Appreciating Insurance

Introduction

Is anything sure about insurance? Well if you don’t pay a premium then you don’t have cover, so effectively you’re self-insured. That’s for sure. After that though it’s complex and for a good reason. It’s an educated gamble.

What I know for sure is that you get peace of mind knowing that you have insurance cover. However, you don’t get to test that peace of mind until you make a claim. I feel sure that most of us claim and then pray.

I thought I’d write an article on Insurance and invite an expert to comment on scenarios they consider important to their clients and colleagues. I then asked a client to review the story and add their thoughts. It’s a dry topic but it gets spicy when you realise how little you know and how exposed most people really are.

The property world is a jungle and people hire me to navigate through it. In looking at insurance, it is no different so working with my friend, Boyd Lees to navigate it has been enlightening. I hope you get something from this story on insurance and what Boyd thinks is important to know. I then asked my colleague, John Favaloro (pictured) to review our story and add his advice. John has considerable commercial experience across major property projects and businesses. His overview has helped support our recommendations. Both Boyd, John and I have provided our advice at no cost in the hope that our readers will be better prepared to ask the important questions and to appreciate the risks of insurance coverage.

The issue for people who need insurance is that they have an asset which needs protection, an insurable interest. The asset might have debt attached to it in which case there are multiple interested parties with an insurable interest. But the real lesson is that the insurance industry is a business and it makes profits from premiums and investing those monies to make more.

What a lot of people don’t know is that some the best mathematicians (known as actuaries) work for insurance companies. Their job is to assess probability, the likelihood that something might occur, price the risk and work out if their business can pay the claims. It’s a fine line pricing premiums whilst measuring risk but they are the best. Now that you know that what’s your knowledge like, are you capable of understanding an insurance policy or even comparing offerings from various companies?

I recall listening to Warren Buffett speak at a Berkshire Hathaway Annual meeting in 2019 about Berkshire Hathaway’s capacity to meet insurance pay outs. Buffett’s message was simple he claimed that Berkshire was so financially strong and well capitalised that it could withstand three catastrophes in a row. A catastrophic event would be a weather event, like a cyclone or a flood which impacts many people and their property.

Berkshire owns Geico (Government Employees Insurance Company), General Re, Berkshire Hathaway GUARD Insurance, Berkshire Hathaway Specialty Insurance, Gateway Underwriters Agency, MedPro Group, National Indemnity Company, and United States Liability Insurance Group. It has just acquired Alleghany Insurance for US$11.6b. It even owns an interest in Australia’s NRMA Insurance. Buffett went on to say that most of Berkshire’s competitors could only withstand a single catastrophic event. He rationalised that Berkshire would be there to meet their commitments under the most severe of occurrences. I feel almost certain that Buffett was factoring that as his competitors failed, his insurance companies would pick up those new clients on even more attractive terms. Whilst I have no way of testing this statement it did raise the point that whoever you insure with must be profitable, financially strong enough to meet their commitments and willing to pay their obligations to policy owners. This point is important because when most people think of insurance policies they focus mainly on price as they don’t have the ability to properly compare or the skill to assess the risks.

So, what is happening in the insurance landscape now. Premiums are rising sharply. Damage to property by fire, flood and storms is severe and unpredictable. Home and land-owners have been devastated. Beachfront land-owners with expensive properties are now coming to grips with rising tides and storms which gouge their land and claim it back to the sea. What used to be prized is now worrying.

Policies are changing to reflect the increased risks and people are less aware of their true coverage. The certainty of weather patterns has changed and this is having a dramatic effect on predicting risks and assessing insurance premiums.

Cybersecurity is a newer challenge with white collar fraud and computer hacking now rife. Infrastructure is ageing and risks are increasing.

So, what are the impacts on property and what lessons should we learn. To understand the pitfalls, I asked an expert guide in Boyd Lees to comment. Boyd’s career in international banking and insurance has ensured that he advises the Ultra High Net Wealth Individuals (UHNWI) and family offices. Boyd’s role is to educate his clients and provide access the best insurance markets to suit their needs. He also acts as their advocate when providers need comparing, premiums need assessing and claims become necessary. In this interview Boyd will speak specifically about the following:

Rising premiums, unacceptable risks, self-Insurance, averaging, premium management, importance of a broker and finally we wrapped it up with common lessons.

Rising premiums.

Costs are going up but it's not all about?premiums. The average person anchors their decision on price, i.e. the lowest cost, which is a flawed premise.?

Insurance premiums, like most other expenses are increasing.?A common grievance I hear is ‘why should I pay more for my cover when I haven’t had a claim in 5 years or maybe longer?’?We know with high confidence levels most homes do not burn to the ground, most contents are not stolen or lost and the great majority of us manage to avoid motor vehicle collisions.?Why then do we buy insurance?

To answer this, it might be worth taking a step back to understand some basic tenets upon which insurance markets operate and common biases embedded in our decision making process.

Insurance theory goes something like this:?those at risk benefit from incurring a guaranteed loss (premium) to purchase protection against far greater potential financial losses that have a relatively low probability of occurrence.

Insurance theory is connected to the notion of Low Probability - High Consequence (LP-HC) events, meaning the chance my house is totalled is statistically small, (low probability) however should it happen, the financial impact is significant (high consequence).?

Paying your premium is in effect the cost of renting a balance sheet significantly larger than your own and represents a small percentage of the value of the assets insured.?Not many of us are willing or financially capable of funding a large or total loss of what is for most our largest asset (family home, contents and valuable items). ?We transfer our risks to an insurance company – for a price.

Our premium, along with everyone else’s is pooled in a fund.?The insurer uses part of that fund to reinsure (lay off) its risks by buying insurance from a reinsurance company, which in turn is a much larger balance sheet than the insurer’s.?A portion of the funds are invested in expectation of generating a return, while the balance of the fund provides liquidity to settle policy holder claims.

Insurance companies are ‘for profit’ organisations owned by shareholders, all of whom expect a reasonable rate of return on their invested capital.?In order to build and retain strong balance sheets to meet all stakeholder’s expectations, insurers apply sophisticated risk measurement algorithms to price customer’s risks.

The role and impact of biases in our decision-making process is a fascinating and well-researched field. ?While there are many biases applicable to our insurance decisions, let’s consider just one - the Availability Bias.?It may help explain our reluctance to pay increasing premiums absent any recallable reference point reminding us of the value of a sound insurance policy.?Simply put, the value we ascribe to something is positively correlated to the ‘nearness’ of its efficacy.??For example, if our motor policy responded to our satisfaction after an accident, we are more inclined to ascribe value to it and happily renew cover.

Yes, premiums are increasing, however so is the value of our largest assets, the costs associated with repairs and the quantum of claims.?Dissonance exists when we pay premiums with no apparent return, until that is when we need to claim.

Unacceptable?risks

More insurance markets are carving out risks such as bushfires, flood and other catastrophes. How can customers manage these risks and what options are available?

Disintermediation of insurance policy distribution has been a financial boon to mass-market insurers.?The underwriting liability is transferred to the insured (by completing an on-line questionnaire) and the insurance company provides a commoditised solution.?All well and good if the nature of the asset aligns with the standard policy wording and the insured has discharged their obligation of ‘utmost good faith,’ i.e. full disclosure and truthfulness.

Most people do not read their policy wording or PDS, after all it’s boring, they haven’t had a claim for 5 years and the insurance company has our best interests at heart, don’t they??For the most part, this works well, i.e. a commoditised solution (insurance) for a commoditised product (average home/contents).?

However, policy wording ambiguity or an assumption of a Definition such as Flood, can result in financial catastrophe for the home owner.?Moreover, exclusions such as bushfire and policy Limits need to be understood ex post the purchase decision.

Maintenance and Wear and Tear are Exclusions in most policies.?If the insurance assessor deems the leak in your roof was due to poor maintenance, your policy will not respond to repair the roof.

If customers build or own property in deemed bushfire, cyclone, flood zones, check the Exclusions section of your policy.?Are policy holders aware their insurer has deemed their properties to be in one of these zones? If in fact they are exclusions, other risk mitigation strategies will need to be undertaken.?Do not rely on your insurance policy.

Self-Insurance

The notion of self-insurance is tempting and worth exploring.?Self-insurance means using one’s personal balance sheet as the insurance company.?An example may provide the most effective explanation.

Increasing your deductible (excess) to the maximum allowable is arguably a more effective risk and premium management tool.?Good policies allow for significant premium flexibility for valuable items such as Jewellery, Fine art and Collectibles.?Mass market policies do not. A good broker should discuss your policy options with you.

Averaging

Averaging or co-insurance is misunderstood. Broadly, insuring your assets for a value materially lower (20%+ depending on insurer) means any claims could be declined or a settlement substantially lower than the sum insured. Claim declinatures are disclosable events and may impact next year’s premium. See calculation below.

A good broker will align your needs with an appropriate insurance market/s.?Correct sums insured are critical to avoid over or under insurance. Valuations (for insurance purposes) should be conducted at the outset of your insurance programme and updated as required.?

Premium Management

Premium management is a fundamental component of high net wealth broking service

This is another service a good private client broker can bring tangible value to a relationship.?Trust is a fundamental plank, allowing the broker to gain a holistic understanding of their client’s needs, lifestyle and expectations of an insurance programme.?Options such as aggregation of jewellery cover, frequency of use, security measures and storage facilities should be taken into account when assessing risk and premiums.??

The importance of the Broker

It’s critical that a broker has the capacity to serve as their client’s advocate in all aspects of their insurance programme

A professionally intermediated insurance programme is fundamental to ensure the needs and expectations of high net wealth families and others are met.

Characteristics of a good broker include:

·?????A deep understanding of their client’s lifestyle, needs and expectations from their insurance arrangements

·?????Honesty from both parties

·?????Proficiency in placing a broad range of risks including superyachts, personal aircraft and international property

·?????The ability to gain and maintain trust with the insured and their family

·?????Access out of business hours

·?????The ability to clearly explain respective policy wordings, exclusions, provide premium management strategies and pricing options

·?????Serve and manage all claims as their advocate

·?????Provision of risk management and mitigation strategies and tactics

Lessons

1.????Take time to understand your policy wording.?If you find it daunting, engage an expert to explain it to you, particularly its Exclusions.?If your policy is deficient, seek ?terms aligned to your needs

2.????Be aware of your biases when making decisions.?We all rely on them, sometimes to our detriment.?Achieving value is significantly more important than price.

3.????Consider engaging an independent insurance broker.?Ask a friend for an introduction and be prepared to have an open conversation.?A good broker should be your advocate not the insurance markets. Several key questions should reveal their motivations.

4.????Undertake a ‘health check’ of your assets, including current valuations, security arrangements, premium review and administrative efficiencies to optimise your insurance programme

A client’s perspective of insurance

In this section John Favaloro reviews our story and adds his views.

I have a few observations to make from a client perspective.

???????????????Clients are required to provide full and frank disclosure. Cover ups are problematic. But it goes a bit further,?this also means that clients?provide?properly detailed information about the property to be covered and in the hard market (such as now) the better brokers and insurers are encouraging clients to have a risk register so that there is clarity about what the insurer is being asked to cover; and the client can present a case?when cover for a particular risk is refused.???All of this needs to be prepared with some care and I have found that even relatively minor omissions and errors can become quite problematic if there is a claim.

???????????????Keeping meticulous records of all information provided to insurers and brokers and insurance policies and certificates of currency are absolutely essential.

???????????????You get what you pay for – a good broker and a good insurer are essential. A good broker can?help deal with insurers especially when there are problems with a claim.

???????????????Always check out the claims management reputation of the insurer(s) before accepting their quote

???????????????A client who has a reputation for?chopping and changing brokers or insurers usually has more difficulty getting good and reasonable cover in a hard market or with difficult claims.

Conclusion

As the great investment and insurance manager, Warren Buffett says “Only when the tide goes out do we get to see who’s been swimming naked”. ?So, if you have an aversion to exposing yourself, engage the services of a trusted broker.?It could save you considerable financial embarrassment.

Boyd Lees works for Howden Insurance Brokers and can be contacted on 0409 418 195.