What Is Catastrophe Reinsurance?

Catastrophe reinsurance is purchased by an insurance company to reduce its exposure to the financial risks associated with 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.

Understanding Catastrophe Reinsurance

Catastrophes are extremely rare events, so buying catastrophe reinsurance is usually a carefully considered decision for an insurance company. Catastrophes are very unlikely to occur with frequency, but when they do, the amount of damages they cause can be mind-boggling. Without reinsurance, claims made after a catastrophe would come from the insurer’s operating cash flow, from debt financing, or from liquidating assets. Insurers have to balance being prepared for a low probability event and taking on premiums from issuing policies that may result in claims.

Insurers use catastrophe reinsurance in order to reduce the risk they take on from underwriting new policies. 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 reduction in risk. 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.

Catastrophe reinsurance prices can be high because the price is based on exposure rather than experience. This means that reinsurers don’t use a long experience period when developing pricing models, and instead use models of risk exposures from current events or events that can be anticipated. For example, reinsurers 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.

Catastrophe Reinsurance Premiums and Predictive Modeling

Modern catastrophe 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.