Reinsurance of Catastrophe Risks

REINSURANCE OF CATASTROPHE RISKS

Introduction

Extreme events happen very seldom, however, they can inflict tremendous damage when they strike. The events are either natural occurrences (earthquake, flood, volcanoes, landslides, tsunamis) or man-made event (fire disasters, plane crashes, riots).

Increasing earthquake damage in recent years is evidence of rising vulnerability for the communities as more people with more valuable property are residing in earthquake-prone areas as it is observed by the rapid population growth. In developing countries most of the growth is in very large urban centres, for example, the Nairobi of today is very different from what it was 15 years ago both in population and property.

The destruction from a catastrophe is of great concern to individuals, communities, governments and private sectors. It interrupts life and can take quite a while before normalcy is restored. It is there critical to know how to manage this possible occurrence.

A catastrophe is defined as the final event of the dramatic action especially of a tragedy or a momentous tragic event or a violent and sudden change in a feature of the earth. A catastrophe is also defined as a sudden, violent, physical manifestation that causes widespread and severe property damage.

How are Catastrophic Risks Funded?

A catastrophic event affects insured and non insured lives and properties. Those who are turned to for support after a catastrophic event are: the governments/public agencies, insurance industry and capital markets as they all have a role to play with respect to providing financial protection against catastrophic losses. How do the players in the insurance industry prepare for such eventualities?

Insurance companies provide funding through direct insurance coverage to residential and commercial property owners for losses due to natural disasters, such as compensation for death or injury, or damage due to a catastrophic event like earthquake or plane crash. The reinsurers then provide protection to primary insurers by insuring a portion of their claims in exchange for a premium.

Why take Catastrophe Protection?

Insurance companies should know their exposure to catastrophic perils affecting properties they have insured; if ignored, these perils can be life threatening because:

• Compared with non-catastrophe type of perils, catastrophe perils are unpredictable as to location, frequency, and severity.

• While the amount of insurance liability is measured by summing the policy limits, the amount of catastrophe exposure cannot be determined with any precision until after the event.

• The law of large numbers is limited in its benefit to the reinsured in catastrophes because they have infrequent occurrences as they affect an individual insurance company.

• The potential of un-reinsured catastrophe exposures is fatal to the insurer and if not managed properly, catastrophe perils can destroy the insurance enterprise.

After assessing the catastrophe exposure, the next critical thing is to seek for protection to cater for the eventualities.

Management through Traditional Reinsurance

Protection for the catastrophe risks is provided by reinsurers through Catastrophe excess of loss which covers the reinsured’s retention against natural catastrophes accumulations resulting from numerous losses caused by the same event. The reinsured add all net losses from an event, after proportional reinsurance, and recover from the reinsurer amount exceeding the deductible of the Catastrophe excess of loss up to the upper limit of cover. The cover is subject to an accumulation event: ensured by inclusion of a two risks warranty, alternatively, the reinsurance prior to the cover is structured such that no individual loss per risk exceeds the deductible.

The definitions of loss events are based on a given number of hours and the term used, “hours clause”, defines an event in terms of a number of consecutive hours following the first loss notification. An enhanced description gives an event as; all insured losses arising directly from the same cause and which occur during the same time period and in the same area.

The primary purpose of catastrophe excess covers is to provide severity protection from a given event that causes an accumulation of individual net losses. While an insurance company may be protected on a risk basis above a given retention level by a working excess cover or by a proportional