out to its customers if there is an accident or disaster.

By sharing the cost of compensation, insurance companies can survive the financial losses from a large-scale event. The reinsurance market ensures that insurance companies survive through difficult times by sharing risks and costs.

Double Insurance

Imagine a situation where both you and your wife hold insurance for your house at the same time. You're not trying to cheat the insurance companies, but you've decided to have two policies on the same property so that you can be guaranteed to get some form of compensation - after all, if one company hesitates in paying out, then you can turn to the other for compensation. This is called double insurance.

What does this mean? If the house burns down, does the couple get twice as much compensation? Unfortunately not. The reason is connected to the concept of indemnity. Indemnity is the idea that if a man has a car accident and writes off his 30-year-old Chevrolet, he is not going to receive enough compensation to buy a new car. He will only get enough compensation to buy another 30-year-old Chevrolet, in the same condition as it was immediately before the accident.

So, with double insurance the insured person will not get more money. The biggest question is which insurer will pay the compensation. It's easy to imagine two insurers arguing about who will pay, but in reality it is much more straightforward. The insured person, or simply the insured, can choose either of the two companies to claim compensation from. The second insurer (who hasn't yet paid out) will still need to pay a share to the company that has paid out.

Clauses About Double Insurance

The insured may have problems in getting compensation if they have double insurance. Many policies have clauses, which are sections of a policy, which state that if a person has insurance at another company for the same property and for the same type of loss (accident, fire etc.), then the insurance company has the right to refuse to pay compensation. Here's the interesting bit: if both insurance companies have that clause, then they effectively cancel each other out. In this way, the insured can still choose which insurer to get compensation from. Later, one insurer will settle up with the other.

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