Most businesses buy insurance against a variety of hazards—the risk that their plants will be damaged by fire; that their ships, planes, or vehicles will be involved in accidents; that the firm will be held liable for environmental damage; and so on.
When a firm takes out insurance, it is simply transferring the risk to the insurance company. Insurance companies have some advantages in bearing risk. First, they may have considerable experience in insuring similar risks, so they are well placed to estimate the probability of loss and price the risk accurately. Second, they may be skilled at providing advice on measures that the firm can take to reduce the risk, and they may offer lower premiums to firms that take this advice. Third, an insurance company can pool risks by holding a large, diversified portfolio of policies. The claims on any individual policy can be highly uncertain, yet the claims on a portfolio of policies may be very stable. Of course, insurance companies cannot diversify away market or macroeconomic risks; firms generally use insurance policies to reduce their diversifiable risk and they find other ways to avoid macro risks.
Insurance companies also suffer some disadvantages in bearing risk, and these are reflected in the prices they charge. Suppose your firm owns a $1 billion offshore oil platform. A meteorologist has advised you that there is a 1-in-10,000 chance that in any year the platform will be destroyed in a storm. Thus, the expected loss from storm damage is $1 billion/10,000 = $100,000.
The risk of storm damage is almost certainly not a macroeconomic risk and can potentially be diversified away. So you might expect that an insurance company would be prepared to insure the platform against such destruction as long as the premium was sufficient to cover the expected loss. In other words, a fair premium for insuring the platform should be $100,000 a year.[1] Such a premium would make insurance a zero-NPV deal for your company. Unfortunately, no insurance company would offer a policy for only $100,000. Why not?
- Reason 1: Administrative costs. An insurance company, like any other business, incurs a variety of costs in arranging the insurance and handling any claims. For example, disputes about the liability for environmental damage can eat up millions of dollars in legal fees. Insurance companies need to recognize these costs when they set their premiums.
- Reason 2: Adverse selection. Suppose that an insurer offers life insurance policies with “no medical exam needed, no questions asked.” There are no prizes for guessing who will be most tempted to buy this insurance. Our example is an extreme case of the problem of adverse selection. Unless the insurance company can distinguish between good and bad risks, the latter will always be most eager to take out insurance. Insurers increase premiums to compensate or require the owners to share any losses.
- Reason 3: Moral hazard. Two farmers met on the road to town. “George,” said one, “I was sorry to hear about your barn burning down.” “Shh,” replied the other, “that’s tomorrow night.” The story is an example of another problem for insurers, known as moral hazard. Once a risk has been insured, the owner may be less careful to take proper precautions against damage. Insurance companies are aware of this and factor it into their pricing.
The extreme forms of adverse selection and moral hazard (like the fire in the farmer’s barn) are rarely encountered in professional corporate finance. But these problems arise in more subtle ways. That oil platform may not be a “bad risk,” but the oil company knows more about the platform’s weaknesses than the insurance company does. The oil company will not purposely scuttle the platform, but once insured it could be tempted to save on maintenance or structural reinforcements. Thus, the insurance company may end up paying for engineering studies or for a program to monitor maintenance. All these costs are rolled into the insurance premium.
When the costs of administration, adverse selection, and moral hazard are small, insurance may be close to a zero-NPV transaction. When they are large, insurance is a costly way to protect against risk.
Many insurance risks are jump risks; one day there is not a cloud on the horizon and the next day the hurricane hits. The risks can also be huge. For example, the attack on the World Trade Center on September 11, 2001, cost insurance companies about $36 billion; the Japanese tsunami involved payments of $35-$40 billion; Hurricanes Katrina, Harvey, and Irma are each estimated to cost companies in excess of $40 billion.
If the losses from such disasters can be spread more widely, the cost of insuring them should decline. Therefore, insurance companies have been looking for ways to share catastrophic risks with investors. One solution is for the companies to issue catastrophe bonds (or Cat bonds). If a catastrophe occurs, the payment on a Cat bond is reduced or eliminated.[2] [3] For example, in 2017, the insurance company, Swiss Re, issued $925 million worth of Cat bonds. The bonds cover the company for three years against any losses from earthquakes in California.
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