Catastrophe Accumulation

Catastrophe accumulation is a term used in the insurance industry that refers to the losses that an an insurer or reinsurer may face across a geographic area from a natural disaster.

Catastrophe accumulation is calculated from a wide range of losses and involves partial loss to total loss across a potentially large number of policies. Normally, insurers and reinsurers absorb individual losses from claims relatively easily. The loss severity is typically low compared to the total value of all premiums. A natural disaster, however, can result in losses far exceeding total premiums. Because natural disasters are rare, it is easy for insurers and reinsurers to underestimate the losses that can occur, and thus require from the insured a lower premium than the risk actually warrants.

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. Even though the insurer takes into account the occurrence of natural disasters in the locality specific to the insurance policy, when a natural disaster occurs the insurer can face costs that far exceed the the amount the policyholder has paid to the insurer.

In order to mitigate the risks associated with natural disasters, insurers purchase something called catastrophe reinsurance. 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.

Companies may create an estimate of a worst-case scenario by calculating probable maximum loss or PML in order to charge proper premiums in areas prone to natural disasters. For example, an insurance company could create a table that models annual aggregate PML for hurricanes over a 100-year and 200-year period, net of reinsurance. Creating such a model allows an insurance company to determine the percentage chance that losses resulting from a hurricane would exceed a certain threshold of an insurer’s reserves and equity.  Long time periods are chosen because catastrophes are rare events. Developing long-term models can be difficult because of a lack of an industry-wide standard in preparing data for use in the model, and because third-party estimates may show wide variations.