Insurance, Excess Insurance, and Reinsurance

The differences between some kinds of insurance policies are easy to figure out. For example, auto insurance covers automobiles and home insurance covers individual houses. However, other terms are not so self-explanatory. You should understand the differences between primary and excess insurance in particular, as you will likely encounter them at some point. You may have also heard of the term "reinsurance," which you are less likely to encounter, but should nevertheless know to avoid confusion.

Insurance is considered primary whenever coverage begins after a written contract has been signed and a potential liability has been triggered by some event. For example, if you take out a fire insurance policy on your home or business, the primary coverage kicks in as soon as the insured property suffers fire damage.

A primary insurance policy normally imposes a duty on the insurance carrier to protect against any claims made against the insured party, such as protecting a car driver who has been hit in an intersection by another car. There may be some stipulations about timing and circumstance, such as promptness to report the claim, but generally, the insurer's obligations follow a similar pattern in each case.

Each primary policy has a limit imposed on the amount of coverage available and normally sets deductible limits for the customer. Primary policies pay out against claims regardless of whether there are additional outstanding policies covering the same risk.

Primary insurance has a slightly different structure, or at least different term usage when referring to medical insurance. Primary insurance in medicine normally refers to the first payer of a claim, up to a certain limit of coverage, beyond which a secondary payer is obligated to cover additional amounts. This is especially important in the interaction between Medicare and other forms of medical insurance.

Excess insurance coverage is a topic of considerable confusion due to the many different uses of the term "excess" in the insurance industry. In fact, there have been some significant malpractice claims against insurance providers that used the term in a confusing or misleading manner.

In its most basic form, an excess liability policy extends the limit of insurance coverage to find an existing insurance coverage, otherwise known as the underlying liability policy. The underlying policy does not have to be primary insurance; it can be reinsurance or another excess policy in many circumstances. Often, umbrella insurance policies are the underlying policies.

However, excess insurance is not necessarily the same thing as umbrella insurance. An umbrella liability policy is written to cover several different primary liability policies. For example, a family might purchase a personal umbrella insurance policy (PUP) from the Allstate Corp. (NYSE: ALL) to extend excess coverage over both their automobile and homeowners policy. If an excess policy only applies to a single underlying policy, it is not considered to be an umbrella insurance policy.

The International Risk Management Institute outlines three uses of an umbrella excess insurance policy. The first use extends excess limit coverage to underlying insurance policies after they have been exhausted by payments of a larger claim. The second use is flexibility, to be used in a situation where the underlying policies are not sufficient, but upgrading the entire policy package is too expensive. Finally, an umbrella policy may provide protection against some claims not covered by the underlying policies.

Unless you own or work for an insurance company, you are unlikely to encounter reinsurance on the market. In effect, reinsurance is insurance for other insurance companies. Each reinsurance agreement commits one covering insurer, or reinsurer, to protect against potential losses arising from insurance liabilities issued by the covered insured, or ceding insurer.

The fundamental operating characteristics of reinsurance are similar to primary insurance. The ceding insurance company pays the premium to the reinsurer and creates a potential claim against undesirable future risks. Were it not for the added protection of reinsurance companies, most primary insurers would either exit riskier markets or charge higher premiums on their policies.

One common example of reinsurance is known as a "cat policy," short for catastrophic excess reinsurance policy. This covers a specific limit of loss due to catastrophic circumstances, such as a hurricane, that would force the primary insurer to pay out significant sums of claims simultaneously. Unless there are other specific cash-call provisions, the reinsurer is not obligated to pay until after the original insurer pays claims on its own policies.