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posted on 05 June 2016

Do Insurers In Catastrophe-prone Regions Buy Enough Reinsurance?

from the Chicago Fed

-- this post authored by Florentine M. Eloundou Nekoul and Alejandro Drexler

To protect themselves from catastrophic losses, insurance companies buy insurance, in the same way that people do. These contracts are called reinsurance agreements, and come in two main forms: proportional and nonproportional contracts. In proportional reinsurance contracts, a reinsurer agrees to repay a fixed proportion of losses incurred by the primary insurer. The simplicity of the agreement makes these types of contracts inexpensive and easy to administer. Therefore, they can be ideal risk-management tools for small insurance companies.

Nonproportional reinsurance contracts, simply put, involve an agreement whereby a reinsurer agrees to pay losses exceeding a certain minimum.1 These contracts are typically written to protect primary insurers from potentially large or catastrophic losses.2 In most cases, insurers combine these two types of reinsurance to protect themselves against the risks they face.

In this Chicago Fed Letter, we explore whether insurers in regions that are relatively susceptible to large, natural catastrophes purchase more reinsurance than those in regions where such catastrophes are less likely. In addition, we examine whether the payments that insurers receive from reinsurers are enough to insulate them from catastrophes.

The protection provided by reinsurance is not only important from the insurers' perspective, but also fundamental for protecting the interests of policyholders. Indeed, insurance is effective only if insurers have sufficient funds to pay policyholders in the event of financial loss. This may be a trivial concern in an average year, when premiums paid by policyholders are enough to cover insured losses. However, when natural catastrophes occur, losses suffered by policyholders can be several times larger than collected premiums, consuming insurers' capital and, if losses are severe enough, potentially jeopardizing claim payments. For example, three of the ten largest hurricanes in United States history occurred in 2005, and 22 property and casualty insurance companies suffered losses that exceeded the sum of premiums collected from their policyholders and their capital. Without reinsurance, policyholders might have faced losses from the hurricanes that their insurance company would not have had the financial resources to pay.

Three of the ten largest hurricanes in United States history occurred in 2005, and 22 property and casualty insurance companies suffered losses that exceeded the sum of premiums collected from their policyholders and their capital.

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