Why does an insurance company need to buy insurance? Because some events are so awful — hurricanes, tsunamis — that the insurance company doesn't have enough money to pay off all the claims.
Firms that sell insurance to insurance companies are called reinsurers, logically enough. The field is the subject of fascinating story in the latest BusinessWeek. It's written by a guy who was consulting for a reinsurance company in downtown New York on Sept. 11, 2001.
The core of the reinsurance business is estimating the probability and costs of massive catastrophes — and figuring out which categories of disaster are fundamentally unpredictable.
This is what the industry casually refers to as the "God clause": Reinsurers are ultimately responsible for every new thing that God can come up with. As losses grew this decade, year by year, reinsurers have been working to figure out what they can do to make the God clause smaller, to reduce their exposure. They have billions of dollars at stake. They are very good at thinking about the world to come. ...
Their choices on risk, with billions of dollars at stake, are necessarily aligned with the pursuit of truth. If a reinsurer is more scared of a risk than it should be, its shareholders will punish it. If it is less scared than it should be, the world, eventually, will break it.
Reinsurers paid out billions of dollars after Sept. 11th. But after that, they began to exclude terrorism from their large policies. The industry decided that massive terrorist acts are fundamentally unpredictable. So there's no way to properly price the risk, which is the core task of any insurance policy.
As one reinsurance exec tells BusinessWeek, "There cannot be a mathematical model for people like bin Laden."