Catastrophe Reinsurance Tower: Retention, Risk Appetite and ILW Alternative
A regional property insurer has a gross 1-in-200 probable maximum loss of ₹1,200 crore from a single earthquake zone. Its surplus is ₹3,000 crore and the board caps retained catastrophe loss at 15% of surplus. It buys a 30% quota share on the property account and a catastrophe excess-of-loss treaty of ₹400 crore excess of ₹100 crore, both on a net account basis. The reinsurer quotes ₹22 crore for the cat layer. The CFO wants to buy an additional ₹300 crore excess of ₹500 crore layer at ₹9 crore, while the chief risk officer prefers a larger retention and an industry loss warranty (ILW). Last year a modelled scenario produced a net loss of ₹410 crore after the existing programme. The insurer also faces a 1-in-50 loss of ₹250 crore.
1. Calculate the net retained catastrophe loss under the existing programme and test it against the board's risk appetite.
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Gross to net
Gross 1-in-200 PML: ₹1,200 crore.
Quota share cedes 30%: ₹360 crore.
Net PML after quota share: ₹840 crore.
Catastrophe XL
The layer is ₹400 crore excess of ₹100 crore on a net basis, so it covers net losses from ₹100 crore to ₹500 crore.
Net retained loss = first ₹100 crore + (₹840 crore − ₹500 crore)
= ₹100 crore + ₹340 crore = ₹440 crore.
Risk appetite test
Board cap = 15% × ₹3,000 crore = ₹450 crore.
The existing programme retains ₹440 crore, only ₹10 crore inside the cap. That is technically compliant but leaves almost no margin for model error, multiple events or a larger return period. The modelled scenario net loss of ₹410 crore is also close to the cap. The 1-in-50 loss of ₹250 crore becomes ₹175 crore net after quota share; the cat XL covers ₹75 crore, leaving ₹100 crore retained, which is within appetite.
The 1-in-200 result is therefore the binding constraint and is too close to the board limit.
2. Evaluate the CFO's proposed additional layer using the numbers given.
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The proposed layer is ₹300 crore excess of ₹500 crore, covering net losses from ₹500 crore to ₹800 crore, at a cost of ₹9 crore.
With the additional layer, the 1-in-200 net retention becomes:
₹100 crore + (₹840 crore − ₹800 crore) = ₹140 crore.
This is comfortably inside the ₹450 crore board cap and reduces the tail by ₹300 crore. The cost is ₹9 crore, or 0.3% of surplus, and about 0.75% of the gross PML. That is not obviously excessive for a layer that protects the solvency-critical tail.
The decision should still test:
- Whether the reinsurer's model and the insurer's PML use consistent assumptions.
- The marginal benefit: the existing programme already meets the cap, but only narrowly.
- The opportunity cost of ₹9 crore against other capital or reinsurance uses.
- Whether a lower attachment or a smaller layer would give better value.
On the figures alone, the CFO's layer is a prudent buy because it converts a marginal cap breach risk into a comfortable margin.
3. How should the insurer weigh the CRO's alternative of a larger retention and an ILW?
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A larger retention increases the insurer's retained loss and volatility. If the retention rose from ₹100 crore to, say, ₹200 crore, the insurer would keep more of the working layer and might reduce premium, but the 1-in-200 retained loss would rise unless offset by additional cover. That conflicts with the board's ₹450 crore cap unless the upper tower is enlarged at the same time.
An ILW responds to an industry loss index, not the insurer's own loss. It can be cheaper and can cover a broad event, but it carries basis risk: the industry loss may not trigger even if the insurer suffers a large loss, or may trigger when the insurer has little loss. For a regional insurer with a concentrated earthquake exposure, basis risk is material.
A balanced recommendation is:
- Buy the CFO's additional layer, or negotiate a lower attachment, to bring the 1-in-200 retention well inside ₹450 crore.
- Do not simply increase the retention without increasing the upper cover.
- Consider an ILW only as a supplement, not a substitute, and stress-test it against the insurer's own modelled losses.
- Review the programme annually as the PML and surplus change.
The choice should be driven by net retention versus risk appetite, not by premium saving alone.