Catastrophe Hazard

What Is a Catastrophe Hazard?

In the insurance industry, a catastrophe hazard is a type of risk that could cause a large number of policyholders to file claims at the same time. Common examples of catastrophe hazards include earthquakes, tornadoes, or acts of terrorism. 

Catastrophe hazards can be particularly costly for insurance companies. For this reason, many insurance policies will contain clauses indemnifying the insurer against losses resulting from this type of risk.

Key Takeaways

  • A catastrophe hazard is a type of risk that is generally not covered by insurance contracts.
  • When these risks are insured, they can prove extremely costly for the insurer.
  • Often, policyholders needs to purchase special add-ons or policies to insure against these risks, potentially requiring very high premiums.

How Catastrophe Hazards Work

One of the fundamental assumptions behind most insurance underwriting is the idea that the individual risks faced by the policyholders are not highly correlated with one-another. In other words, insurance companies generally assume that, if an event happens that causes one of their customers to file a claim, that same event will not increase the likelihood of a second or third customer filing claims as well. This is an important consideration for insurance companies because, if these assumptions hold true, it allows the insurance company to reduce their overall risk by diversifying their insurance contracts across a large pool of policyholders. If, on the other hand, their risks were largely correlated, then adding additional customers would not reduce their overall risk.

From this perspective, catastrophe risks such as natural disasters or acts of war pose a severe risk to insurance companies. After all, if a single severe weather event hits a particular community, many or even all of the policyholders within that community might need to file a claim at the same time. Depending on the size of the catastrophe, these combined claims might be more than the insurance company budgeted for, potentially forcing them into bankruptcy. For this reason, many insurance contracts specifically exempt the insurer from covering these kinds of risks. If the customer wants to obtain this insurance, they need to purchase it separately either as an add-on or as a new policy. Given the potential costs involved, insuring these types of catastrophe hazards can require very large premiums.

In addition to excluding these risks from insurance contracts, another way that insurance companies seek to reduce their exposure to catastrophe hazards is by carrying a catastrophe reserve fund. If a catastrophe hazard does occur, the insurance company can draw down this fund and use it to cover the sudden influx of claims. Moreover, if a new catastrophe occurs in a region that did not experience one before, that region might be designated as a high-risk area and become exempt from coverage in future contracts.

Real World Example of a Catastrophe Hazard

One recent example of a catastrophe hazard occurred in 2017, when Hurricane Harvey devastated many communities throughout Texas. This was an unforeseen catastrophic event that caught many people and insurance companies off-guard. Without catastrophe coverage, many people may not have had everything they needed to replace covered by insurance.

An area that is hit by a catastrophe that arises from nature may also have a long-lasting impact on potential insurance for residents in the future. For instance, if an area was not considered high-risk for a natural disaster—such as a tornado or hurricane—is hit by a natural disaster, insurance companies may reclassify that area as a high-risk area with a catastrophe hazard. Assigning a high catastrophe hazard to residents who have already been through a natural disaster may make insurance rates higher or raise the premiums for existing insurance policies.