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Originally Posted by Racnad
The Jazz:
Thanks for sharing your knowledge. Here's where I don't understand insurance. I can understand insurance for things like autos. If you have a million policy holders, you can predict that within a year a certain percentage will have accidents, and those claims will average $XXXX. You can base your premiums on that caluculation and add some for expenses and profit.
But what about natural disasters like earthquakes? These events are difficult to predict. The "Big One" probably won't happen in a given year, or even a given decade. But when it does happen, a huge number of people will have claims. So when it doesn't happen, the insurance company is sitting on a huge pile of cash, but you can't pay it as dividends or refund it because the "Big One" can happen at any time. And when the "Big One" does happen, and there are thousands or hundreds of thousands of claims, will there be enough cash to pay them all?
How does the industry resolve this?
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As eribrav pointed out, there are an entire subset of insurance company called reinsurers who spread risk among many companies. Earthquake insurance is actually something that my company does get involved in quite a bit, so I have a decent working knowledge of it. Earth movement (i.e. earthquakes or landslides) is typically excluded on most Property policies, just like flood insurance. That allows buyers the option of buying it separately because it does represent so much risk in some areas.
Almost every company buys reinsurance at some level, and Berkshire Hathaway (Buffett's company) is probably the largest, depending on what measuring stick you use. Generally speaking though, they lay off a portion of the risk as well to someone else. At the end a large hotel or something with a huge ($500M+) value, you might end up with 5 insurance companies issueing policies to the buyer but another 30 policies issued between the primary insurers and the reinsurers and then between various reinsurers as they promise to pay part of the loss. It gets even more confusing at times when one company acts as a "front" for another, and none of the loss gets paid by the company that issued the policy to the buyer.
Interestingly enough the companies that write stand-alone earthquake coverage are the same ones that write earthquake coverage, and it's almost always the same underwriters doing both.
And Crompsin, earthquake coverage IS volcano coverage unless you somehow had a volcano without the earthquake. In that case, it's just simple fire insurance.
If there is a big earthquake along one of the major fault zones, whether it's the New Madrid near St. Louis or one of the California ones, the insured losses will be in the billions. As a referrence point, the amount of premium for earthquake coverage on average runs around $500M, with some variation year to year. It's the same with hurricane coverage, and there will definitely be occassions where premium dollars paid by Florida folks goes to California folks after a quake.
If it seems complex, it is. Just tell me what I didn't explain well enough.