What Is Catastrophe Accumulation?
In the insurance industry, the term “catastrophe accumulation” refers to the aggregate claims that would need to be paid if one or more catastrophes were to occur across an entire region. In this sense, the catastrophe accumulation is a type of estimate of potential damages caused by catastrophes such as earthquakes or severe weather events.
- A catastrophe accumulation is an estimate of the potential risk born by an insurance company if one or more catastrophes were to occur within a particular region.
- It is used by insurance companies to manage their risks.
- Depending on their level of catastrophe accumulation, insurance companies may choose to raise premiums or purchase reinsurance.
How Catastrophe Accumulation Works
The basic business model for insurance companies is to collect premiums from a large number of policyholders, where the premiums charged are high enough to support the claims that are likely to be made against those policies. If the claims rise above their expected level, however, the insurance company may be unable to fund the claims through the previously-collected insurance premiums, leading to a loss and potential insolvency.
This basic challenge is particularly acute when dealing with catastrophic risks, such as earthquakes or hurricanes. Unlike most insurance contracts, in which the likelihood of a policyholder filing a claim is not influenced by whether a second or third policyholder does so, catastrophes can be much more dangerous to insurers. This is because a single event could potentially affect policyholders across an entire region, leading to a cascade of policy claims all at the same time. From the insurance company’s perspective, this is a kind of “worst-case scenario” because the total value of these claims could vastly exceed the premiums collected on those policies.
To manage this risk, insurance companies keep track of the potential losses associated with these types of catastrophes, grouping those estimates for each region or for the business as a whole. Insurance companies refer to this running total as their catastrophe accumulation, since it is essentially the accumulation of the risk presented by any potential catastrophe. For example, a home insurance provider that insures against earthquakes might keep track of its catastrophe accumulation for a particular state or city that is especially prone to earthquakes. Depending on the level of catastrophe accumulation they record, the insurance company may need to raise their insurance premiums or purchase reinsurance to manage their risk.
Real-World Example of Catastrophe Accumulation
Insurance companies evaluate the risk associated with underwriting a new policy by examining the potential severity and frequency of losses. The severity and frequency will vary according to the type of peril, the risk management, and reduction techniques being employed by the insured, and other factors such as geography. For example, the likelihood that a fire insurance policy will see a loss depends on how close buildings are to each other, how far away the nearest fire station is, and what fire prevention measures the building has in place.
After considering these factors, the insurance company might try to estimate its worst-case scenario by calculating its probable maximum loss (PML). For example, an insurance company with exposure to fire-related risks might create a table that models annual aggregate PML for wildfires over a 100-year period. Because catastrophic events are inherently rare, long periods such as this may be needed to ensure that a large enough number of past events are included in the data set.