Catastrophe Excess Reinsurance

Catastrophe Excess Reinsurance

Investopedia / Ellen Lindner

What Is Catastrophe Excess Reinsurance?

Catastrophe excess reinsurance protects catastrophe insurers from financial ruin in the event of a large-scale natural disaster.

For instance, if a regional insurer covers 60% of the properties along a coastline affected by a storm surge, it can be suddenly hit with multiple claims that must be paid out in unison, which could otherwise bankrupt an insurer.

Key Takeaways

  • Catastrophe excess reinsurance is a type of reinsurance in which the reinsurer indemnifies–or compensates–the ceding company for losses stemming from multiple claims occurring simultaneously.
  • Natural disasters, for instance, may cause damage to a large number of insured properties in an insurer's portfolio of policies all at once.
  • Insurers buy catastrophe excess reinsurance to allow them to pay out all claims owed and to continue operations in such an event.

Understanding Catastrophe Excess Reinsurance

Catastrophe excess reinsurance protects insurance companies from the financial risks involved in large-scale catastrophic events. The size and unpredictability of catastrophes force insurers to take on a tremendous amount of risk. Although catastrophic events infrequently happen, when they do happen, they tend to cover wide geographic areas and cause large amounts of damage. When an insurer encounters a large number of claims all at once, the losses potentially could cause it to restrict new business or cause it to refuse to renew existing policies, limiting its ability to recover. 

Insurance companies use reinsurance to transfer some of their risk to a third party in exchange for a portion of the premiums the insurer receives. Reinsurance policies come in a number of forms. Excess-of-loss reinsurance, for instance, establishes a limit to the amount the insurer will pay following a catastrophe, somewhat similar to a deductible in a regular insurance policy. Provided no catastrophes take place that causes an insurer to exceed their limit over the duration of a contract, the reinsurer simply pockets the premiums.

To the extent reinsurance provides a financial backstop for an insurer's potential losses, its presence allows insurers themselves to underwrite more policies, making the coverage more widely and affordably available.

Example of Catastrophe Excess Reinsurance

Companies that purchase reinsurance policies cede their premiums to the reinsurer. In the case of catastrophe excess reinsurance, the insurer exchanges premiums for coverage of some percentage of claims above a defined threshold. For example, an insurance company might set a threshold of $1 million for a natural disaster such as a hurricane or earthquake. Suppose a disaster incurred $2 million in claims. A reinsurance contract covering all claims over the threshold would pay out $1 million. A reinsurance contract for 50 percent of claims above the threshold would pay $1.5 million. While reinsurance can cover a percentage of claims above a threshold, it does not constitute proportional coverage, which requires reinsurers to pay a percentage of claims in exchange for the proportion of premiums ceded to them. Returning to our example, a disaster that incurred $800,000 worth of claim would cost the reinsurer nothing.

Note that, unlike other types of reinsurance, catastrophe excess reinsurance policies may not have a hard cap on the amount the reinsurance company must pay out in excess claims, and therefore may offer more downside risk to a reinsurance company than other types of arrangements.