Insurance is a fund which brings together the contributions (premiums) of many insureds, out of which the claims of the minority who suffer loss are met. The chief function of insurance is thus to replace uncertainty about the
possibility of a major loss with the certain payment of a much smaller amount.
Insurance, other things being equal, will be a financing method which is appropriate for risks which are too large to be borne, but is likely to be too expensive for small risks. If the cost of losses can be met from an
organisation’s own resources without being spread over more than one year, there is little point in buying insurance if doing so increases the overall cost.
Insurance is a very important and very commonly used method of financing risk. The following are some of the reasons.
Risk Aversion
Most organisations are not risk neutral, but tend to be, to some extent, risk averse, where pure risks are concerned. They will therefore be prepared to pay more than the actuarially fair premium in order to have the security
that insurance can provide.
Additional Risks Transferred
By purchasing insurance, the insured not only transfers to the insurer the financial effects of the risk insured against, but also a number of associated risks.
Fluctuation risk
Since the occurrence of pure losses is random, there is always the possibility that the loss experienced may be very much higher than could have been predicted from the past record. If the risk were retained, the organisation
itself would have to find a means of financing this possibility, but if it insures, the risk falls upon the insurer.
Investment risks
If risks of any size are to be funded internally by the company, it will be necessary to invest funds to provide the resources necessary to meet the cost of losses. Maturity and liquidity of investment funds must be matched
with the need for them. Since the occurrence of losses cannot be accurately predicted, this matching may not be achieved. This risk is also transferred to the insurer in return for the premium.
Compulsory Insurances
In nearly all countries, some insurances are compulsory, and there is therefore no choice as to the risk financing method to be used. Professional Indemnity insurance required of lawyers is one such example.
Taxation
Insurance premiums are normally deductible from corporation taxes. It is not possible to make tax-deductible provisions for unknown losses, and contributions to internal contingency funds are therefore at a tax disadvantage
compared with insurance premiums.
Partial Insurance
The most effective form of using insurance may not be to insure all levels of severity of a particular risk. It may be more appropriate to retain the risk of small losses, but to insure larger ones of the same kind. This can be achieved by means of a deductible.
A deductible gives protection against the loss which is too large to be retained, while not buying insurance protection unnecessarily for the small losses.
Disadvantages of Partial Insurance
All partial insurance depends upon estimates of the probability and potential severity of losses. These estimates may prove to be wrong, leaving the organisation retaining more risk than expected, which could expose it to
losses it is ill-prepared to bear.
Where a large deductible is concerned, the effect is to retain the levels of loss which are most predictable, leaving the insurer with large losses where there is the greatest uncertainty both about frequency as well as
severity. Since this involves both less predictability and a greater possibility of fluctuation in the results of insuring the risk, the insurer will be required to retain some of the premium to contribute to a catastrophe
reserve.
The Insurance Buying Decision
Whether or not insurance is a suitable method of financing a specific risk will depend upon the answers to a number of questions:
Every organisation, including law firms, will have to evaluate this for itself before deciding what level of insurance cover it needs and how large a deductible it wishes to take on.
Stanley Jeremiah
Goodwins Law Corporation