Reinsurance is one of the most important tools an insurance company uses to protect balance sheet assets. Without the proper reinsurance, you may not have enough cash to settle claims. And your customers are relying on your promise to pay their claims in their time of need.

You don’t want to break your promise, do you?

Here are three of the biggest reinsurance buying mistakes, and what to do instead.

Mistake #1 – Retaining Too Much Volatility – One of the main functions of reinsurance is to transfer volatility, or loss severity, to your reinsurers. If you retain too much severity, you risk losing too many assets from a catastrophic loss. This is a common risk if you have a small capital base.

What To Do Instead – Make sure you have an actuary that understands how reinsurance works perform a reinsurance retention analysis for you. It is better to buy a little more reinsurance and pay a little more now than to have a financial disaster later.

Mistake #2 – Not Buying The Right Catastrophe Protection – Everyone in the insurance industry knows that the catastrophe models drive the amount of limit a company buys, and the price they pay for that capacity. But relying too much on the modeling results alone can leave you vulnerable to losses that the models didn’t contemplate.

What To Do Instead – Make sure you consider other loss scenarios. Sometimes an unusual increase in the frequency of catastrophe losses can leave your balance sheet more vulnerable than losses from one big storm. If you write personal lines insurance in Florida, the Gulf area or the Atlantic seacoast, make sure you consider this.

Mistake #3 – Not Fully Understanding The Total Cost Of Your Reinsurance – I’ve seen many reinsurance buyers fall in love with “swing rate” or “spread loss” contracts because they focus on the minimum premium if the reinsurers don’t have to pay any losses. These buyers lose sight of the potential huge additional premiums they would owe reinsurers if there were an increase in loss frequency. Inexperienced buyers can be especially vulnerable to this mistake.

What To Do Instead – While these types of reinsurance have their uses, you should only buy one after fully analyzing the potential costs you could incur. Most actuaries can do this analysis for you; while they are at it, make sure they perform a risk-transfer test of the terms as well. If you still have doubts, buy reinsurance with a fixed rate. It may cost more if there are no losses, but you know in advance the maximum amount you will pay.

What To Do Next To Buy Reinsurance The Right Way

To buy reinsurance the right way, you need the right expertise and the ability to perform the proper analysis.