Reinsurance – the business with calculable extreme risks

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The reinsurance business is a complex business. The difficult economic environment at the moment makes things even more difficult. The consequences of the interest rate hikes and fluctuations on the capital markets are reflected in the results of reinsurers. A look behind the scenes of the reinsurance business could reveal investment opportunities for investors.

Reinsurance – how does it actually work?

Everyone knows them – insurance against one or the other risk has become an integral part of everyday life. Whether motor vehicle, liability or legal protection – almost everyone has had to deal with insurance at one time or another. However, what many are not aware of is what is known as reinsurance. Admittedly, reinsurance plays a rather subordinate role for private individuals because they cannot take it out directly. However, they play an important role for the insurer, because reinsurance, to put it simply, is insurance for insurance companies. What this means in detail will be examined in more detail below.

The business model of insurance companies is based on the so-called “solidarity principle”. The underlying idea is that a large number of insured persons pay a fixed premium at a defined rhythm. The insurance company pays the insured person a sum of money from the premiums received when an insured event occurs. This principle works just as long as an insured event occurs less frequently than the premium amounts are due. Engineers, mathematicians and statisticians work for insurance companies in order to be able to express and measure the risks numerically. So much for the traditional insurance business. But why do we need reinsurers now?

The origin of reinsurance lies in the great catastrophes of this world. For example, the great fire in Hamburg in 1842 was one of the triggers for the founding of the oldest reinsurance company in the world: the Cologne Re. The Swiss Re, also known today, had a similar experience. This was founded two years after the severe fire in Glarus in 1863. However, reinsurers not only insure fire catastrophes, but also various large-scale risks for which primary insurers do not have a great appetite for risk either. However, reinsurers also have a limited appetite for risk when it comes to so-called top risks. These include, for example, the hurricane risk on the east coast of the USA, which harbors enormous damage potential and brings with it considerable cluster risks. Modern examples of top risks include cyber risks, which are difficult to calculate due to poor data. The pandemic risk is also such a top risk. The Covid-19 pandemic, which has been ongoing since 2020, has caused losses for reinsurers in the areas of business interruption, event cancellation and life insurance. The resulting estimated loss volume for the global reinsurance industry was over US$ 40 billion (end of September 2021), making it the third costliest event in reinsurer history.

In order to be able to handle major risks better, Swiss insurance companies, among others, have introduced the so-called elementary damage pool. The population and all insurance companies benefit from this, in that, in addition to the damage compensation mechanism among the individual insurance companies, the elementary damage pool also buys reinsurance for all its members. The problem with a pandemic, on the other hand, is the lack of risk compensation. Natural disasters mostly occur in specific regions, while a pandemic affects many different segments at the same time and worldwide. For this reason, such extreme events cannot be globally diversified.

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