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Friday 8 December 2023 Dublin: 9°C
Mike Groll/AP/Press Association Images Some of the destruction caused by Hurricane Sandy.

Explainer: What is reinsurance, and how does it help cover natural disasters?

With the costs of Hurricane Sandy expected to be at least €20 billion, insurers will be looking to reinsurance companies to cover most of the bill. But what are they?

AS HURRICANE SANDY made landfall this week, by far the biggest cost of this was the human one.

As the weeks and months pass, however, it is the rebuilding of that which was destroyed that will become the focus.

With early estimates of the damage at €20 billion, governmental aid and the work of NGOs will make the news, but what part will insurance, or more specifically, reinsurance, play?

What is reinsurance and  why does it exist?

Put simply, a reinsurance company is a company that insures another insurance company.

Why do insurance companies need reinsurance? They need it because of catastrophic events such as Hurricane Sandy.

If, for example, a single insurance company was to provide insurance for 20 houses in a single estate in Florida, they would get 20 premiums.

Although it may feel like it when the bill comes through the door, this premium is calculated not on the cost of having to pay out for every client, but the probability of having to pay out on a certain percentage of them.

Events such as Hurricane Sandy throw these calculations out of kilter, making things that were uncorrelated (something happening to No 7 Fake Street having no impact on No 10) correlated (No 1-20 being destroyed by a natural event).

Without having a fail-safe, paying out on all 20 houses could both bankrupt the insurer and leave people who had paid their premiums out of pocket.

There is also another reason why insurance companies get reinsurance, however.

Having another company to guarantee against certain losses results in less of the insurance companies working capital from being tied up, which means they can invest it elsewhere.

What’s involved?

It starts with the single, jargon-filled sentence: A cedant cedes a cession.

A cedant is, in this scenario, the insurance company that wants to transfer some of the risk that they have take on, otherwise known as their “exposure”.

What they perceive their exposure to be, will depend on what they believe could happen.

For example, Florida is prone to hurricanes. As a result, insurance companies in Florida will seek to get reinsurance that will pay out in the event of a hurricane.

They may also get reinsurance for secondary events (things caused by the primary), such as flooding or fire.

Something like an earthquake, however, is unlikely to be reinsured against in this case, as Florida is not as prone to them.

To cede is to assign or to relinquish. The insurance company is assigning their risk of having to pay out if any of the houses that they have insured in Florida are damaged by a hurricane.

The cession, in this case, are the houses in Florida or, more precisely, the contracts for them that the insurance company is on the hook for.

How does it work?

When determining the premium that they wish to charge an insurance company for covering part of their risk, reinsurance companies generally generate a number of scenarios, based on historical data, to determine the level of destruction that could potentially occur.

This isn’t the end of the story, however.

They will then decide how much of this risk they wish to insure against. They do this by insuring one or more layers.

The example above contains three layers, and are commonly referred to in the terms of some amount in excess of another amount.

For example, the middle layer would be referred to a five X (for excess) five layer – this means that the reinsurance company will cover all losses between five million and 10 million, with either another reinsurer, or perhaps, the actual insurer, covering the first five million (also known as the ground-up loss).

The higher up you go, the lower the premium that the reinsurer is likely to charge, as it is less likely that they will have to pay out the full amount.

Should a reinsurance company, for example, cover the five X 10 layer, and the total damages of the event come to €12.5 million, the resinsurance company will have to pay €2.5 million.

The reinsurance company that covered the five X five layer will have to pay the full €5 million.

Reinsurance companies can also decide to cover part of a layer with one or more reinsurers. This is known as gross participation.

If, for example, the reinsurance company that covers the five X 10 layer had a gross participation of 33.3 per cent and the total damages were €12.5 million. They would only have to pay one-third of the damages which entered their layer (€2.5 million divided by three).

Reinsurance companies can also pass off some of their risk to another reinsurance company. This is known as retrocession.

It’s still hard to tell how much Hurricane Sandy is going to end up costing reinsurance companies. Depending on how long services and businesses remain out of action, business interruption – another risk that reinsurers insure against – may end up costing billions more.

The most expensive natural disaster for reinsurance companies is likely to remain Hurricane Katrina, however, which ended up costing in the region of $125 billion.

Pics: The aftermath of Superstorm Sandy’s east coast rampage >

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