Are You Buying Too Much Insurance?

Here’s a simple question that’s a lot more difficult to answer than it first seems: does it make financial sense to purchase insurance?

Like most questions, this one has many layers of nuance to it and depends on a large variety of conditions.

Many people feel there are cases where buying insurance is the obvious thing to do, but that’s really only the case when you are compelled to do so by law.

You may think that insurance premiums are what you pay to defray the costs of a damaging event. Read on to find out what you’re actually paying for and whether it really makes sense.

Insurance by Any Other Name

Before we even get into how much is too much, you should ask yourself if you should buy it at all.

Insurance is just a form of risk transfer. You’re transferring the risk (financial impact) of an event occurring from you to the insurer. But it’s not entirely risk-free.

Insurers can fail just like any other business and that can leave you with a claim that won’t be paid. In effect, you’ll be out of pocket the payments you’ve made on premiums (and the irrecoverable IPT) and you will have to cover the claim yourself (most large organisations are not covered by the FSCS, except for compulsory covers, see below)

Monitoring Your Insurer

No insurer can guarantee that they will be able to pay your claim, no matter how stable they are. Neither you nor they know when you’ll make a claim and what their financial situation will be at that time. Some claims, for example industrial diseases especially asbestos, can be notified 60 or more years after the policy was taken out, and are still covered by that historic policy.

If you do purchase insurance, it’s in your interest to monitor the insurer’s long-term financial stability. And if that insurer is purchased by another company, that new company will own your policy and it’s that new company’s financial stability that will determine how safe you are.

Furthermore, insurance is not a “frictionless” transaction. It’s subject to a 12% insurance premium tax (IPT) that is non-recoverable (unlike VAT).

What About Compulsory Insurance?

The case for compulsory insurance is a little different. Most organisations have to buy it, so it’s not a question of whether or not it makes financial sense.

However, it’s important to note that in cases of compulsory insurance, you’re covered by the FSCS, if you are compelled to buy it. This means that you’re protected for 100% of any shortfall resulting from insurer failure. This also means that paying for Insurer Security Reviews is hardly ever worth the money.

Public bodies (such as local authorities) are not compelled to buy such insurances and thus are not covered by the FSCS if those insurers fail.

When Does It Make Sense to Buy Non-compulsory Insurance?

So, suppose you still want to buy insurance even though you’re not compelled to do so. How do you know if the numbers work out in your favour? One of the most surprising – and often ignored – factors to most clients is their “financial planning time horizon”, aka their “risk financing timeframe”, that is, over how many years in the future could they spread/recoup/recover the financial impact of a large loss?

Local authorities, for example, have constitutional permanence, ie they can be assumed to continue indefinitely. In other words, short-term volatility (caused by a large claim) is not a major issue nor a major threat to claimant security (claimants are unsecured creditors in the event of your bankruptcy). On the other hand, smaller companies (or large companies with share prices to consider) may want to limit the volatility of their insurance claims from one year to the next, or publicly prioritise claimant security over premium savings.

When selling a policy, insurers are hoping that you’ll focus on the results of an event and what it might do to you financially – and in the short-term. That can lead to emotional thinking that clouds your judgment and makes you buy a policy even if the premiums will cost more in the long run, especially if you have a long risk-financing timeframe.

The basic question is therefore this:

“Over your risk financing timeframe (which may be very long or very short) what are you likely to gain in claims versus what are you likely to lose in premiums, IPT and lost investment income, allowing for claimant security?”

By thinking in terms of probabilities, you can get a much better idea of whether it makes sense to insure.

So, say you take out business interruption insurance with nil XS and an annual premium of £1m (excl IPT). Then suppose you lose two days of business due to a plumbing failure that flooded your offices that cost you £250k of business.

Short-term Thinking vs Long-term Thinking

Unless you expect to have 4 or more such events during the year, in the short-term, you’ll be paying more in premiums than you’ll be getting back. Moreover, you’re more likely to have no such events in a modern office, let alone 4 in one year. Losing two business days is certainly not inconsequential, but it makes more sense to absorb that cost than to pay for insurance, at least in the short-term

In the long-term, say over a 10-year planning horizon, you might expect to have a more catastrophic loss, say a £5m event (40 days loss of business), at least once. Over that time, you have paid £10m in premiums, c£1m in additional IPT and foregone at least £1m of investment income you could have made by retaining the premiums yourself, a total strategy cost of £12m, for a benefit (insurance recovery) of £5m, ie a net cost to your business of £7m.

Thus, if you had a short risk-financing timeframe, a £5m uninsured loss could be unacceptable, severely impacting your EBITDA, Investor Metrics, Loan Covenants, your share price etc. In this case, the £7m net cost of this strategy would rightly be deemed to be sensible, to protect you against unwanted short-term volatility

If your risk-financing timeframe is long, the £7m net cost is much less clear-cut and would be judged against your bespoke balance sheet strength etc. If you have constitutional permanence, it is almost always the case that a £5m uninsured loss is not material to you, and is more cost-effectively self-insured

It’s all about thinking in terms of probabilities and what makes more financial sense for your bespoke risk financing timeframe and balance sheet strength. Insurance is designed to protect corporate policyholders against short-term claims volatility; over the long-term, the insurers almost always come out better.

So, What Are You Paying for?

It’s not the case that insurance is completely useless. If you think that it’s easier to make small regular (premium) payments over a long period rather than a large (claim) payment once in a while, it makes perfect sense, if you don’t mind losing the investment income and paying 12% IPT on top.

Insurance is a form of risk transfer, and that risk can be of a catastrophic nature. If you simply cannot absorb the cost of an event, insurance for it is almost always sensible, even if it isn’t compelled by law.

The answer to whether you’re buying too much insurance is, therefore, quite bespoke to your situation. If you think that you’re insuring against an event that you can’t recover from, it’s perfectly sound reasoning. If you’re insuring simply to have peace of mind, you may want to consider it from a more logical and fact-based perspective, especially if you have a longer-term risk financing timeframe and adequate balance sheet strength.

If You Insure, Do So Wisely

If you end up deciding that you need insurance, make sure you’re purchasing a policy with an insurer that is at least as financially stable as you are. Under Solvency II, you have access to extensive and easily accessible information that will help you assess the financial health of an insurer.

Should you have any doubts about how to select an insurer and whether you need to insure at all, consult a professional. At InsuranceInspect Services we can help you analyse your insurance options and figure out what works best for your bespoke situation.

The InsuranceInspect Services approach to Insurance Buying

In summary:

Stage

Purpose

I.Your Past

What can you learn from your past? How much profit have insurers made from you?

II. Your Future

What can happen in your future? How likely are large claims really? What’s the best way to pay for them?

III. Your CustomMade Product

Is an off-the-shelf policy right for you? What are the alternatives? Why insure in the first place?

IV. Your Best Providers

Is the brokers’ panel comprehensive enough? How much are they being paid? What if you need a bespoke solution?

V. Your Money

Where does your money go? Offshore? Tax Haven? Who is your actual insurer? What about your claimants?

VI: Your Review Process

How do you know that you made the right decision at the last renewal? What information do you need?


“Ask John to perform his version of search and destroy on your premiums”

“Ask John to perform his version of search and destroy on your premiums”