Differences Between Insurance & Re-Insurance

Insurance and reinsurance are both financial protection against the possibility of losses. While they
are similar in concept, they are quite different in terms of how they are used and who uses them.
You purchase insurance to protect against possible property losses. Who protects the insurance
company from possible property losses? For smaller losses, the company is probably self-insured.
But, as a hedge against large losses, they purchase reinsurance.

Definition of Insurance
Insurance is a contract purchased by individuals and companies to manage their risk of loss of life, home, auto,
property or whatever the insurance was purchased to cover. Purchasers pay a fee (premium) for a
policy/contract while the insurance company agrees to reimburse the purchaser for a financial loss due to one
of the circumstances covered by the policy.

Definition of Reinsurance
Reinsurance is insurance purchased by an insurance company from other insurance companies to manage their
risk. It protects against significantly large claims or disasters, allowing the insurance company to cover more
individuals without fear of bankruptcy should a disaster occur, resulting in multiple policyholders filing claims
at one time. In some reinsurance arrangements, several insurance providers pool their policies and divide the
risk among a number of insurance providers, sometimes globally.

Similarities
Insurance and reinsurance are similar in many ways. Insurance is purchased to provide protection from
covered losses; reinsurance guards the insurance company from too many losses. They both contractually
transfer the cost of the loss to the company issuing the policy. They both have deductibles. For an insurance
policy covering a home from fire, it might be $1,500. For a reinsurance policy covering an insurance company
from a wildfire destroying hundreds of homes, it might be $45 million.

Differences
State insurance commissioners regulate both insurance and reinsurance. However, insurance policies are
typically bought from companies that are allowed to offer policies in one state, while reinsurance policies are
often purchased across state lines or even international borders. Reinsurance companies may be special
divisions of large insurance conglomerates or companies that undertake only the reinsurance business.
Ordinary insurance policies can be purchased to cover a variety of needs such as home, auto, life or disability.
Reinsurance policies fall into two types: treaty, which covers a pool of policies from either one or several
insurers over a long term, and facultative, which covers a specific risk and is priced and purchased separately
from the insurers other reinsurance policies. Think of facultative as a separate reinsurance policy purchased
for something that the treaty wouldnt cover, usually because the potential loss is much higher. For example, a

maritime insurer may have treaty reinsurance over most of the ships it covers, but negotiate facultative policies
on an extremely expensive vessel.

LEVERAGE
In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is any
technique to multiply gains and losses.[1] Most often it involves buying more of an asset by using
borrowed funds, with the belief that the income from the asset or asset price appreciation will be
more than the cost of borrowing. Almost always this involves the risk that borrowing costs will be
larger than the income from the asset, or that the value of the asset will fall, leading to incurred
losses.

Financial Leverage And Capital

Structure Policy - Financial Leverage
Financial leverage is the degree to which a company uses fixed-income securities such as
debt and preferred equity. The more debt financing a company uses, the higher its financial
leverage. A high degree of financial leverage means high interest payments, which
negatively affect the company's bottom-line earnings per share.
Financial risk is the risk to the stockholders that is caused by an increase in debt and
preferred equities in a company's capital structure. As a company increases debt and
preferred equities, interest payments increase, reducing EPS. As a result, risk to
stockholder return is increased. A company should keep its optimal capital structure in mind
when making financing decisions to ensure any increases in debt and preferred equity
increase the value of the company. (Learn more about leverage in ETFs: Losing At
Leverage and 5 Ways Debt Can Make You Money.)
Degree of Financial Leverage
The formula for calculating a company's degree of financial leverage (DFL) measures the
percentage change in earnings per share over the percentage change in EBIT. DFL is the
measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.
Formula:
DFL = percentage change in EPS or EBIT
percentage change in EBIT EBIT-interest
A shortcut to keep in mind with DFL is that if interest is 0, then the DLF will be equal to 1.
Example: Degree of Financial Leverage
With Newco's current production, its sales are $7 million annually. The company's variable
costs of sales are 40% of sales, and its fixed costs are $2.4 million. The company's annual

interest expense is $100,000. If we increase Newco's EBIT by 20%, how much will the
company's EPS increase?
Calculation and Answer:
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000$100,000)
DFL = $1,800,000/$1,700,000 = 1.058

Read more: http://www.investopedia.com/walkthrough/corporate-finance/5/capitalstructure/financial-leverage.aspx#ixzz3icf14AGl

Follow us: @Investopedia on Twitter