The life and death of insurance firms

Paul Krugman has written a nice piece explaining the "death spiral" problem in the insurance business. He said:

Bear in mind that private health insurance only works if insurers can sell policies to both sick and healthy customers. If too many healthy people decide that they’d rather take their chances and remain uninsured, the risk pool deteriorates, forcing insurers to raise premiums. This, in turn, leads more healthy people to drop coverage, worsening the risk pool even further, and so on.

The background is the teetering state of some private health insurers in California.

Chapter 3 of Numbers Rule Your World addresses this problem, using Florida hurricane insurers as an example. Statistics is behind the entire concept of insurance. With large numbers of customers, insurance firms can predict their annual losses (i.e. payouts) with a high degree of certainty. This is a result of the law of large numbers. Because individuals, especially when young, will have difficulty predicting when, and how, they will die, they have an incentive to buy insurance.

But hurricane insurance, or more broadly, disaster insurance, firms face even thornier issues than health insurers. Health insurers can reliably predict and control what proportion of their customer base will get sick each year. What about hurricane insurers? For them, "healthy customers" are analogous to residents with homes in areas that are not hurricane-prone; do we think they are carrying hurricane insurance?

PS. For the economists out there, the question being tossed around is: are hurricane risks insurable? can a private market for hurricane insurance survive?

Comments

[silly things]

"healthy customers" are analogous to residents with homes in areas that are not hurricane-prone; do we think they are carrying hurricane insurance?

The above is not an issue for a good disaster insurance co for 2 reasons.

1. disaster insurance companies operates over both space and time (not just space).

2. disaster insurance insures against different uncorrelated disasters. Places without hurricane may have earthquake.

[Kaiser]

ST: Good comment. The problem for a hurricane insurer is to find customers who won't need payouts when a hurricane hits, otherwise it will go bust every time. This spatial concentration is unique to the hurricane (natural disaster) insurance business.
Insurers do not put premiums collected from hurricane policies in the same risk pool as those collected from earthquake policies. In fact, some even ring off Florida policies into its own risk pool precisely because other states that are not as exposed to hurricanes do not want to be in the same pool as Florida.
The book discusses all this in greater detail. The point is that in reality, you can only put people into the same risk pool if they feel like they are "fairly treated".
There is something called reinsurance that pools together policies from uncorrelated disasters. I think those structures are a disaster waiting to happen. Will write more about that in the future.

[Maria]

I frankly hope that not repeat disaster from previous hurricanes.

http://www.viewheadlines.com/News/Article.aspx?i=17939&t=Tropical-storm-plus-oil-slick-equals-more-fear-and-uncertainty

[Insurance Claim Help Florida]

The next major hurricane to hit Florida should answer all your questions.