Insurance · Risk Management

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.

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