Catastrophe Reinsurance

You bet your friend that the Dallas Cowboys won’t win the Super Bowl for the next five years. But it’s a bit more complex than just a straight up bet. There are terms.

The deal goes like this: You will pay him $100 every time that the Cowboys win the Super Bowl, and he’ll pay you $10 a year at the start of every season for five straight years.

Now, you’ve made an interesting bet. You’re guaranteed to get $50 over five years. But if the Cowboys win five consecutive Super Bowls, you’ll end up paying $500 total ($450 net).

Given that this is a lot of money you could lose, you turn to a friend of yours and ask him to insure some of your potential losses. You say that you’ll give him $2 a year out of the $10 payments...as long as he’s willing to pay $50 if the Cowboys win the Big Game, and you aren’t able to meet your obligations to the original friend. He accepts that deal, knowing how rare it would be for the Cowboys to win even one Super Bowl, let alone one.

One Cowboys win wouldn't bankrupt you. But two might be a catastrophe, not just for your bank account, but also for the morale of everyone in America. Your payments to the person to back up your payments if too many wins are similar to what is known as a catastrophe reinsurance policy.

Insurance companies will buy reinsurance to protect against the aftermath of a massive catastrophic event, or a series of them. Think of an insurance company that must pay for damage from hurricanes...and then a second hurricane hits just months later.

Catastrophe reinsurance lets insurance firms shift some of the risks to other companies in exchange for part of the premiums they receive from policy buyers.