Chapter 10: Catastrophe Reinsurance

Catastrophe excess of loss reinsurance (catastrophe excess) protects primary insurers from financial consequences resulting from an accumulation of losses from a single event.
These treaties safeguard policyholders’ surplus and stabilize underwriting results to ensure a predictable loss experience.
Coverage is triggered when accumulated losses from a single occurrence exceed a specified attachment point.
Catastrophe reinsurance typically applies to all property business or specific geographic subsets, such as property exposures in Alabama, Mississippi, and Louisiana.
Most treaties contain a co-participation provision to encourage sound claim handling after the attachment point is exceeded.

Term Clause: Usually defines a one-year term to prevent cancellation during catastrophe seasons; included extended expiration provisions protect against losses in progress at the time of treaty expiration.
Retention and Limits Clause: States net retention as the ultimate net loss per loss occurrence and includes co-participation requirements.
Ultimate Net Loss Clause: Defines actual losses retained by the insurer after deducting salvage and inuring reinsurance (e.g., facultative or pro rata agreements).
Loss Occurrence Clause: Defines what constitutes a single catastrophe event for coverage purposes.
Other Reinsurance Clause: Specifies how the treaty interacts with underlying layers to avoid coverage gaps.
Reinstatement Clause: Provides for automatic restoration of the reinsurance limit after a loss, typically for an additional premium.

Catastrophe pricing uses exposure rating and trend analysis rather than experience rating due to the low frequency of events.
Two primary measures for evaluating pricing include:
- Payback Period: $\text{Payback Period} = \frac{\text{Reinsurance Limit}}{\text{Reinsurance Premium Paid}}$
- Rate on Line (ROL): $\text{Rate on Line} = \frac{\text{Reinsurance Premium Paid}}{\text{Reinsurance Limit}}$
ROL is the mathematical inverse of the payback period and serves as a quick gauge of treaty pricing.
Lower layers typically have higher ROLs and shorter payback periods because they are more likely to experience losses.

Hazard Component: Simulates event intensity, frequency, and location using scientific data from meteorologists, seismologists, and geophysicists.
Engineering Component: Uses damage functions to estimate structural damage based on construction, occupancy, age, and building code enforcement.
Financial Component: Translates physical damage into monetary insured losses, accounting for policy conditions and socio-economic factors like demand surge.
Average Annual Loss (AAL): Also called catastrophe loss cost or pure premium; represents the long-term expected loss for in-force policies.
Exceedance Probability (EP) Curve: Represents the spectrum of potential losses and their probability of being equaled or exceeded.
Return periods (e.g., a $100$ -year event) are the inverse of the exceedance probability ( $0.01$ annual probability for a $100$ -year loss).

Primary insurers are often required to participate in state-mandated facilities based on market share.
Coastal Pools: Formed in Gulf of Mexico and Atlantic states for properties in high-risk areas.
FAIR Plans: Established in states following urban riots in Los Angeles, Detroit, and Newark, New Jersey; these provide property insurance in areas where voluntary coverage is unavailable.
Catastrophe treaties often cover assessments from these facilities resulting from specific loss occurrences.

Lines of Credit: Bank arrangements providing loans following a loss; these represent capital access rather than risk transfer.
Catastrophe Bonds: Issued through Special Purpose Vehicles (SPVs); interest or principal is forgiven to pay losses if a catastrophe exceeds a specified amount.
Catastrophe Options: Financial instruments where payments are tied to a catastrophe index, such as Property Claims Services (PCS) provided by Insurance Services Office, Inc. (ISO).
Industry Loss Warranties (ILW): Reinsurance-linked securities triggered by industry-wide loss thresholds rather than the specific insurer's losses.
Reinsurance Sidecars: Limited-existence SPVs that provide additional capacity for property catastrophe business via quota share agreements with investors.