What is a catastrophic loss?

A catastrophic loss is a really bad thing that happens which causes a lot of damage and costs a huge amount of money. It doesn’t happen very often, but when it does, it’s a big deal. A catastrophic loss comes from something called a catastrophic hazard.

Some examples of catastrophic hazards

Catastrophic hazards are things like:

Big hurricanes
Terrible earthquakes
Awful tsunamis
Dangerous volcanoes erupting
Deadly pandemics

When one of these catastrophic hazards actually happens, it can cause a catastrophic loss. The loss is catastrophic because it destroys so much and is super expensive.

How bad can catastrophic losses be?

Catastrophic losses can be very, very bad. They might damage or destroy:

A lot of buildings and houses
Important infrastructure like roads, bridges, power lines
Businesses, schools, hospitals
Farms and crops

Many people could lose their homes. Businesses could be wiped out. There could be a lot of injuries and even deaths. The damage could cost billions of dollars to fix. It disrupts everything in the area that was hit by the catastrophe.

Protecting against catastrophic losses

Companies and people try to protect themselves from catastrophic losses in a few key ways:

Insurance

One main way is by buying insurance. Insurance is when you regularly pay a company some money, and if something bad happens that you’re insured for, the insurance company pays you a lot of money to help cover your losses.

Many people have insurance on their homes and cars in case something really bad happens to them. Businesses usually buy insurance too, to help them survive a catastrophic loss.

Reinsurance

Insurance companies themselves often buy something called reinsurance. It’s basically insurance for insurance companies.

Since insurance companies could go broke if they had to suddenly pay out a huge amount of money for a catastrophic loss, they protect themselves by getting reinsurance from other companies. The reinsurance company agrees to pay the insurance company some of the money they need if a catastrophic loss happens.

Catastrophe bonds

Another way to protect against catastrophic losses is something called catastrophe bonds or “cat bonds”.

Here’s basically how cat bonds work:

A company or government that is worried about a potential catastrophic loss issues bonds
Investors buy the bonds, giving their money to the bond issuer
The investors get regular payments on the bond, so they earn interest
But, if the catastrophic loss actually happens, the investors lose most or all of their original investment
That money goes to the bond issuer to help pay for their catastrophic losses

So cat bonds are a way of getting money from investors to help pay for really bad losses if they occur. The investors take on the risk of losing money in exchange for earning extra interest as long as the catastrophe doesn’t happen.

The challenge of catastrophic losses

Even though there are ways to protect against catastrophic losses, they are still a huge challenge for a few key reasons:

Hard to predict

Catastrophic losses don’t happen very often. And it’s really hard to know in advance when and where they will occur, or how bad they will be. This makes it very difficult to accurately predict the risk of catastrophic losses.

Extremely expensive

When catastrophic losses do happen, they are enormously expensive. The costs can easily be in the billions or even hundreds of billions of dollars for the worst catastrophes. It’s hard for insurance and reinsurance companies to afford such huge payouts.

Sometimes uninsurable

Some catastrophic hazards are so potentially bad that insurance companies won’t even insure against them at all, or only at a very high price. This is called being uninsurable.

For example, it’s very hard and expensive to get insurance for homes in areas with a high risk of catastrophic flooding, or for companies that operate near active volcanoes. The risk is considered too high for insurance to be affordable or even available.

Dealing with catastrophic losses

Societies have to prepare for the possibility of catastrophic losses as well as they can. Some key steps include:

Building stronger buildings and infrastructure that can better survive catastrophes
Restricting construction in the highest risk areas
Improving warning systems to help people evacuate to safety
Having good emergency response and recovery plans ready
Budgeting money to help pay for disaster relief and rebuilding
Encouraging insurance coverage, while recognizing its limits
Spreading and diversifying risks through reinsurance and cat bonds
Studying catastrophic hazards to improve predictions and risk calculations

Even with the best preparations, catastrophic losses will still happen sometimes. And they will still be devastating. But by understanding them, protecting against them, and preparing for them, we can hopefully reduce how often they occur and how much damage they do. Managing the risk of catastrophic loss will always be an ongoing challenge.