How do insurance companies have the funds to cover so many claims after a natural disaster?

As I’m writing this answer, the news is filled with hurricane devastation, with the media reporting higher and higher costs for the damages caused by these storms (find out How to Prepare Your Home for a Hurricane). When these kinds of events happen, it’s natural to wonder who is going to pay for all this. Can the insurance companies really afford to such astronomical sums?

To understand how insurance companies have the funds to pay for damage on this scale, we have to start by exploring how insurers operate and how they manage risk.

First, not all of the damages caused by natural disasters are insurable. Many insurance policies (particularly homeowner’s insurance) won’t cover natural disasters or acts of God, as they are called. To get insurance coverage for floods, earthquakes, or wildfires, you have to reach out to your insurance company and purchase additional policies for each specific type of disaster, or pay more on your original policy to cover the added peril. And even then, it’s not guaranteed that you will be able to secure coverage (learn more in The Seas Are Rising – Do You Need Flood Insurance?).

Most insurance companies also practice and implement risk management strategies. For one thing, they will limit their exposure to risk in a particular geographical area in order to limit the impact any single natural disaster can have on their business. That means that even if there is massive devastation in some area, chances are the burden of paying for it is split among many insurers.

But even with all those exclusions and risk management tactics, a devastating disaster still floods an insurance company with more claims than it normally handles. That’s where regulation comes in. There are many government departments at many levels monitoring the financial health of insurance companies to ensure they have the ability to pay for catastrophic losses. Regulators make sure that insurance companies keep enough reserves and are liquid enough to fulfill their insurance obligations even in the event of a disaster. If that fails, there are also government bureaus that will step in to see to it that policyholders are compensated even when an insurance company goes bankrupt. In Canada, the Property & Casualty Insurance Compensation Corporation fills that role (see An Intro to Reinsurance to learn more about how insurance companies protect their financial health).

So, in summary, the amount insurance companies are responsible for paying might not be as big as it initially seems. There are also checks and balances in place to ensure that these companies are ready to meet their financial obligations even when the unexpected happens.