Understanding Insurance

There’s a lot of loose talk about insurance and insurers, making insurance companies out to be fairweather friends at best. Having conducted lawsuits both for and against insurers, I got to see the innards of the business quite closely. Let me share a few insights.

As a business proposition, insurance companies and lottery agencies are nearly identical, that is, you collect relatively small amounts from a large number of customers, and pay out large sums to a much smaller number, keeping a slice for operations and profit. Nothing unfair about that.

In lotteries you get the big payout if you’re lucky, in insurance you get the big payout if you’re unlucky, that is, your house burns down, you die, or you cause a catastrophic accident. But the math is essentially the same.

If an insurance company hopes to remain in business it needs to make sure there will always be enough money to pay out claims. There are three ways to do this. First, premiums need to be large enough to generate a pot of money from which to pay claims. Second, because there’s usually a time gap between collecting premiums and paying out claims, insurers typically have tidy sums on hand, and these they invest in much the same way that banks do, earning a profit on their investments. Nothing scandalous about that.

Third, insurers know better than most that bad things can happen unexpectedly and they need to be be prepared. The worst thing that can happen to an insurance company is to have to pay out more than they have available. To guard against this eventuality, they practice what they preach – they buy insurance! This is known as re-insurance, and many of the top-tier insurance companies in the world have few, if any, private clients, with marketplaces such as Lloyd’s of London acting in a sense like a great financial backstop or firewall, insurers of insurers.

Insurers by nature are risk-averse, which is a good thing, because we want them to survive and be around when we need them. But the most important thing to understand about insurers’ risk aversion is that they will walk away from trouble while trouble is still young. They pay some pretty smart people to tell them what risks are coming and how much they will cost. Then they trim their sails accordingly.

If you’re reading much about the experience of homeowners in California or the American South, you’ll see the subtext that many insurers are simply not issuing policies in riskier areas. They might cover you for theft or vandalism or occupiers’ liability, but they won’t touch floods, storms, or wildfires. Or they just quit servicing the vulnerable market.

There’s nothing unreasonable about a private enterprise not wanting to do business if the risks are out of control, but the upshot for homeowners is that they find themselves uninsurable at a manageable cost, or even at all. And if you own a million dollar home that is uninsurable, who wants to buy it? Or give you a mortgage loan?

Now, of course, when you have large communities of otherwise wealthy homeowners who find themselves unable to sell their largest asset, and are terrified of losing everything in the event of fire or flood, they will turn to …. Guess whom? Right, the government.

So, even in the most right-wing states of the US, governments are getting into the insurance business, in markets abandoned by prudent insurers. Yes, you read that correctly. Governments are entering markets that smart people left because they couldn’t make a go of it. But fortunately they have re-insurers. They’re called taxpayers.

Of course this will end well.