Redefining Risk & Return by Jesper Lyng Jensen & Susanne Sublett

Author:Jesper Lyng Jensen & Susanne Sublett
Language: eng
Format: epub
Publisher: Springer International Publishing, Cham

Defective Insurance

It is quite certain that insurance plays an important role in preventing red phone situations. As mentioned in the section on capital, it is not profitable for risk owners to hold enough reserve capital to cope with all and any unforeseen events resulting from risk or uncertainty. That is why taking out insurance can be a financially sound way to avoid specific events with potentially high costs. When we take out insurance, the insurance company provides our reserve capital. If we purchase a new car for DKK 600,000, most of us want to be certain that we can get another one if the car is stolen or totalled in an accident. Without insurance, each one of us would have to carry reserve capital corresponding to the value of the car, which would be impossible for most people and financially uninteresting for society.

It is more capital efficient to let the insurance company function as a reserve capital depot. This is because, for example, an insurance company that decides to underwrite insurance for ten risk owners who each purchase a car for DKK 600,000 does not hold a reserve capital of DKK 6 million. If the statistics say that there is only 10% likelihood that a car is totalled, the likelihood of all ten cars being totalled is minimal. Therefore, the insurance company can have less than the DKK 6 million and still have enough capital to cover the most frequently occurring situations. The rare, expensive situations where many of the ten cars are damaged can be covered by the insurance company through re-insurance.

In this way, the insurance companies are able to remove red phones from all the insured with the use of less and more efficiently utilized reserve capital than what the risk owners would be able to do themselves.

However, as a tool for fighting structural risk costs, insurance is not always ideal.

This is because—even if compensation is paid—insurance does not aim to keep the insured fully free of costs.

Insurance is a product described in an insurance policy. The policy terms and the other general insurance conditions specify the compensation for which the policyholder qualifies. It is the product described in the insurance policy that you pay for.

Depending on the “quality” of the product, this means that even if a risk owner is insured, situations may easily arise in which a risk owner still sees considerable draws on his finances.

One such situation is when the risk owner is underinsured—e.g. due to ignorance or because the person has a higher appetite for risk than others. As a case in point, the writer of this book was exposed to a major risk event while writing this book. Parts of my farm burned down; two out of the four wings were a total wreck after the fire. Fortunately, no person or animal was hurt, I hasten to add. The burned-down wings were a workshop and a room used for parties, so the damage was purely material and there was not a big loss of property with sentimental value.

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