A hurricane in one country is paid for partly by capital held on another continent. Reinsurance is the mechanism that moves the loss, and it explains why local premiums respond to distant events.
Why an insurer needs insurance
An insurer writing policies in one region holds a portfolio of correlated risks. A single event can damage a large share of them at once, which is precisely what capital is meant to absorb.
Holding enough capital for the worst plausible event would be prohibitively expensive and would sit idle in normal years. Transferring the tail is cheaper than funding it.
Reinsurance therefore lets a smaller insurer write larger exposures than its own balance sheet supports. Capacity in a local market depends on capacity in the global one.
How the two main structures differ
Proportional reinsurance shares premiums and losses on an agreed split from the first currency unit. The reinsurer participates in ordinary results as well as extreme ones.
Excess of loss reinsurance responds only above a retention, covering a layer up to a limit. The insurer keeps routine claims and passes on severity.
Large programmes stack several layers with different reinsurers, so no single participant carries the whole exposure. The structure is assembled annually.
Why losses travel so far
Reinsurers deliberately write business across many regions and perils to reduce correlation within their own books. An earthquake and a windstorm on opposite sides of the world are unlikely to coincide.
That diversification is what allows the same capital to support risk in many countries at once. Each region effectively borrows capacity from the others' quiet years.
It also means capital is fungible across borders. A costly season in one region reduces the capital available everywhere.
How capital market instruments extend the pool
Catastrophe bonds transfer defined event risk to investors, who receive coupons and lose principal if the trigger is met. The risk moves outside the insurance sector entirely.
Triggers may be based on actual losses or on measured physical parameters. Parameter-based triggers pay faster but may not match the loss exactly.
These instruments appeal to investors because catastrophe risk is largely uncorrelated with financial markets. That independence is the product being sold.
Why the cycle turns sharply
After heavy losses, reinsurance capital is depleted and prices rise until new capital is attracted. Primary insurers pass the higher cost into local premiums.
Availability tightens along with price, with terms narrowed and retentions raised. Coverage in exposed regions can become difficult to obtain regardless of price.
Regulatory treatment of reinsurance credit differs by jurisdiction and changes over time, which affects how much relief a local insurer actually receives.