Insurance master

With the increasing use of derivatives and the impending deadlines of Basel II, we should see more variety in the types of insurance policies to cover foreseeable loss events. Insurance provides a safety net for sustaining losses where the costs in a single period would be too punitive. If the risk is deemed too large to handle singly by the company and collectively by shareholders, the risk must be transferred out and dispersed among a wider pool.
Insurance is the latest but one line of defence against risk, after capital reserves and before benefiting from bankruptcy law. It does not protect against risk but just smoothens the risk over time, transforming risks into costs. Pooling by transferring to institutions with more capital; or transferring to those who know the risk better.
Insurance results in a transfer of insurable risk into a tail credit risk and a host of legal risks. For these reasons of legal friction and contractual costs, insurance ends up a very incomplete market. A lot of risks are not covered at any price other than at excessive levels because of the paucity of up-to-date market information and the risk-aversion of many companies. If financial markets were as incomplete as insurance, a considerable number of arbitrages between market segments would not be possible, and trading would be minimal.
The effects of large impact disasters, certainly after the emergence of terrorist waves post 9/11, and the collapse of stock-market prices are causes for concern. The major worries for the insurance industry are that they:
will not be able to pay the insurance liabilities of clients’ claims
will reduce their cover by expanding exclusion clauses, so that clients will find self-insurance protection more attractive
When we are unsure of a specific type of risk, e.g. with complex damage or liability risk, a convenient get-out is to pass it to the insurer. You can protect yourself better against investment or corporate failure – for a premium. Thus, a popular policy was the D&O insurance – the Director and Officer cover. A company could cover the performance of its key staff, as well as protect against shareholder lawsuits through purchasing this policy. Unfortunately, with the rise in company scandals and accounts restatements post-AEW, this D&O cover has become more expensive. So, General Electric found its D&O policy quadrupling within one year.
Market players should familiarise themselves with the idea that buying insurance not solve all their risk problems. Furthermore, investors and company chiefs should acquaint themselves with the basic techniques of risk maps and loss databases to provide advance warning of potential corporate damage. Funnily enough, the insurers are the ones who are most likely to have understood the benefits of a loss database and created one, years before the banks and managed funds.
Do the groundwork – you need to be:
Assessing areas of risk weakness or corporate vulnerability.
Assessing cost-benefits of buying in risk management expertise or cover.
Assessing areas of non-coverage for corporate cover.
Read the small-print beforehand in great detail, there are obvious advantages to be gained. Corporations and individuals have become used to retaining risk that would have been insured. Insurers trap the cost of losses over time, charging their expenses for the risk burden. Insurance provides a safety-net for sustaining losses where the costs in a single period would be too punitive. The normal view was that a corporation takes a diversified portfolio of investments plus their associated risks. The increasingly common perspective will be to view enterprise risk management (ERM) status of the client.
This means that clients will be assessed upon the value and quality of their portfolio, plus to what degree they have the tools, techniques and business processes to manage risk. This is analogous to the Basel II view of operational risk. The insurer would work progressively with the client to develop strategies, implement them tactically and monitor business performance. A hands-off “just post us the premium cheque” will be less commonplace. More detailed inspection will take place before policies are signed.
If the risk is deemed too large to handle singly, the risk is farmed out or dispersed. The directors and shareholders will tend to shun investments where the insurance premiums eat too much of the associated profits. The idea of ceasing to buy insurance is not new, the investor can take on the total potential loss.