Spreading risk, peace of mind

We have been taught that the health of the economy and the success of business are underpinned by the insurance system. We have taken this principle as a truism and clearly there is no disputing this fact. However, over time and with the increased sophistication of financial models and risk management techniques businesses no longer are totally dependent on the traditional commercial insurance market. In Trinidad and Tobago, like in other parts of the world certain insurances are compulsory — motor third party and workmen’s compensation. Apart from these the purchase of other forms of insurance is purely optional. What then motivates businesses and for that matter the ordinary consumer to buy or not to buy insurance? The answers will vary according to the attitude towards risk, the size of businesses and indeed the perceived benefits for the buyer of the particular insurance programme.

Insurance is about the spreading of risks so that the financial burden will be made light and therefore policyholders pay a premium and in return will receive payment up to the sum insured in the event of a genuine claim since the insurance company distributes the risk over a large number of policyholders. It is for that reason that the premium is a mere fraction of the sum insured. If a business is large and is comprised of many risks of a similar nature and size it could use the same principle and either buy insurance coverage beyond what its balance sheet could bear or buy no insurance at all. Multi-national companies fall into this category and they in fact adopt these principles in arranging their insurance programmes.

The main reasons for buying insurance cover might be outlined as follows:
— The transfer of risk from a company’s balance sheet to insurance companies that are specialised in the risk business.
— Peace of mind — the business is insured so in the event of something going wrong the insurance company will pay the claim so there is some certainty in terms of reimbursement for a loss.
— Volatility reduction — insurance manages peaks and troughs except as regards premium increases.
— In times of soft insurance premiums, transfer of risks to insurance companies is seen as a cheap way to cater for losses.
— In the present climate of transparency and corporate governance — shareholders and investors expect the managers to take precautions to protect their interests and again insurance buying is viewed as a low-risk strategy. The point here is that insurance is a tried and tested strategy while some other mechanisms for risk transfer through financial instruments might be more difficult to explain.

However, the mere buying of insurance does not totally eliminate risk but must been seen as a substitution for risk. There is no such thing as “risk-free” in this world but rather there must be good judgment in the handling of risk so that it becomes manageable and minimised to a point that any residual loss can be absorbed without endangerment to the business. There will always be credit risks in the sense that insurance and reinsurance companies can fail. There is no guarantee that any company no matter how strong will be there when required especially when you are dealing with risks that have a long shelf life — liability claims, for example, which could turn up many years after the event. For instance notwithstanding the best efforts of regulators insurance companies do sometimes fail and are unable to meet the full expectations of policyholders. In some countries there are mechanisms to deal with such fallout while in many other countries there are no systems in place and depending on the severity of the failure governments have been known to become involved as the insurer of last resort.

The world’s household names in the reinsurance business have been experiencing some downgrade by the rating agencies and this would have been unthinkable until recently, so while there is no rush to the exit it does bring into sharp focus the instability in the world’s financial markets and the impact that has on developing countries. While many businesses in Trinidad and Tobago require insurance to protect their shareholders’ interests, there is need for understanding of other risk transfer mechanisms to judge whether they have the right strategy for managing their risks. The first principle is always to behave as if no insurance coverage existed as it would come as no surprise what measures a company would adopt to safeguard itself as it would have no insurance policy to fall back on. In addition, an insurance policy is a legal contract and there will be disputes. The WTC 9/11 is a case in point. The WTC leaseholder — Larry Silverstein — has claimed that the destruction of the two towers constituted two events entitling him to receive US$7.0 billion. The judge in the first instance agreed on a simple review of the case that US$7.0 billion is payable. The major insurance companies appealed and a US Appeal Court has now ruled that the events constituted a single occurrence as a matter of law so only a single payment US$3.5 billion is payable.

Lawsuits are also proceeding against the Port Authority of New York and New Jersey, Boeing and the airlines so it will be some considerable time before closure is brought to the events of 9/11. It is not unusual for insureds to take their insurance companies to Court and insurance principles have been settled and established through legal rulings and case precedents. The insurance industry is not only about collecting premiums but also about paying large sums of money in claims. The Property Claims Service (PCS) unit has forecasted that some 485,000 claims will be presented from commercial and residential property owners as a result of Hurricane Isabel with a cost of US$1.2 billion. The state of Virginia alone is likely to account for US$450 million. At the end of September, Typhoon Maemi hit South Korea and the losses have been estimated between US $500 million to US$1.0 billion. The economic losses are likely to be in the order of US$4.0 billion. Insurance does have a role to play as individuals cannot themselves bear the losses.
E-mail: daquing@cablenett.net