Natural and man-made catastrophes have a low probability of occurrence, but when they do occur the consequences can be of high severity, affecting a large number of persons as well as their property. For many individuals and enterprises, insurance is the most practical and effective way of handling a major risk such as a catastrophe. After all, by obtaining insurance, individuals and enterprises spread risks so that no single entity receives a financial burden it can not cope with. But catastrophic loss presents special problems for insurers because large numbers of those insured incur losses at the same time. Reinsurance supports insurance companies to underwrite large risks, limit liability on specific risks, increase capacity, and share liability when claims overwhelm the primary insurer’s resources. In reinsurance transactions, one or more insurers (i.e. the reinsurers) agree, for a premium, to indemnify a primary insurer against all or part of the loss that that primary insurer may sustain under its policies. The contractual and business relationships between insurers and reinsurers facilitate relatively low transaction costs. However, in the case of extremely large or multiple catastrophic events, insurers might not have purchased sufficient reinsurance, or reinsurance providers might not have sufficient capital to meet their existing obligations.

In any event, after a catastrophic loss, reinsurance capacity may be diminished and reinsurers might limit availability of future catastrophic reinsurance coverage, while, on the other hand, the demand of potential victims increases. This simultaneous occurrence of shrinking supply and rising demand naturally leads to a sharp increase in reinsurance pricing. High reinsurance prices induce investors to invest capital in the reinsurance business (e.g. new reinsurance companies may be formed, investors may be willing to purchase new tranches of equity issued by existing reinsurers). This, in turn, ends in an increase in the supply of catastrophe cover and causes prices to stabilize once again. Finally, in case no major catastrophe happens shortly after the first one, reinsurers offer premiums at prices below expected loss and costs, while primary insurers have excess supply of capital and are therefore capable of supporting new risk exposures. In order to win or retain market share, reinsurers would lower their underwriting criteria and may accept marginal risks or liberalize policy conditions. This ushers in a period of low premium rates. Reinsurance is thus clearly influenced by price cycles, which are particularly pronounced in catastrophe insurance. Given this cyclic nature of the reinsurance market, investors have incentives to look for alternative capital sources.