by Trevor Juntunen

Created on: August 06, 2009

Insurance companies acquire risk as they write policies. The goal is to be able to collect more in premium than it costs to pay claims and run the business. Unfortunately this does not always pan out, and this is where reinsurance steps in.

What an insurance company tries to do is generate an underwriting gain for the year. An underwriting gain is when the collected premium exceeds the costs of that years claims plus the agent's commission plus the overhead cost of running the company. Using the following illustration I will put some numbers to this concept.

The company writes a homeowners policy. For a $100,000 coverage on the dwelling with a $500 deductible a premium of $400 is charged for the year. The agent's commission on this account is 12%. The overhead costs of the company are on average 40% of the yearly premium. This means that the company has only 48% of the collected premium left to pay claims and try to make a profit, or $192.

Now on the same homeowners policy the company is providing up to $100,000 for the dwelling, $10,000 for other structures, $70,000 on the contents and $20,000 for loss of use. A fire breaks out damaging the home and melting the vinyl siding on the garage. The cost to repair the home comes to $88,000. New siding on the garage is $2,700. Contents that are replaced cost $62,000 and the company spends $11,500 to rent another home for the insured while their house is being repaired. The insurance company just lost $164,200 on that claim against the $192 they made writing the policy. This means the insurance company needs to write 855 additional claim free policies earning them $192 just to break even for the year. This leads to the catch-22 of writing insurance. By writing 855 more policies, you now have 855 more possible claims, or more risk.

Risk becomes more evident when a forest fire or a tornado occurs. These natural catastrophes can generate one to hundreds of claims for an insurer to have to pay, costing potentially millions of dollars. States require that insurance companies keep a certain amount in savings to pay claims. This amount varies by state insurance requirements. Even with this money in savings, a major catastrophe could wipe a company out.

There are two types of re-insurance a company can buy. The first is on a per risk basis. An insurance company selects a deductible that they pay on any one claim and the re-insurance pays the rest. These deductibles are normally $100,000 or greater.

The second type of re-insurance is catastrophe (cat) coverage. Cat coverage kicks in when multiple risks are damaged. It usually also has a deductible of $100,000 or more, and is purchased in layers. A first layer could cover damages from $100,000 to $500,000 and a second layer could cover from $500,000 to $1,000,000. If the total damages from a single catastrophe were to happen to an insured with these limits, the insured would have up to $900,000 they could recover from re-insurance.1

In example a hail storm may cause only $4,000 of damage per home, but the insurance company has 120 homes in the affected area. They now have $480,000 in claim payments to make. The first type of re-insurance pays nothing as all the claims individually come in under deductible. The cat coverage reimburses the insurer $380,000 of their losses.

The numbers I used were created for the sake of example to help explain how this coverage works.

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