New on FinoLib · Volume III: Finance Encyclopedia
I have added a new article to FinoLib, my finance education website: Reinsurance Explained: How Insurers Insure Themselves, part of Volume III: Finance Encyclopedia. This page gives you the core of the topic in expert but plain language; the full article goes much deeper.
The idea in plain words
Reinsurance is insurance that insurers buy for themselves. In a quota share, the reinsurer takes the same proportion of every policy. In excess of loss, it pays only the part above a set limit, called the retention. Cover comes as treaties for whole portfolios or as facultative cover for single risks. Catastrophe bonds are not reinsurance. They are insurance-linked securities: fully collateralized notes sold to investors in the capital markets.
Key points
■A $50m-excess-of-$50m layer costing $6m (a 12% rate on line) caps a $150m event at $106m net.
■Reinsurers buy their own protection, called retrocession.
■Cat bond collateral sits in a trust from day one, so the sponsor carries no counterparty credit risk but may carry basis risk.
■Triggers range from indemnity (lowest basis risk) to parametric (fastest, most basis risk); Jamaica’s $150 million bond paid in full after Hurricane Melissa in 2025.
A closer look
Reinsurance is insurance that insurance companies themselves buy, from specialist reinsurers, to protect against losses too large or too concentrated for a single insurer to comfortably absorb — most classically, a catastrophic event (a major hurricane or earthquake) that could otherwise generate claims across an insurer’s entire regional policy book simultaneously.
A worked example
Worked Example — What an Excess-of-Loss Layer Pays
An insurer buys a catastrophe excess-of-loss layer of “$50 million excess of $50 million”: the reinsurer pays event losses between $50 million and $100 million. The premium is $6 million, a rate on line (premium ÷ limit) of $6m ÷ $50m = 12%. Recovery = min(max(loss − $50m, 0), $50m). Event loss Reinsurance recovery Insurer’s net loss Net loss including the $6m premium $30m $0 $30m $36m $80m $80m − $50m = $30m $50m $56m $150m $50m (limit reached) $100m $106m The layer pays for itself in any year with an event loss above $50m + $6m = $56 million, and above $100 million the insurer is on its own again.
Under the hood
Under the Hood: Cat-Bond Triggers and the Basis-Risk Trade-Off
The trigger defines what counts as a loss. Each choice trades basis risk (the gap between what the bond pays and what the sponsor actually lost) against moral hazard and speed. Trigger Pays on Basis risk for the sponsor Investor concern Indemnity The sponsor’s own claims Lowest: a near-complete hedge Moral hazard: the sponsor controls underwriting and claims handling; slow to settle Industry index Estimated industry-wide loss from a reporting agency Moderate: depends on how closely the sponsor’s book tracks the industry Low moral hazard, third-party verified Parametric Physical measures of the event, such as wind speed, central pressure or ground shaking at defined locations Highest: the event can miss…
Decision rule
If the problem is too much premium for the capital, then a quota share frees capital in proportion to what is ceded. If it is one event large enough to breach capital, then buy excess-of-loss layers up to the modeled loss at the return period your regulator and board require (Solvency II calibrates to 1-in-200, Part 1.8: Solvency Regulation — Solvency II and Risk-Based Capital). If the top of that tower is scarce or expensive, or you want multi-year, fully collateralized protection, then add a cat bond.
The costliest mistake
Counting parametric protection as if it were indemnity. An insurer swaps its $50m-excess-of-$50m indemnity layer for a $50 million parametric bond that pays only if a storm’s pressure falls below a set level inside a defined box. A storm passes just outside the box and the insurer loses $90 million. The indemnity layer would have paid min(max($90m − $50m, 0), $50m) = $40 million; the bond pays $0. The insurer carries $40 million more than planned in the very year it needed protection. Measure basis risk on historical and simulated events before substituting one for the other.
Recap
Reinsurers take a share of insurers’ risks through quota share or excess-of-loss contracts, written as treaties for portfolios or facultative cover for single risks, and buy retrocession for themselves. Catastrophe bonds are insurance-linked securities, not reinsurance: fully collateralized capital-market notes whose trigger choice trades basis risk against speed and moral hazard.
What the full article covers
The full article includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, Reinsurance Explained: How Insurers Insure Themselves, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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