Reinsurance reinstatement option

With the entire furor over the so-called “double deductible” problem in Florida, a contractual issue is looming in the market for catastrophe reinsurance which may be much more significant economically. Insurers writing property insurance routinely purchase reinsurance coverage for the purpose of limiting their catastrophe exposures. When insurers purchase reinsurance, they must decide whether to pay extra for an option which automatically reinstates coverage after an insured event occurs. The default reinsurance contract pays for one insured event, and then the coverage disappears unless the insurer has purchased the option to reinstate. Insurers can select how many reinstatements they wish to have. Typically, the cost to reinstate coverage is roughly half the cost of the original reinsurance premium. For example, suppose a reinsurer quotes $100 for the default reinsurance contract which does not reinstate. Then the reinsurer might quote a price of $110 for a contract which reinstates once, $120 for a contract which reinstates twice, etc. Whenever reinstatement occurs, the reinsurer would charge the insurer an additional $50 premium.
Since it is rare that multiple hurricanes strike the same properties, many insurers will prefer to purchase the default reinsurance contract and retain the risk of a subsequent catastrophe. Unfortunately, this is likely to be the most popular strategy for the smaller, less solvent companies for two reasons: 1) since the “option to default” conveyed by the legal rule of limited liability is more valuable for such firms, smaller, less solvent insurers are likely to reinsure less than larger, moresolvent insurers by not purchasing the reinstatement option, and 2) by foregoing the purchase of the reinstatement option,this results in significant reinsurance premium savings. Furthermore, given the dynamics of the Florida insurance market (where, for a variety of reasons, many of the worst risks are covered by such companies), we may be looking at a much worse insolvency scenario for the Florida insurance industry than we might have otherwise expected.
I wish to thank my good friend and colleague, Dr. Richard Derrig, for pointing this problem out to me.

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