Insurance companies are themselves buyers of insurance. They transfer part of the risk they have accepted to reinsurers, and that transaction shapes what they can write and what it costs.
Pooling fails against correlated losses
Insurance works because individual losses are largely independent. One house burning down does not make the neighbor's more likely, so a large pool produces predictable totals.
Catastrophes break that independence. A hurricane or wildfire damages thousands of insured properties at once, and the losses arrive together rather than spread across the year.
A pool that is perfectly adequate for ordinary claims can be exhausted by a single correlated event, which is the specific problem reinsurance exists to address.
Reinsurance moves the tail, not the average
Most reinsurance arrangements do not cover routine claims. They attach above a threshold, absorbing losses only once the primary insurer's own retention has been consumed.
The primary company keeps the frequent, predictable losses it is well equipped to handle and passes on the rare, enormous ones that could threaten its solvency.
Other arrangements share a fixed proportion of every policy instead, which transfers premium and losses together and supports growth rather than protecting against extremes.
Capital requirements make the transfer worthwhile
State regulators require insurers to hold capital against the risks on their books, with more capital demanded for concentrated or volatile exposures.
Ceding risk to a reinsurer reduces the exposure the primary company carries, which reduces the capital it must hold against it.
That freed capital can support additional policies, so reinsurance functions as a way to write more business without raising more equity.
Reinsurance pricing reaches consumers
Reinsurers price by geography and peril, and their view of catastrophe exposure is updated as models and loss experience change.
When reinsurance for a region becomes more expensive or harder to obtain, the primary insurer's cost of writing there rises even if its own claims have been unremarkable.
That is one reason availability and pricing in exposed regions can change quickly, and why the pressure often appears to arrive from somewhere outside the local market.
The chain extends beyond reinsurers
Reinsurers themselves cede risk onward through retrocession, spreading a single event's cost across an international network of balance sheets.
Capital markets participate too, through instruments that pay out to insurers when a defined catastrophe occurs and otherwise return capital to investors.
The effect is that the cost of a large US catastrophe is ultimately distributed among many holders of risk worldwide rather than resting on the company whose name is on the policy.