What is reinsurance? Why is it important in Florida?
Reinsurance is insurance for insurance companies. Almost all insurance companies reinsure at least some of their risk. The reasons for purchasing reinsurance vary. Companies can use reinsurance as a way of trying to achieve more-predictable returns on their investment capital; as a way of being able to write more business by tapping the reinsurers’ capital (this is called “surplus relief”); and, most importantly for Florida, to pay their claims after catastrophes. In Florida the most likely and worrisome such risk is hurricane catastrophe risk.
What is catastrophe risk?
Catastrophe risk is the chance of something really bad happening to a lot of insured things—households, individuals, cars, businesses—at the same time. Insurers, fundamentally, premise their business model on the idea that bad things don’t often happen simultaneously. In Florida, policies that cover homes against fire provide a good example of this: While all homes have some risk of burning down, it’s hugely unlikely that all of the homes insured by a single company will burn down at the same time. Fires may spread to neighboring houses (although it’s pretty rare), but it’s unlikely those neighboring houses will be insured by the same company.
A catastrophe happens when uncorrelated risks become correlated, often because of an extreme natural event. In Florida, hurricanes are a key example of catastrophes: A single hurricane can cause simultaneous wind damage to thousands of homes insured by the same company. To handle this risk, any insurer writing in hurricane-prone areas of Florida (and almost all of Florida is prone to hurricanes) will purchase reinsurance.