What it means
Catastrophe reinsurance protects an insurer's balance sheet rather than any individual policyholder. The reinsurer steps in once total claims from one event pass an agreed attachment point and pays up to an agreed ceiling above it.
Without it, an insurer with a geographically concentrated book could be wiped out by one storm. Regulators and rating agencies therefore examine how much catastrophe cover a company holds relative to its modelled worst-case event before granting a licence or a rating.
Cover is bought in layers, each described as a limit "excess of" an attachment point. An insurer might retain the first $50,000,000 of any event, buy $100,000,000 above that, then add a further $250,000,000 on top, with each layer placed among a different group of reinsurers.
Price is quoted as rate on line, meaning premium divided by limit. Higher layers sit further from expected losses so they carry lower rates on line, and the reciprocal of the rate gives a rough payback period, the number of loss-free years needed to fund one full limit loss.
Most treaties restrict how many times a layer can be used within a year, which is why reinstatement terms deserve attention. Aggregate covers, which respond to the accumulated total of several smaller events rather than one big one, are a common complement to pure per-occurrence protection.
In practice
Real-world examples.
Example
A regional insurer with 180,000 coastal home policies buys a four-layer hurricane programme totalling $600,000,000 of cover above a $40,000,000 retention. Its rating agency treats the programme as a condition of maintaining its financial strength rating.
Example
A specialist marine insurer buys retrocession, which is reinsurance for reinsurers, after taking on large shares of other carriers' catastrophe layers. The purchase converts an uncomfortable aggregate exposure into a known maximum loss for the year.
Example
A national crop insurance pool in a drought-prone country buys an aggregate catastrophe treaty that responds once total season claims exceed a set threshold. Individual bad fields never trigger it, but a systemic drought across the whole growing region does.
Formula
Calculation
Reinsurer's payment = the lower of (gross loss - attachment point) and (layer limit)
Layer premium = layer limit x rate on line
Payback period = 1 / rate on line
A mid-sized insurer buys a catastrophe layer described as $100,000,000 excess of $50,000,000. The rate on line is 12%, so the premium is $100,000,000 x 0.12 = $12,000,000 and the notional payback period is 1 / 0.12 = 8.3 years.
A hailstorm produces $130,000,000 of gross claims. The insurer retains the first $50,000,000, and the reinsurer pays $130,000,000 - $50,000,000 = $80,000,000, comfortably inside the $100,000,000 limit.
That leaves only $100,000,000 - $80,000,000 = $20,000,000 of limit available. If a second event later in the year produced $200,000,000 of gross claims with no reinstatement in place, the reinsurer would pay just $20,000,000 and the insurer would carry $200,000,000 - $20,000,000 = $180,000,000 itself.Case study
Seen in the real world.
Northgate Mutual is a fictional Midwest insurer invented to illustrate how layered cover behaves. It retained the first $20,000,000 of any single event and bought a layer of $80,000,000 excess of $20,000,000 at a rate on line of 15%, paying a premium of $80,000,000 x 0.15 = $12,000,000.
A severe hail outbreak produced $70,000,000 of gross claims across three states. Northgate absorbed $20,000,000 and the reinsurers paid $70,000,000 - $20,000,000 = $50,000,000, leaving $30,000,000 of the layer unused for the rest of the year.
In the illustrative renewal that followed, reinsurers pushed the rate on line to 21%, taking the premium to $80,000,000 x 0.21 = $16,800,000. Northgate responded by lifting its retention to $30,000,000 and buying the layer $70,000,000 excess of $30,000,000 instead, accepting more of the frequent losses in exchange for a smaller bill.
Watch out
Common mistakes.
- Believing reinsurance removes risk from the insurer. It transfers a defined slice of it, and everything below the attachment point or above the limit stays exactly where it was.
- Comparing programmes on premium alone. A cheaper programme with a higher retention and no reinstatement can be far more dangerous in a two-event year.
- Treating rate on line as a yield. It is a price per unit of limit, and the sensible comparison is against the modelled expected loss of that specific layer.
Questions
People also ask.
What is a reinstatement?
It is the right to restore a used-up layer for a further premium, so a second event in the same year still has cover behind it.
Why do upper layers cost so much less?
They are hit far less often, so their expected loss is much lower and their rate on line falls accordingly.
Who ultimately carries the risk?
A chain of reinsurers, retrocessionaires and capital market investors, which is why catastrophe bonds and reinsurance are priced against each other.
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