Obviously, this is a major source of profit for a insurance company, but I imagine is also used to refill reserves after a big payout year. Insurers must have been piling cash away for years after Andrew, Katrina, Sandy etc to recoop payouts. How would this balance with returning money on good years?
Underwriting profit shouldn't be a major part of the business model. If you're making too much money year to year from that, there's going to be regulatory pressure to lower your filed rates in a given market, and absent that, competitive pressure, because your competitors are going to have similar loss behavior in your segments and will cut rate to take market share from you. Customers see insurance as ~fungible and they will shop, although not as often as they should.
EDIT: I see the OP responded to you, and independently, I'll say he gave a great explanation and probably knows WTF he's doing. Didn't expect to see IBNR explained on HN!
Thanks! Oh IBNR... I'm surprised too, but glad it got a chance to shine!
And you are right - UW profit shouldn't be a big part, but it's a contentious issue right now with interest rates where they are. Since it shouldn't be a big part of our profit model, we're looking to put our money where our mouth is and return it.
Underwriting profit hasn't always been a big component of insurer profits - typically "float" or that interest on the premiums held has been the big driver. But in a low interest rate world, companies have had to keep more and more underwriting profit in order to exceed cost of capital. As they need more UW profit, so the fight over claims gets worse...
You are right though that money needs to be set aside for bad years - in insurance we call it "reserving", and actually it is already accounted for before the 5-15%. It is stashed away in the loss ratio as "incurred but not reported" or is paid in reinsurance premiums, which are a fixed cost. 5-15% is what is left over after all that (and admin expenses).
CAT Reserves are not IBNR...IBNR would, e.g., be after the CAT event happens, but before the claims are reported. I'd like to see a definition that says otherwise!
"You are right though that money needs to be set aside for bad years - in insurance we call it "reserving", and actually it is already accounted for before the 5-15%. It is stashed away in the loss ratio as "incurred but not reported"
Is not correct. CAT reserves are not related to IBNR. IBNR is a) we know the loss has already occurred b) the policyholder has not reported the loss yet. (Or at least in a probabilistic sense, like the hurricane has landed, and we know it will take 10 days for all the claims to be reported, and that 2 days after landfall, say 20% of claims have been reported, and the other 80% of those hurricane claims will be reported over the next 8 days. So at that moment "2 days after landfall" the actuaries will estimate how much IBNR there is.)
What you described is a CAT reserve...it's a seperate reserve taking into account, say, over a 10 year period, the odds and severity of a CAT risk.
If you still are unclear about the distinction, please consult your local actuary or CPCU :-)
Obviously, this is a major source of profit for a insurance company, but I imagine is also used to refill reserves after a big payout year. Insurers must have been piling cash away for years after Andrew, Katrina, Sandy etc to recoop payouts. How would this balance with returning money on good years?