Catastrophe Excess Reinsurance

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

Catastrophe excess reinsurance protects insurance companies from the financial risks involved in large-scale catastrophic events. The size and unpredictability of catastrophes force insurers take on a tremendous amount of risk. Although catastrophic events happen infrequently, 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 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 cause 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.

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.