The loss exposure above the retention, up to the policy limits of the reinsurance contract, is indemnified by the reinsurer. Reinsurance helps to stabilize loss experience on individual risks, as well as on accumulated losses under many policies occurring during a specified period. These fluctuations result, in part, from the unique nature of insurance, which involves pricing a product whose actual cost will not be known until sometime in the future. Through reinsurance, insurers can reduce these fluctuations in loss experience, thus stabilizing the company's overall operating results. Reinsurance provides protection against catastrophic loss in much the same way it helps stabilize an insurer's loss experience.
Insurers use reinsurance to protect against catastrophes in two ways.
The first is to protect against catastrophic loss resulting from a single event, such as the total fire loss of a large manufacturing plant. However, insurers also seek reinsurance to protect against the aggregation of many smaller claims which could result from a single event affecting many policyholders simultaneously, such as an earthquake or a major hurricane. Financially, the insurer is able to pay losses individually, but when the losses are aggregated, the total may be more than the insurer wishes to retain. Through the careful use of reinsurance, the disruptive effects catastrophes have on an insurer's loss experience can be reduced dramatically. Capacity measures the dollar amount of risk an insurer can assume based on its surplus and the nature of the business written.