Insurance companies manage their risk in many ways. Risk Management can be accomplished by targeting certain regions or types of product offerings, introducing more conservative underwriting guidelines or individual risk evaluation, and by having others share in the risk for a fee. This risk/reward metric is used to stabilize growth, smooth financial results and protect the insurance company from catastrophic losses due to a hurricane, tornado or hail event.
In regions where there is significant exposure to catastrophic risk, one of the best and most efficient ways to spread the risk of a hurricane, tornado or hail event, is to utilize partnerships with reinsurance markets. Reinsurers in London, Bermuda, Germany, Switzerland, the United States, and other international markets, provide most of the traditional reinsurance capacity. Hedge funds, pension funds and other institutional investment funds comprise the majority of what is remaining.
To clarify, reinsurance is the insurance that insurance companies buy to spread the risk of loss on insurance policies that have been underwritten. Reinsurance enables the insurance carrier to underwrite more insurance, stabilize underwriting results and secure the necessary catastrophe protection against major losses. For that spread of risk, the insurance company pays the reinsurance partner(s) a portion of the premium it collects from the primary policyholder. The reinsurance company will then agree to reimburse the insurance company for losses and expenses incurred after an event that is covered within the reinsurance agreement.
As part of the reinsurance agreement, the insurance company has a similar deductible requirement as a primary policyholder. The insurance company’s deductible is called a retention. The retention for catastrophic protection is customarily a multi-million-dollar requirement and at a level that does not exceed a certain percentage of the insurance carrier’s surplus.
An insurance company’s surplus is essentially the sum remaining after all liabilities are deducted from assets. It is the insurance company’s net worth. The surplus, in combination with current loss and loss expense reserves, provide financial protection to policyholders in the event a company suffers unexpected or catastrophic losses.
Rating Agencies and Insurance Department Regulators study the overall strength of an insurance company and examine each company’s level of reinsurance protection. An appropriate and conservative amount is needed to not only protect the insurance company from a major catastrophic event, but also the threat of multiple events occurring in a given season/year. The support of reinsurance partners is a vital component insurance companies use to provide that much-needed protection.
Written by Eric Gobble, Chief Risk Officer