You probably wonder just how your insurance company sets the premium you pay for your home insurance policy. It’s clear that the more risk or likelihood of a claim, the more you will be charged because that’s a definite correlation between the premium and risk. However, you might be surprised to learn that Wall Street and the financial markets also have a significant impact on your insurance premium, as well as the general availability of insurance to consumers.
The basic principle of insurance is the pooling and spreading of risk. Insurance companies collect a premium from you and many other policyholders, but they’re not likely to pay claims to everyone. Insurance providers spend a lot of time calculating the average amount of claims paid and use that number as the primary basis for setting premiums. With a very large amount of policyholders, the law of large numbers is in the insurance companies’ favor and their predictions can be fairly accurate.
From time to time, large catastrophic events, such as earthquakes- in San Francisco and Los Angeles – and hurricanes – such as those prone to Houston, Miami, and Baltimore – can throw off the insurance companies’ predictions and result in tremendous losses. While you may get your money’s worth from your insurance company in the event of a serious claim, too many policyholders doing the same thing at the same time may put the insurance companies out of business. To prevent this from happening, insurance companies have two ways of protecting themselves: reinsurance and catastrophe (cat) bonds.
Reinsurance is basically insurance that an insurance company buys to insure its own policies. The policy you bought from your insurance company may be financially supported behind the scenes by other insurance companies known as reinsurers. The process of reinsurance allows insurers to write many more policies than they otherwise would have the financial capability to write. But what’s in it for the reinsurers? Well, for one, reinsurers prefer being reinsurers because they can still be in the insurance business, but not have to deal with the “front-office” activities it usually entails, such as issuing thousands of policies and handling claims with individuals.
Cat bonds, on the other hand, work much like regular investment bonds. Investors purchase the bonds and are paid a return, or interest rate. Also like regular bonds, the riskier the bond, the higher the rate of return. The investors in cat bonds are essentially betting a catastrophe will not occur and that they will receive a strong return on the investment as well as their principal without incident. In the event of a catastrophe, though, the insurance company uses the investors’ money to pay claims and the investors lose their investment.
While risky, some investors like cat bonds because the risk they present is not correlated to the regular financial market’s fluctuations. After all, an overall economic downturn has nothing to do with a hurricane or earthquake. This uncorrelated risk allows investors to diversify their risk and provides an alternative to regular financial market investments.
Both reinsurance and cat bonds are vital to the insurance industry, and both are mechanisms that keep insurance companies solvent and insurance available to homeowners at reasonable premiums. So, the next time you wonder why your insurance premium has changed from year to year regardless of your personal loss experience, you should consider the financial forces working behind the scenes.