A key question in labor market research is how the unemployment insurance system affects unemployment rates and labor market dynamics. We provide new answers to this old question by studying one of the largest unemployment insurance reforms in recent decades, the German Hartz reforms. On average, lower separation rates into unemployment account for 76% of declining unemployment after the reform, a fact unexplained by existing research focusing on job-finding rates. Exploiting institutional changes by age, employment duration, and wages, we establish a causal link between the reform and changes in labor market dynamics. Relying on labor market theory, we generalize our empirical findings beyond the German case and establish separation rate changes as an important macroeconomic adjustment channel after UI reforms. We derive analytically that the change of separation rates increases in proportion to average unemployment duration suggesting an equally important role for most other European labor markets.