Reinsurance

How Insurance Companies Manage Risk

The reason insurance companies can take on the risk that we may not be able to handle comfortably, or perhaps not even at all, is that they spread the risk they take on among many clients.

The impact of a risk is going to always be relative to one’s own capital, so with an individual or even a company, major losses, such as losing a building to a fire, is going to usually represent too large of a percentage of their capital to be comfortable with.

So let’s say there’s 1 chance in 100 this will happen during any given year, but if it does happen, you will be out $100,000, to keep the numbers simple. So it costs you $1500 a year to protect yourself against this, and even though by the time this is likely to happen it will cost you more in the long run, the impact of having it happen with you unprotected leaves you in an unacceptable position.

For an uninsured individual, this would usually mean having to still make mortgage payments while still needing to find a place to live for instance. While they would likely end up defaulting on the mortgage, whatever equity they have built up on the property over the years would be lost, including the whole thing if it’s free and clear.

So say an insurance company insures 100 such homes in a neighborhood, and they therefore take in $150,000 a year in premiums, and their expected losses will average out to $100,000 from the one home that’s expected to be lost. They are making enough to cover that, and will have built up enough of a cushion to handle situations where 2 or 3 of these homes burn down.

In reality they will be insuring many more homes than 100, and the law of large numbers will put them in a very comfortable position to manage this risk, and will have significant reserves which they invest which adds to the profits and the extent of their capital.