An insurer that has sold cover across a region faces a problem the individual policyholder never sees. A single event can produce claims from a large share of its customers at once, and the answer is reinsurance.
Concentration undermines the pool
Insurance works because losses are spread across many unrelated risks. An insurer writing extensively in one area holds risks that are anything but unrelated.
A storm, flood or earthquake generates simultaneous claims from thousands of policies, and the aggregate can dwarf a year of collected premiums.
The insurer's own capital would have to absorb that, so it either limits how much it writes in one place or transfers part of the risk elsewhere.
Reinsurers pool across geographies and perils
A reinsurer accepts portions of risk from many insurers in many countries, which restores the diversification that a regional insurer cannot achieve alone.
A hurricane and an earthquake on different continents are unrelated events, so a book containing both is far more stable than either on its own.
The reinsurer is therefore not simply a larger insurer. It exists because diversification across regions is the only way to make correlated risks poolable again.
The same logic explains why reinsurers invest heavily in catastrophe modelling, since their whole position depends on knowing which of their exposures would be hit by the same event.
Two structures cover different problems
Proportional arrangements pass a fixed share of premiums and claims to the reinsurer, which reduces the insurer's exposure across the whole book evenly.
Excess-of-loss arrangements respond only above a defined threshold, leaving routine claims with the insurer and transferring the tail.
The second structure is what protects against catastrophe, since routine claims are predictable and it is the extreme event that threatens solvency.
Capacity and price move in cycles
After a period without major events, reinsurers accumulate capital and compete for business, which lowers prices and widens terms.
A large loss depletes capital across the sector simultaneously, and prices rise sharply as available capacity shrinks.
Because primary insurers must buy this cover to write business at all, those swings pass through to household premiums with a lag of a year or two.
Capital markets now share the load
Some catastrophe risk is transferred to investors through instruments that pay a return unless a defined event occurs, in which case the principal funds claims.
The appeal to investors is that such events are unrelated to markets, so the exposure diversifies a portfolio of financial assets.
This has enlarged the capital available for catastrophe cover, which moderates price spikes, though availability still tightens after large losses and terms vary by jurisdiction.