Insurance affordability is a hot topic in New Zealand. How do you know that you are getting a good deal when you buy insurance?
Over the past few years, we have seen some of the biggest increases in insurance pricing ever seen. The hardening in the insurance market, combined with the Auckland Floods and Cyclone Gabrielle, could not have come at tougher time for businesses and households that are already impacted by inflationary pressures and the cost-of-living crisis.
It’s during these tough times that we review our spending and look at ways of trimming expenses, and this extends to insurance.
So, how do we know that we are getting a good deal when buying insurance? How do we know that it is money well spent? This is a tough question because the answer extends beyond the financial value of an insurance policy to our appetite for risk and our mindset in knowing that we are fully covered.
The most immediate response is that the value of insurance is only realised when we make a claim. This is the point of truth when your insurance policy responds to a loss event and seeks to "make you whole again". However, for most of us the process of actually making a claim is fortunately a fairly rare event.
When we don't make claims we can be led to thinking that “I have never made a claim and I don’t expect to have any losses”. This statement is skewed by what’s called recency bias. Relying on past events as an indicator of future events can result in costly mistakes, particularly when it comes to insurance decisions. The fact that we already have an insurance policy sends an immediate signal that we do think there is a probability of a loss at some stage in the future – otherwise we wouldn’t have brought that insurance policy in the first place!
To help our thinking, it is useful to revert to first principles. At its core, insurance is all about using someone else’s balance sheet (i.e. the insurer) to provide financial protection or to reimburse against losses and damage. Insurance plays an important role in a risk management strategy by providing financial protection, asset protection, business continuity solutions, and most importantly, “peace of mind” of knowing that we are covered. The cost of using an insurer’s balance sheet is reflected in the premium charged by the insurer for this benefit.
If I take Bounce Insurance as an example, on average, we charge a premium of 1.6% (give or take a little depending on the location) of the sum insured amount for parametric earthquake insurance policy. This means that we might pay a premium of $16,000 for a policy that will provide an upfront payment of $1,000,000 when it is triggered by an earthquake. From a customer perspective, they have “peace of mind” knowing that they have an insurance policy that provides protection from an earthquake event, where the settlement of the claim is provided using someone else’s balance sheet, which in our case is Munich Re via Lloyd’s of London.
The alternative to having an insurance policy is to put some capital aside in the form of self-insurance. To make this decision we need to ask ourselves whether our capital is better used to grow our business, or putting it aside to cover an unexpected event? In this case we would hold $1,000,000 in a bank account which can then be used to support our recovery after a loss event. The good news is that we will still earn a low-to- moderate return on that “rainy day” money. The bad news, from a strategy perspective, is that these funds are technically not available to invest in the long-term growth of our business and this results in an opportunity cost. Most importantly, we don’t want to get this decision wrong. The failure to adequately allocate sufficient “self-insurance” capital can result in disastrous consequences for businesses that don’t have the financial capacity to withstand an unexpected shock or event.
Another way of looking at value is to calculate how many years it would take for us to “break even” when choosing to self-insure. So, if you don’t experience a loss, how many premium payments would we have to save to cover the sum insured amount? In our earlier example, where we are paying $16,000 of premium for $1,000,000 of cover, it would take 62½ years to breakeven. The next big question we need to ask ourselves is “how confident are we that we would NOT experience a loss event within that 62½ year period, and is that a bet that we are prepared to take”?
In this context, the value of insurance is about protecting our assets and business from loss and damage, while at the same time freeing up our balance sheet to execute on our strategy. This is the value of an insurance policy. There is always going to be a sting in the tail when paying premiums, but the benefits of cover outweigh the opportunity costs and the financial consequences of having insufficient cover when we need it most.
