A single storm can generate more claims than any one insurer could pay from its own resources. Reinsurance is the mechanism that makes such exposures underwritable at all.
Concentration is the underlying problem
Insurance works by pooling risks that are independent, so that a bad outcome for one policyholder is offset by ordinary outcomes for the rest.
Catastrophes destroy that independence, because one event damages thousands of insured properties in the same region simultaneously.
An insurer with geographically concentrated exposure faces losses that arrive together rather than spreading out, which is exactly what a pool cannot absorb.
The risk is passed up a chain
Reinsurers accept portions of insurers' exposures in exchange for a share of premium, and they diversify across regions and perils that are unlikely to fail at once.
A reinsurer covering wind in one hemisphere and earthquake in another holds risks that are genuinely independent, restoring the pooling effect at a larger scale.
Reinsurers in turn buy their own protection, so a large event is ultimately absorbed by capital spread across many balance sheets worldwide.
Layers define who pays what
Excess of loss cover attaches at a defined level, with the insurer retaining losses below it and the reinsurer paying above it up to a limit.
Programmes are built from stacked layers placed with different counterparties, so no single reinsurer carries the whole exposure and each knows precisely what it has accepted.
Losses above the top layer return to the insurer, which is why the height of a programme is a critical decision rather than a technical detail.
Proportional cover works differently
Under a proportional arrangement the reinsurer takes an agreed share of every premium and every claim, rather than attaching above a threshold.
This supports insurers writing more business than their capital alone would allow, since the reinsurer is effectively funding part of the portfolio.
The two structures serve different purposes, with proportional cover managing capacity and excess of loss managing severity.
Capital markets have joined the chain
Securities that transfer catastrophe risk to investors pay a return unless a defined event occurs, in which case the principal is used to meet losses.
Investors are drawn to these because the risk is largely uncorrelated with financial markets, which makes them useful within a broader portfolio.
The result is that reinsurance pricing now reflects conditions in capital markets as well as recent loss experience, and both feed through to what primary insurers charge.