Some natural disasters devastate huge amounts of property and assets costing huge amounts of money that I would assume policy holders would want to claim. Maybe I am naive to the huge amounts of profit that insurance companies make, but how do they survive financially?
In: Economics
As you suggested, “huge amounts of profit that insurance companies make” is the answer here.
For every natural disaster that costs millions or billions of dollars in repairs and claims, there are many months of premiums being collected in which there are no pay outs.
Risk Managers sole purposes are to assign a risk level to any prospective customer to determine how much to charge them for their insurance premiums to mathemtaically hedge their bet and assume that over the lifetime of their contracts they’ll pay out less than they receive in premiums.
That’s the nature of how insurance companies make money. They do massive amounts of research and determine the probability of paying out vs how often they’ll receive monthly premiums and not have to pay.
It’a basically a casino, but instead of betting that you’ll lose roulette more often than not, they’re betting that your house won’t flood more often than it does.
They insure themselves against a major catastrophe. It’s called reinsurance. Who insures the reinsurers? Well, in the end, it all turns into an securitized asset (like stocks and bonds). So investors see their portfolio value fall.
For one, they, like banks, probably have rules that govern how much money they have in readily cashable forms to disburse to claimants. Like maybe they have to be ready to pay out 10% of their total holdings (banks have to have a certain amount of ready cash for depositors to withdraw). The exact rules probably depend on the country and the company and how risk-averse they are.
Secondly, every insurance company is going to be geographically and portfolio diverse. Meaning there will never be an insurance company that _only_ insures wooden residential structures in drought and forest fire prone areas. Yes, the insurance premiums for those clients will be higher, but if there IS a huge forest fire, the claims for them will be softened by continued revenue of premiums from other clients in completely different areas of insurance and elsewhere geographically.
In the case of whats going on in Australia (you know, the whole country burning down), its going to be a rough year for Australian insurance companies. A lot of payouts gonna happen. But, the coastal cities that don’t burn down, where frankly the majority of the populace lives, will continue to pay premiums. And, to hedge against big disasters, the insurance companies will have pretty good and pretty safe investments. They don’t just take your insurance premiums and blow it on drugs and hookers. Ok, some, but not all. Its even possible that insurance companies themselves have insurance against massive payout disasters.
And, stats wonks at insurance companies are continually looking out for this type of thing. Like, how likely is it that all of our rural clients have their houses burn down in a freak once in 100 years forest fire. In fact they call disasters exactly this based on their likelihood of occuring. 50 year floods, 100 year floods. A flood so bad it happens once every 100 years.
As the likelihood of things like these fires and floods goes up with climate change, our permiums (in likely affected areas) will continue to go up. Watch flood premiums for people in flood prone and fire prone areas of the American south and California hills start to skyrocket if they haven’t already.
To add to what other have said: they diversify/have exposure limits. So first, a given policy may be underwritten by a syndicate of many insurers, each taking on just a small percentage of the risk. Second, the individual insurers may then further reduce their exposure by purchasing reinsurance, which is essentially insurance provided by one insurance company to another insurance company, covering losses payable by that second company.
Each insurer will have internal exposure limits to ensure that any particular catastrophe will not result in undue losses.
Note that this is not always followed, and has had devastating results for certain insurers. For example, see below from the Wikipedia entry on Lloyd’s of London (Lloyd’s is probably the largest and most well known insurance market in the world):
“For most of Lloyd’s history, rich individuals known as Names backed policies written at Lloyd’s with all of their personal wealth and took on unlimited liability…[t]he asbestosis losses in the early 1990s devastated the finances of many Names: upwards of 1,500 out of 34,000 Names (4.4 per cent) were declared bankrupt.”
Reinsurance. I used to work at an insurance administrator. One of our motor insurers went bust, because some big catastrophe happened in NZ which cleared them out on a policy they never expected to be used. They weigh up risk against profit. That insurer made the wrong call!
If they are Farmers Insurance like we have in Texas they raise your homeowners insurance by 42%.
We live in north Texas but they lost money on homes destroyed or damaged by hurricanes.
Almost to the point we would be better off making our own escrow account.
Reinsurance. Risk gets spread well beyond the initial policy issuer. Big losses are spread, and not really held by people selling the initial insurance
If a potential risk is big enough then the individual insurers will just take a small percentage. Then they can reinsure that if they feel too ‘exposed’.
Then if that risk is too big for the Reinsurers then they can reinsure it too (for instance I’ve seen an old policy for earthquake insurance for Tokyo and the layers are insane.)
Insurers tend to limit their exposure to any one type of risk anyway so they don’t get hit multiple times for a single event.
Watch John Oliver on Flood Insurance shows you the lengths insurance companies go to to protect their profits.
Most insurances have exceptions so for example when your car gets bombarded because of freshly started war they won’t pay you a dime. One of many exceptions widely used.
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