Mind Your Business - 8 October 2008

What is insurance?

Every business has to think about insurance in one form or another; it is one of the inescapable fixed costs that must be paid. Like domestic insurance, the principle is fairly simple - it is a means by which an individual or a business can be put back into a position that it was in prior to some event occurring. For businesses, having insurance cover means that they are protected, to some extent, from the effects of an external shock to the business.

Insurance is based on:

• The potential risks of some event occurring in the future - a claim by a customer who is injured on your premises or having buildings or stock damaged by fire for example
• How much would be needed to cover that liability - how much money would it take to put the business back into the position it was in before the event occurring
• How many people are willing to contribute premiums (the amount the business has to pay out to gain the insurance cover)
• The ability of the fund managers working for insurance companies who invest the premiums to get the returns necessary to cover potential outlays.
• The more risky the likelihood of the outcome, the more expensive the premiums will need to be and the less willing insurance companies will be to cover the risk

How does insurance work?

The principle behind business insurance is simple but often misunderstood. The insured risk is that identified as being something that needs some form of cover. Let us take a simple example. A business has a warehouse with a stock of goods. It knows there is a risk that this building could catch fire and it would lose all its stock. The building and the stock in it, therefore, becomes the insured risk.

An insurance company will be approached to offer a quote on what it will cost to cover that risk. The insurance company will use the services of an actuary to assess the risk involved. The actuary will look at similar buildings, the area, incidents of fire damage and hosts of other data to assess the risk. The insurance company is then able to make a quote to the company based on this risk. The business concerned will then have to pay premiums to the insurance company for the lifetime of the policy. It could be that the business never has to make a claim for fire damage, in which case it will have paid large sums in premiums over the years and never get anything back.

On the other hand, it could be that the day after taking out the policy, the whole warehouse goes up in smoke and the company loses all its stock. The insurance company would have to then pay out, potentially, millions of pounds even if it has only received one premium! The insurance company therefore has to balance the risk of the event occurring with the number of people taking out policies and the expected payouts that they need to cover over a period of time.

In so doing, they will be looking at the amount of premiums they receive in relation to what they expect to have to pay out.

The premiums should cover the expected payouts, but the company cannot just aim to cover the anticipated payouts - statistics might give a useful indicator to chance, but reality tends to throw up events at any time. The insurance company therefore has to ensure that it has the funds available to cover all these eventualities and so uses the premiums it receives to invest in a range of financial instruments, including shares and bonds, to build up reserves of funds to cover their liabilities.

The basic way in which insurance works is shown in the diagram below:

Imagine that there are 10 businesses, A-J, each looking to secure insurance on their premises against fire. Each business values the buildings at £1 million. The actuaries have estimated that the risk of one of the buildings being completely damaged by fire and needing replacing is a 1:10 risk. The premiums are therefore set at £100,000 per year for each business. Each business pays the premium to the insurance company, which in turn uses the £1 million received to invest in various financial instruments. The returns from these investments plus the capital sum of £1 million represents the pool of money that the insurance company has available to pay out in the event of a claim.

The risk of fire might be low, but when it strikes it tends to be devastating. Insurance helps a business to get itself back to the position that it was in before the disaster struck.
Image source: httt://www.sxc.hu/photo/1022804

Let us assume that business J is unlucky enough to have that fire - the fund is used to pay business J £1 million to rebuild their premises. The fund managers will have to ensure that they have sufficient funds to meet this obligation. Of course, it could be that during the year, none of the businesses makes a claim, in which case the funds are kept in the pot to be built up. In another year, it is entirely possible that more than one firm could be unlucky enough to suffer a loss, in which case the insurance company has to make sure that they have sufficient reserves to cater for this eventuality. It is also possible that a firm makes a claim but that the claim will not be for the whole £1 million.