Risk Management · Insurance

What Really Matters When Using Insurance to Avoid Risk

In college I studied economics but never believed in its practicality and as a result my grades in the subject reflected my disillusionment. The ideas only made sense if the world was perfectly rational, but as we all know the world is not rational and that is why economic theory is just that – theory. Actually, the world is rational, it is humans that are not.

So why would do I bring behavioral economics up on an insurance blog? I think we first have to understand what behavioral economics is. Behavioral economics is the study of why individuals and institutions make the decisions they do in spite of the fact that those decisions are often not the most efficient or rational decisions, people make decisions based on emotion. For example, if I have a fair coin and you win $600 if it is heads, but if it is tails you lose $400, most people will turn this bet down even though the expected outcome is for you to win $100 ($600 x 0.5 + 400 x 0.5 = $100). The reason people turn the bet down is because of risk aversion, the fear of losing outweighs the happiness of winning. According to studies, the potential for gain needs to be at least twice the pain you suffer from a loss, so in our example, if you could win $800 if it heads, but still only lose $400 if it is tails, most people would take the bet.

Now that we understand Expected Value or Expected Outcome let’s discuss how that relates to insurance. The rational choice for consumers would be that when the premium plus the deductible is less than the Expected Value we buy insurance as shown below:

Insurance premium + deductible ≤ Expected Value

As discussed, we dislike pain (losing) twice as much as we enjoy pleasure (winning) so we won’t buy insurance or forego insurance based on the premium compared to the expected value, we will be willing to pay more than Expected Value. However, because there is such a large delta between Expected Loss Value and Maximum Loss Value the mindset changes.

This is where it gets tricky because we buy insurance to protect us against events that could cause large financial loss but that have a low probability of occurring. Insurers typically can’t get away with charging double the Expected Value because the probability of an insured loss occurring is much lower than a coin flip and we can’t define the amount of the loss beforehand, it is vague. At this point insurers and actuaries will start talking about Utility Theory. Utility Theory supposedly will determine how much an insured will pay above the Expected Loss Value for their insurance. I personally believe Utility Theory is hogwash when it comes to insureds buying insurance.

If you have ever bought insurance at all, be it as an individual, a Risk Manager, or a CFO, have you ever been told what the Expected Value of your losses is for the next 12 months? My guess is you have not. There are ways to back into Expected Value based on aggregated data, at least an approximation, but it is not much use unless you are in a position to self-insure. The market is the market, meaning if we don’t like the cost that is too bad. We are often compelled to buy insurance because of mortgages, contracts, statutory requirements and social norms. We don’t calculate the Utility of buying or not buying insurance because we don’t feel like we have a choice, it is something that we just have to have because that is the way it has always been.

The insurance carriers are the ones that are determining how much risk they are comfortable taking on, it is not the insureds. Most insureds are buying based on price and if they are not it is still a key consideration. If an insured buys a new type of insurance coverage, they are then buying because they have a new exposure (bought a car/cyber insurance) or because of “herd mentality,” meaning they are doing what their peers are doing. “Herd Mentality” is why brokers show benchmarking (how much or what peers are buying), if a board of directors knows that peers are buying more limit for their D&O insurance then that company will probably buy more to keep up and feel more comfortable. Why insured

As I said, insurers are the ones that determine how much of a premium over Expected Value is required for them to take on your risk. The data they all use is similar, so their Expected Values should all be fairly close to each other. There could be a number of different reasons why pricing varies, such as:

  • A carrier might be new to that particular market or industry so they either underprice to steal market share or overprice because they want to test the waters first.
  • A carrier could have been lucky or unlucky and their losses vary significantly from their peers despite having similar underwriting standards.
  • The devil could be in the details. Coverage might look the same from a high-level but there are key differences in coverage wording or policy sub-limits.

The third point is the key point for insureds because this is where you mold coverage based on how risk adverse you might be. A policy that is broadly worded will give you more coverage and most likely carry a premium to a policy that is narrowly worded. Sub-limits are something you want to pay close attention to as well. Sub-limits are something that the carrier provides either as a selling feature, meaning they will never be used, or because the carrier wants to restrict coverage to particular risks that they believe have a higher probability of occurring. Two examples of restrictive sub-limits that have a higher probability of occurring are “backup of sewers and drains” on your homeowner’s policy (probably on your commercial property policy or BOP as well) and “spoilage” on a commercial property policy.

When buying insurance, understand that insurance purchases are usually made with the past of least resistance. We buy the insurance we “need” because a third party mandates that we have it. We do not think about Expected Loss Value or the Risk Premium, we just understand that insurance is there to protect us when a low probability event causes us to have a financial loss. Trying to determine Expected Loss Value and Risk Premium are wastes of time, but if we instead try to pinpoint where an insurance company is restricting coverage we will most likely be able to better determine what risks or types of losses have the highest probability of occurring and have the highest Expected Loss Values. Remember, the insurance company writes the policy and they make more money when there are fewer claims. This is where it is important to have a broker that understands your business risks but also has a deep understanding of your insurance policies – just because something appears similar does not mean it is.

Financial Loss · Insurance · Investment

Cost is the Most Important Consideration When it Comes to Investments – It Always has been in the Insurance World

I read an intriguing blog post today on The Reformed Broker titled – “Two Thirds of Advisors Care Most About a Fund’s Cost.” The article is about financial advisors, not insurance advisors, I think if it was talking about insurance advisors the number would be even higher. The article seems to allude that cost is being driven by the client and not the advisor, the advisor is simply trying to provide for what the client is asking for which makes sense when the goal for most advisors is to increase AUM.

To me, this is a mildly surprising stat. Fees, and their potential impact on returns have been hammered home by the likes of Vanguard and Warren Buffett so they are at the front of everyone’s minds. That being said, performance should matter. Most of our purchases in life aren’t simply figuring out what we need and then buying the cheapest version of that product, but it appears that is what we are doing with our investments.

When it comes to insurance price is even more important for consumers. Does the consumer care about coverage details or will price drive the decision as long as coverage is somewhat similar? My experience shows that price will be the driver because brokers do not do a good enough job of demonstrating the differences in coverage in a policy that appear similar but are vastly different. If you buy an S&P 500 ETF cost is very important because the products are the same, they track the S&P so every additional basis point that ETF charges will lower your performance compared to that index; price matters in this case. If, on the other hand, you have ever looked at your insurance policy you realize the language is archaic, there are endorsements and exclusions added to the policy, policy sections refer to other parts of the policy, definitions that might differ from everyday use, and so forth and so on. This is why insurance is bought more on price, it is hard and tedious to go through a policy and figure out what the differences are. The buyer will usually ask if there are any “major” coverage differences and if the answer is no then the consumer will buy on price. The problem becomes we often don’t know what a “major” difference between policies is until after a loss that is either covered or excluded. What we thought was a minor coverage difference turns out to be the reason why a loss was covered or not covered.

Price should and will always be a factor when buying insurance, but coverage should play a more integral part. I understand that insurance is not something people are excited to buy as it has no upside, it is designed only to make you whole after a loss so there is no ROI on an insurance policy. All too often though, the insurance policy does not make insureds whole after a loss because what was once considered a minor policy difference has now caused a major issue in the coverage. The loss is either excluded or the coverage limit is not adequate so the insured is left making up the difference.

Financial Loss · Insurance

How CFOs are Protecting Themselves From Manufacturing Disruptions as Gene Therapy and Immunotherapy Manufacting is Being Stretched Thin

Today there was an article in STAT about the shortage of manufacturing capacity for gene therapy companies (find the article here). The article goes on to talk about how the problem might only get worse as companies pursue indications in larger patient populations and the trial sizes get bigger and bigger. There was also a comment about by the CEO of an immunotherapy company pointing out that immunotherapy companies are dealing with the same issue.

When I see articles on this subject I automatically think of supply chain risk, particularly for companies that are sole sourced, which is pretty much all gene therapy and immunotherapy companies. Some of these companies are trying to bring the manufacturing in-house as early as possible which alleviates some supply chain issues but not all. Companies that manufacture in-house or outsource manufacturing have the same risk if manufacturing is disrupted; if there is a fire or some other type of event that shuts manufacturing down companies will be negatively impacted, resulting in lower revenue or delayed clinical trials.

Insurance can alleviate this risk, but unfortunately companies do not usually have their policies setup correctly to protect against these losses. Most companies mistakenly believe that their business income will provide coverage, but this would only be true if a company manufactures in-house. If a company outsources their manufacturing then business income would not respond, dependent or contingent business income coverage would be needed to have protection. I talk to countless CFOs who incorrectly believe these two coverages are one in the same, but they are not. The CFO will point out that they have blanket business income, but that will only cover losses that occur at your locations and not third party locations.

If you are dual-sourced company or have a contingent manufacturing plan in place then dependent business income insurance is not nearly as important for you as a company that is sole-sourced but still something to be considered. If, on the other hand, you are sole-sourced (either manufacturing yourself our using a single CMO) you need to pay special attention to this coverage in your property policy or you could be putting your company at risk.

Family · Insurance · Kids · Risk Management

What Halloween and my Kids Peanut Allergy Taught me about Insurance that you can Benefit From

Two of my kids have peanut allergies which makes Halloween a bit stressful around our house. Fortunately, our kids’ reactions are not as bad as I know some other people have it so candy in a wrapper won’t cause them to have a reaction. They can still go trick-or-treating and my wife and I don’t have to worry about them having a reaction half-way through the night.

Our stress comes after we have gotten home and we start to go through the candy. We need to sort out everything that has peanuts in it and the candy we aren’t familiar with we need to check the label. Every year we do this at least one piece of candy seems to slip by and cause a reaction, thankfully we have never had a terrible reaction, but any reaction unnerves you as a parent.

m and m

Why I bring this up is because it is similar to when I audit a prospect’s insurance program. Their broker should know what risks could cripple the company, that companies “allergy.” Based on that risk assessment they should know where there might be vulnerabilities in the insurance program and doing everything they can to eliminate those coverage gaps. However, when I review prospects’ insurance policies I still almost always find numerous coverage gaps that are significant. I don’t use the word significant lightly, these are coverage gaps that could cause six figure plus losses that should otherwise be insured but aren’t. The broker isn’t getting rid of the candy with peanuts.

In the past, either me or my wife would go through the candy and put aside anything that had peanuts. Last year we started something new, I went through the candy like I always have and put aside the candy with peanuts but then my wife went through the now smaller collection of candy to make sure I did not miss anything. Sure enough, my wife found things I had missed.

Your broker is probably doing a pretty good job of making sure the obvious things are covered and does want to make sure you have no coverage gaps in your policies. The question is, how do you know they are not missing anything? My kids are the most important thing in the world to me (no offense to my clients) and I have missed pieces of candy that could do undue harm to them, so do you really believe your broker hasn’t missed anything? Wouldn’t it make sense to double check? We audit policies all the time for new prospects without charging them a dime. If we find no significant coverage gaps that is great, it means your broker is doing a good job so you should stay with them. If we do find something significant we will share it with you and show you how we can fix it for you. Either way it is a win, so shoot me and email or give me a call and we can discuss how to get started.


(610) 635-3326

Financial Loss · Insurance

How Thinking in the First-Order Could be putting your Company at Risk.

Have you ever heard of “second-order” thinking?  It seems like an idea I am hearing more and more frequently as of late.  I became much more aware of the concept after I read Ray Dalio’s book Principles, although he uses the phrase second order consequences. For those of you that don’t know who Ray Dalio is, he runs the largest hedge fund in the world – Bridgewater Capital – and his market returns speak for themselves.  Another investor who is known for this thinking is Howard Marks who talks about it in his book The Most Important Thing and whose investing track record, again, also speaks for itself.

“Second-order” thinking has traditionally been most associated with the investment world but it can and should be applied to most of the decisions we make.  Second-order thinking is basically looking beyond the obvious or assuming that all decisions are binary.  It is recognizing that a multitude of variables could impact a decision and that a decision can manifest itself into something that was unexpected.  Basically it is foregoing the immediate ease or satisfaction of a decision because you understand there are long term implications that could be unintended or harmful.  An extreme example is being offered a cookie.  Most people would go through an instinctive decision making process where all that mattered was whether they were A) hungry and B) like cookies.  Second-order thinking would contemplate those two inputs but the decision making process would go beyond that and ask what happens after the cookie is consumed. Maybe it would lead to diabetes down the road, maybe you feel overwhelming guilt that outweighed the pleasure from eating the cookie leading you to be in a funk for the rest of the day, maybe you would feel you needed to go to them gym an extra day that week giving up precious time with your family, and so forth and so on.  As you can see, second-order thinking is looking beyond the immediate consequence of a decision and instead at the domino effect of that decision.

A real life example of a second-order thinking would be a professional quarterback.  A QB goes to the line of scrimmage with a pre-determined play call and the offense lines up accordingly, but then he reads the defense and recognizes that the play they were going to run has a low probability of success against the defense so he changes the play to something he believes has a higher probability of success.  He might call a play where one of his receivers does a short crossing pattern that forces the safety to come up which in turn creates one on one coverage (a favorable matchup) for the receiver going deep.  As you can see, the QB not only needs to recognize what type of defensive scheme is being used, but how the defense would respond to certain offensive plays, call the play that is best suited to be successful against that defense, identify where the weakness will be against that defense, and finally execute and exploit that weakness.  He has just a few seconds to process this information and execute.  A great professional QB needs to not only be a great athlete but be a second-order thinker.

First-order thinking, on the other hand, is the path of least resistance.  It is looking no further than the immediate consequences of a decision we might make.  With first-order thinking we try to make things binary and we look at the immediate consequences of that decision which are typically either good or bad.  When we use first-order thinking we don’t look at root causes or try to ascertain why something is what it is, a rudimentary example would be buying solely off of price.  The second-order thinker might instead try to figure out why the products are priced so differently – is it quality, brand-name, type of warranty, backend customer service?  Once that information is collected they can make a better decision for what suites their needs.

In insurance, first-order thinking is the predominant way of thinking for both the buyer and the seller.  The seller or broker understands that a lot of buyers think of insurance as a commodity, there is not much difference between policies, so they push price or service.  The broker also recognizes that most buyers do not really understand insurance so they might use their brand name recognition and position themselves as an “expert.”  A few of the phrases that I have heard that signal a buyer is a first-order thinker are:

  • CFO (buyer): We have always purchased insurance this way.
  • Risk Manager (buyer): We’ve been with our broker for four years and never had a problem.
  • CFO (buyer): Our broker just saved us a bunch or money.
  • CFO (buyer): They insurance XX% of the Fortune 500 companies.

I could go on and on, but the point is that in insurance it is easy and definitely the path of least resistance to be a first-order thinker.  Most buyers, and brokers, do not want to get into the weeds of a policy and ask the “what if” questions.  An incumbent broker will seldom say this to a client, “X is not in your current property policy, should it be?”  They might say you should like at adding cyber coverage or employment practices liability coverage, but rarely will they tell you something is not in your policy unless you as the buyer bring it up.  Unless you are a company that is fortunate enough to have a risk manager, it is hard to become a second-order thinker when it comes to buying insurance, CFOs or whoever is in charge of insurance, have too many other things that they are responsible for.  Really the only way I know for a company to think on the second-order when it comes to insurance is having a third party review your program and ask you the questions your current broker either doesn’t know to ask or is afraid to ask because they are afraid of how that might make them look.


New California Sexual Harassment Law and What It Could Mean for your EPL Policy

If your business is in California or if you have employees in California you need to be aware of the new law that was recently signed into law regarding sexual harassment settlements.  I know most companies will never engage in this type of activity but it does not mean that you can’t be accused of this type of behavior.  So what is the new law?  Essentially, confidential settlements will no longer be allowed beginning January 1, 2019.  For more depth on the law I suggest you check out this article from Sheppard Mullin’s Labor Employment Law Blog that can be found here.

I would be shocked if this does not have implications on the Employment Practices Liability (EPL) insurance marketplace in California.  California is already the toughest state for procuring EPL insurance.  Insurance companies typically charge a higher rate in California and mandate higher deductibles for claims brought in the state.  I suspect this will continue if not accelerate.

Why do I think this?  I believe this law will disincentivize companies that believe a case is without merit from settling. If more cases go to trial it will result in higher legal expenses and higher claim costs for insurance companies.  Yes, companies will still want to save money and time by settling, but once your claim hits the deductible what incentive will a company have to not fight the claim?  The caveat is that your insurance policy might have a “duty to defend” and/or “hammer clause” which gives the insurance company a disproportionate say on how to proceed on these lawsuits/claims.  I think best case scenario is we see premiums stay flat but a spike in deductibles or stronger hammer clause wording.

I could very well be wrong and would love to hear why am wrong?  Leave a comment or send me email telling me what I got wrong.  That being said, I am not taking a position on whether law is just or unjust, I am simply stating what impact it will have on the insurance market.

Insurance · Risk Management

Preventing the Preventable – Eliminating Risks Without Impeding Your Upside

I read a tweet today from an attendee at a venture capital conference that said, “Opportunity is all around you, so take risks.”   I 100% agree with that quote, but I would add this caveat to the end, “but eliminate risks that you can, prevent the preventable from occurring.”

Insurance should be used to eliminate the risks that can hinder a company from being successful but are unlikely to happen.  Insurance works like this – you pay a relatively low premium to the insurance company and in return they make you whole financially in the event you suffer a loss.  The lower the probability of loss occurring, the lower your premium, and conversely, the higher the probability of loss, the higher your premium.  A more technical way to look at is that premiums are the outcome of discounted future losses plus some profit for the insurance company.

I go into this because it should help companies understand what types of insurable (i.e. preventable) losses are most likely to occur.  Insurance companies spend a lot of money on data and analytics to better understand the probability of risk, knowing how and why they price your risk the way they do might help you determine where it makes the most sense to insure or self-insure.  For example, public company Directors and Officers insurance has premiums that are multiples of what a private company would pay for Directors  & Officers because losses are larger and more likely to occur.  Workers Compensation insurance is inexpensive for a life science company that outsources R&D but for a construction company that might be the biggest insurance spend they have.

How should companies approach “preventing the preventable?”  Companies should first figure out what can be insured and what can’t be insured, cost should not even enter the conversation at this point.  Companies can do this by sitting down with their broker and identifying all the risks that a company faces.  The broker’s job is to then recognize which of those risks are insurable.  For instance, you may point to a large company infringing on your patent and your broker should be able to tell you that yes, you can insure the costs to defend your patent.  Once the insurable risks are determined then you go through the process of figuring out what it will cost to insure and making a determination of where to spend your insurance dollars.  Remember, the larger the premium the more likely a risk is to occur.