Reinsurance is insurance that insurers buy for themselves. In a quota share, the reinsurer takes the same proportion of every policy. In excess of loss, it pays only the part above a set limit, called the retention. Cover comes as treaties for whole portfolios or as facultative cover for single risks. Catastrophe bonds are not reinsurance. They are insurance-linked securities: fully collateralized notes sold to investors in the capital markets.
Why it matters: Reinsurance spreads big losses across more shoulders so no single insurer is crushed.
Summary: Reinsurance is insurance bought by insurers: quota share splits every policy proportionally, excess of loss pays above a retention, and contracts come as treaties for whole portfolios or facultative cover for single risks. Catastrophe bonds are not reinsurance but insurance-linked securities: fully collateralized notes sold to capital-market investors.
- A $50m-excess-of-$50m layer costing $6m (a 12% rate on line) caps a $150m event at $106m net.
- Reinsurers buy their own protection, called retrocession.
- Cat bond collateral sits in a trust from day one, so the sponsor carries no counterparty credit risk but may carry basis risk.
- Triggers range from indemnity (lowest basis risk) to parametric (fastest, most basis risk); Jamaica’s $150 million bond paid in full after Hurricane Melissa in 2025.
- Aon counted $63.4 billion of cat bonds and $144.5 billion of alternative capital as of June 30, 2026.
Reinsurance is insurance that insurance companies themselves buy, from specialist reinsurers, to protect against losses too large or too concentrated for a single insurer to comfortably absorb — most classically, a catastrophic event (a major hurricane or earthquake) that could otherwise generate claims across an insurer’s entire regional policy book simultaneously.
| Reinsurance structure | How It Works |
|---|---|
| Quota Share | The reinsurer takes a fixed percentage of every policy’s premiums and, in exchange, pays that same percentage of every claim — a proportional risk-sharing arrangement |
| Excess of Loss | The reinsurer only pays once claims from a single event exceed a specified threshold, covering losses above that point up to a further agreed limit — the primary tool for catastrophe protection |
How reinsurance is bought. The table describes how losses are shared; the contract form describes how risks get in. A treaty covers a whole portfolio, such as all of an insurer’s Florida homeowners policies for a year, automatically: every policy that fits the terms is ceded without individual review. Facultative reinsurance is negotiated one risk at a time, for a single large or unusual exposure (a refinery, a stadium) that falls outside the treaties or would strain them. Reinsurers in turn buy their own protection, called retrocession, to limit concentrations and catastrophe losses, so a large event is shared through several layers of the market. In the US, a reinsurer’s location and status matter to the insurer that buys from it: under NAIC rules, an insurer generally gets balance-sheet credit for reinsurance from an unauthorized reinsurer only if that reinsurer posts collateral, typically 100% of its obligations, while authorized, certified and reciprocal-jurisdiction reinsurers face reduced or no collateral requirements.
An insurer buys a catastrophe excess-of-loss layer of “$50 million excess of $50 million”: the reinsurer pays event losses between $50 million and $100 million. The premium is $6 million, a rate on line (premium ÷ limit) of $6m ÷ $50m = 12%. Recovery = min(max(loss − $50m, 0), $50m).
| Event loss | Reinsurance recovery | Insurer’s net loss | Net loss including the $6m premium |
|---|---|---|---|
| $30m | $0 | $30m | $36m |
| $80m | $80m − $50m = $30m | $50m | $56m |
| $150m | $50m (limit reached) | $100m | $106m |
The layer pays for itself in any year with an event loss above $50m + $6m = $56 million, and above $100 million the insurer is on its own again. In most years it pays nothing, and its expected payout is below its premium because the reinsurer must be paid for capital and costs. Its value is that it caps the event that would otherwise breach capital: without it, the $150 million event costs $150 million; with it, $106 million.
Reinsurance, together with insurance-linked securities such as cat bonds, functions as a risk-distribution mechanism across the entire global financial system — spreading catastrophe risk that would otherwise concentrate dangerously within a single regional insurer out across a global pool of reinsurers and capital markets investors, meaningfully reducing the odds that any single major disaster triggers an insurer insolvency.
Catastrophe bonds are not reinsurance. A cat bond is an insurance-linked security (ILS): a security sold to capital-market investors, not a contract with a reinsurer, which is why the market calls this “alternative capital.” The sponsor (an insurer, reinsurer or government) sets up a special purpose vehicle that issues notes to investors and holds the proceeds in a collateral account invested in highly rated, liquid securities such as US Treasury bills. Investors earn the collateral yield plus a risk premium paid by the sponsor. If a defined catastrophe occurs, some or all of the collateral goes to the sponsor and investors lose that principal; if not, it is returned at maturity, on average about three years later. Because the money is in the trust from day one, the sponsor carries no risk that the protection seller cannot pay, the credit risk that a reinsurance recoverable carries. The market grew out of the shortage of coastal reinsurance after Hurricane Andrew in 1992. As of June 30, 2026, Aon counted $63.4 billion of cat bonds outstanding and $144.5 billion of alternative capital in total, against $790 billion of global reinsurance capital as of March 31, 2026.
The trigger defines what counts as a loss. Each choice trades basis risk (the gap between what the bond pays and what the sponsor actually lost) against moral hazard and speed.
| Trigger | Pays on | Basis risk for the sponsor | Investor concern |
|---|---|---|---|
| Indemnity | The sponsor’s own claims | Lowest: a near-complete hedge | Moral hazard: the sponsor controls underwriting and claims handling; slow to settle |
| Industry index | Estimated industry-wide loss from a reporting agency | Moderate: depends on how closely the sponsor’s book tracks the industry | Low moral hazard, third-party verified |
| Parametric | Physical measures of the event, such as wind speed, central pressure or ground shaking at defined locations | Highest: the event can miss the trigger while still causing loss | Transparent and fast |
| Modeled loss | A catastrophe model’s estimate of the sponsor’s loss, run on actual event data | Moderate | Model dependence; now rare |
A parametric trigger at work. Hurricane Melissa struck Jamaica on October 28, 2025; the National Hurricane Center’s advisory that morning, issued as landfall approached, reported sustained winds of 185 mph and a central pressure of 892 millibars. The NHC’s post-storm Tropical Cyclone Report puts that 892-millibar reading at the storm’s peak, about five hours before landfall, and estimates 897 millibars at landfall near New Hope. Jamaica’s $150 million World Bank cat bond, issued in 2024, used triggers based on the storm’s central pressure and path. On November 7, 2025, ten days after landfall, the World Bank announced that the third-party calculation agent had confirmed the triggers were met and the full $150 million would be paid. For a government that needs cash for relief within days, that speed is the point; the price is basis risk, because a storm that tracked just outside the defined zone could have caused severe damage and paid nothing.
If the problem is too much premium for the capital, then a quota share frees capital in proportion to what is ceded. If it is one event large enough to breach capital, then buy excess-of-loss layers up to the modeled loss at the return period your regulator and board require (Solvency II calibrates to 1-in-200, Part 1.8: Solvency Regulation — Solvency II and Risk-Based Capital). If the top of that tower is scarce or expensive, or you want multi-year, fully collateralized protection, then add a cat bond. Prefer indemnity triggers unless payout speed is worth more than basis risk, as it often is for governments.
Counting parametric protection as if it were indemnity. An insurer swaps its $50m-excess-of-$50m indemnity layer for a $50 million parametric bond that pays only if a storm’s pressure falls below a set level inside a defined box. A storm passes just outside the box and the insurer loses $90 million. The indemnity layer would have paid min(max($90m − $50m, 0), $50m) = $40 million; the bond pays $0. The insurer carries $40 million more than planned in the very year it needed protection. Measure basis risk on historical and simulated events before substituting one for the other.
How does a catastrophe bond work?
Investors buy notes from a special purpose vehicle that holds the money as collateral. They earn the collateral yield plus a risk premium paid by the sponsor. If a defined catastrophe occurs during the term, part or all of the collateral goes to the sponsor; otherwise investors get their principal back at maturity, typically after about three years.
Is a cat bond the same as reinsurance?
No. Both transfer catastrophe risk, but a cat bond is a fully collateralized insurance-linked security sold to capital-market investors, while reinsurance is a contract backed by a reinsurer’s balance sheet. Cat bonds therefore carry no counterparty credit risk, but they may carry basis risk if the trigger is not indemnity-based.
What is the difference between treaty and facultative reinsurance?
A treaty covers a defined portfolio automatically for a period, so every qualifying policy is ceded without separate review. Facultative reinsurance is negotiated for one specific risk, usually a large or unusual one the treaties exclude. Treaties carry the bulk of a book; facultative fills the gaps.
Reinsurers take a share of insurers’ risks through quota share or excess-of-loss contracts, written as treaties for portfolios or facultative cover for single risks, and buy retrocession for themselves. Catastrophe bonds are insurance-linked securities, not reinsurance: fully collateralized capital-market notes whose trigger choice trades basis risk against speed and moral hazard.
Four questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. An insurer buys a $20 million excess of $30 million catastrophe layer. A storm causes a $45 million loss. How much does the layer pay?
- $20 million
- $25 million
- $15 million
- $45 million
Reveal Answer
Answer: C. Recovery = min(max($45m − $30m, 0), $20m) = $15m.
2. The same $20 million layer costs $3 million in premium. What is its rate on line?
- 15%
- 10%
- 30%
- 6.7%
Reveal Answer
Answer: A. Rate on line = premium ÷ limit = $3m ÷ $20m = 15%.
3. Why is a catastrophe bond classed as an insurance-linked security rather than reinsurance?
- It is a policy guaranteed by a state fund
- It is a collateralized note sold to investors
- It is a quota share with a fixed percentage
- It is a treaty contract issued by a reinsurer
Reveal Answer
Answer: B. Investors buy notes from a special purpose vehicle that holds the principal as collateral; no reinsurer’s balance sheet backs the protection.
4. An insurer must protect a single refinery that falls outside its existing reinsurance contracts. Which form fits?
- Retrocession bought by the primary insurer
- A parametric bond on regional windstorm
- A treaty covering the whole portfolio
- Facultative reinsurance for that one risk
Reveal Answer
Answer: D. Facultative reinsurance is negotiated risk by risk for large or unusual exposures that treaties exclude.
- NAIC, Reinsurance — Credit-for-reinsurance collateral categories and retrocession
- World Bank, Hurricane Melissa triggers 100% payout of $150 million catastrophe bond for Jamaica (November 7, 2025) — Parametric trigger payout
- National Hurricane Center, Tropical Cyclone Report: Hurricane Melissa (AL132025) — 892 mb peak before landfall; 160 kt and an estimated 897 mb at Jamaica landfall, October 28, 2025
- NHC Advisory 29, Hurricane Melissa