What Is Catastrophe Reinsurance?

Catastrophe reinsurance is purchased by an insurance company to reduce its exposure to the financial risks of a catastrophic event occurring. Catastrophe reinsurance allows the insurer to shift some or all of the risk associated with policies that it underwrites in exchange for a portion of the premiums that it receives from policyholders.

Key Takeaways

  • Catastrophe reinsurance is purchased by an insurance company to reduce its exposure to the financial risks of a catastrophic event occurring. 
  • It allows insurance companies to shift some or all the risk associated with policies that it underwrites in exchange for a portion of the premiums it charges policyholders.
  • Though rare, catastrophes do happen, resulting in a large number of claims that can potentially cripple a non-reinsured insurer’s operations.
  • Reinsurers are aware of the risks that they would be taken on, employing sophisticated catastrophe probability models and charging high prices for coverage.

Understanding Catastrophe Reinsurance

Reinsurance, otherwise known as "insurance for insurance companies,” is an option that permits insurers to transfer portions of their risk portfolios to other parties. The insurer, or the cedent, sells a fixed percentage of its business to the reinsurer, obligating it to foot a portion or all of the bill should a claim be made against one of the policies it bought in exchange for a share of the insurance premium—the payment customers are charged for coverage under a given plan.

Catastrophe reinsurance specifically involves outsourcing some of the financial risks associated with large-scale catastrophic events, consisting of natural disasters such as earthquakes, floods, and hurricanes, and human-made disasters including a riot or terrorist attack.

Buying protection against these risks is usually a carefully considered decision for an insurance company. Catastrophes are rare and unlikely to occur with frequency. That said, when they do strike, the amount of damage they cause can be mind-boggling. Suddenly an insurer could encounter a large number of claims all at once, building up losses that might force it to stop taking on new business or refuse to renew existing policies.

$75 billion

Estimated global total economic losses from natural and man-made disasters in the first half of 2020, according to insurer Swiss Re.

Because reinsurers will demand a portion of the premiums in exchange for taking on risk, insurers must balance how often they use reinsurance with the benefit they receive for experiencing a risk reduction. Insurers identify how much catastrophe risk they are willing to take on through their underwriting activities, and determine how exposed they are to catastrophes from the policies that they create.

Advantages and Disadvantages of Catastrophe Reinsurance

Without reinsurance, claims made after a catastrophe would come from the insurer’s operating cash flow (OCF), from debt financing, or from liquidating assets. The impact could be devastating and potentially put the insurer out of business, making refusal to cover such events or catastrophe reinsurance a viable option.

Catastrophes are generally excluded from standard homeowner insurance policies.

The problem is that catastrophe reinsurance prices can often be excessive. Reinsurers don’t use a long experience period when developing pricing models, preferring instead to use models of risk exposures from current events or events that can be anticipated. That means, for example, that reinsurers would look at how rising ocean levels and global warming could increase the likelihood of future hurricanes rather than look at how many hurricanes occurred historically.

The ratio of catastrophe insurance premiums to the losses an insurer may expect from a catastrophe occurring can be high. This can push insurance companies away from purchasing reinsurance against large catastrophe events and toward purchasing reinsurance for smaller events.

Special Considerations

Modern catastrophe predictive models take advantage of the most recent science and engineering knowledge, employ vast computing power made possible by recent IT advances, and are frequently configured using new catastrophe events.

Catastrophe models can analyze risks at a location level and then build the location-level results up to a portfolio level. This differs from the exposure curve approach, which is based on aggregate exposures.