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What is reinsurance, and why is it more important than ever?

As Canada is increasingly hit with severe weather events, it's becoming pricier for insurers to keep up.

If you've noticed your home insurance premiums creeping up in recent years, you're not alone. Severe weather is becoming more and more common, making this country more expensive to insure. 

Part of the rising cost of home insurance can be attributed to increasing challenges in reinsurance, a strategy used by insurance companies to reduce their exposure to major events. Let’s lift the curtain and take a behind-the-scenes peek at the concept of reinsurance and how it affects the price you pay.

What is reinsurance in simple terms?

Reinsurance is a way for insurance companies to spread their risk so they don’t bear the full financial burden of large-scale claims.

Imagine you have a big jar of marbles, each representing an insurance policy. Now, these marbles are valuable, but they're also delicate and can break (i.e., pay out a claim) at any time. But what happens if you drop the entire jar?

To protect yourself from losing everything if too many marbles break at once, you decide to share the risk with a friend who has a big jar of marbles of their own. You agree that if either one of you drops your jar, the other will help cover the cost.

How does reinsurance work?

In the insurance world, each jar of marbles might be a neighbourhood, city, or region. It’s no big deal to the home insurance company if an occasional house catches on fire. But if an entire subdivision is destroyed by wildfires, the claims could be so massive that it could wipe out an insurance company’s reserves and potentially even bankrupt it. 

Also read: What to know about home insurance during wildfire season

With reinsurance, the insurance company can make claims of its own to help cover the cost of rebuilding the subdivision. The cost could be spread out over multiple insurers, reducing the financial impacts to (relatively) minor expenses and making sure the affected homeowners receive the protection they were promised.

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How does reinsurance affect insurance rates?

In many cases, reinsurance actually helps keep insurance rates in Canada low and affordable. Without it, each insurance company would need to be prepared to cover a much larger share of the policies it issues. You’ll still pay higher premiums if you live in a high-risk area, but not nearly as high as if your provider wasn’t able to reinsure.

A problem that’s beginning to crop up is that natural disasters and climate change are becoming more prevalent, and more costly, than ever before. That’s putting upward pressure on the cost of reinsurance, which is putting upward pressure on the prices you pay as an individual. 

Even if you don’t live in a particularly high-risk area, your rates could be pushed higher to help offset the cost of reinsurance for other places and allow your insurance company to stay competitive in those locations. Imagine an insurance company sold policies in three low-risk areas, and one high-risk area. Based on its costs, it could set very low rates in the low-risk areas, and charge a much higher rate in the high-risk area.

Insurance premiums: Individual geography.

But what if that insurance company could spread some of the cost to customers in lower-risk areas? It could make its premiums more competitive in the higher-risk area, and increase its profit margins at the same time. So for example, they may increase the cost of home insurance in Ontario to offset the cost being incurred to insure homes in Alberta or Nova Scotia. The latter two provinces have experienced a lot of recent significant extreme weather related claims.

Insurance premiums: Spread out.

But as the cost of reinsurance climbs for high-risk areas, more of that cost is distributed to other clients to even things out. And even though people living in lower-risk areas haven’t become any more expensive to insure, they end up paying more.

Insurance premiums: Rising reinsurance costs.

Are insurance rates going up in Canada?

The short answer is yes. Insurance rates are on the rise, and there are several reasons for this trend.

  • Increasing natural disasters: Canada has experienced a surge in natural disasters, including wildfires, floods, and extreme weather events. These occurrences result in higher claims payouts for insurers, which, in turn, lead to higher premiums for policyholders. 

  • Reinsurance costs: Remember our jar of marbles analogy? Reinsurance isn't free; insurers have to pay for it. When reinsurance companies see an uptick in claims due to natural disasters, they may raise their rates. Insurers then pass these increased costs down the line to policyholders.

  • Property values and construction costs: As property values and construction costs rise, so does the cost of insuring homes. When homes are more valuable and expensive to rebuild, insurers adjust their rates accordingly to ensure they can cover potential claims. This is exacerbated by a labour shortage that’s making it more costly to get work done.

Overall, the cost of insurance claims in this country has risen by a multiple of five over the last 15 years. That’s a big expense that’s going to lead to higher prices, and there’s little recourse when climate change is doing much of the damage. To help combat the rising costs, we encourage Canadians to compare home insurance quotes and shop the market in order to find the best rate.

The bottom line

As natural disasters continue to become more prevalent and the cost of reinsurance rises, the cost of insurance is going to go up for all Canadians. Despite this, reinsurance is still a valuable tool that helps our insurance industry stay resilient and makes sure your policy can provide the protection you expect.

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