Things happen sort of sometimes. You are never sure. Take a universe. Technically, there are so many conditions to meet if you want to have a decent universe that is seems a real blessing we have one. You need them electric charges, for example. We call them negative and positive, fault of a better description, but the fact is that in reality, we have two kinds of elementary particles, A and B, I mean protons and electrons, and each A repels any other A but is irresistibly attracted to any B. Same for B’s. Imagine that 50% of B’s start behaving like A’s, i.e. they are attracted by other B’s and repel A’s. You would have 50% of matter devoid of atoms, as you need A and B to behave properly, i.e. to cross-mate A+B, and avoid any A+A or B+B indecency, in order to have an atom.
Kind of stressful. You could think about an insurance. An insurance contract stipulates that the Insured pays to the Insurer a Premium, and in exchange the Insurer gives to the Insured the guarantee of paying them damages in case a specific unpleasant event happens in the future. We insure our cars against physical accident and theft, same for our houses and apartments. You can insure yourself when you travel, and you are afraid of medical bills in case something happens to your health when on the road.
I learnt, with a big surprise, when reading the magnificent Fernand Braudel’s “Civilisation and Capitalism” , that insurance was the core business of the first really big financial institutions in Europe. Yes, we used to do banking. Yes, we did all that circulation in debt-based securities. Still, it was all sort of featherweight business. Apparently, the real heavyweights of finance appeared with the emergence of maritime insurance. When small, local bankers started offering to the owners of commercial ships those new contracts, guaranteeing to pay for their damages in case there are any, and they gave those guarantees in exchange of relatively small insurance premiums, it was, apparently, like the release of a new iPhone in the world of gadget-lovers: a craze. By offering such contracts to captains and ship owners, those local bankers had rapidly swollen to the size of really big financial institutions.
Financial instruments always have an underlying behavioural pattern. Financial instruments are what they are because we, humans, do what we do. One of the things we do is selective individuation. There is a hurricane coming your way. You board your windows, you attach your garden furniture, you lock yourself in your house, and you check the insurance of your house. You brace against the calamity as an individual. That hurricane is going to do damage. We know it. We know it is going to do damage to the whole neighbourhood. Technically, the entire local community in threatened. Still, we prepare as individuals.
As I check the insurance of my house, I can read that in exchange of a premium, which I have already paid, I can possibly receive a coverage of my damages. Do I really want things to take such a turn, which would make those damages material? With rare exceptions, not really. Yes, I have that insurance but no, I don’t want to use it. I just want to have it, and I want to avoid whatever event might make those damages payable.
I imagine other people in a similar position. All bracing for an imminent hurricane, all having their individual insurances, and all sincerely expecting not to suffer any damage covered by those insurance contracts.
This is selective individuation as it comes to the foresight of future events. I know some bad s**t is heading my way, I know it is going to hit all around, and I just expect it is not going to hit me. As it is bound to hit all around, there is bound to be some aggregate damage. The hurricane is bound to destroy property for an amount of $5 000 000. There are 500 000 people under threat. Let’s say that 24% of them think about insuring their property. How will an insurer approach the situation?
First of all, there is bound to be those $5 000 000 of damages. Seen from a financial point of view, it is a future, certain capital expenditure. I stress it very strongly: certain. What is just a probability at the individual level becomes a certainty at a given level of aggregation. What is the “given level”? Let’s suppose there is a 1% likelihood that I step on a banana skin, when walking down the street. With 100 of me, the 1% becomes 1%*100 = 100%. Sure as taxes.
You have (I hope) already studied my lectures on equity-based securities, the debt-based ones, and on monetary systems. Thus, you already know three manners of securing capital for a future, certain outlay. Way #1: create an entity, endowed with equity in some assets, and then split that equity into tradable shares, which you sell to third parties. This way is good for securing capital in the view of slightly risky ventures, with a lot of open questions as for the strategy to adopt. Way #2: borrow, possibly through issuance of promissory notes (oldie), or bonds, if you really mean business. This path is to follow when you can reasonably expect some cash flows in the future, with relatively low risk. Way #3: get hold of some highly liquid assets, somebody else’s bonds, for example, and then create a system of tokens for payment, backed with the value of those highly liquid assets. This manner of securing capital is good for large communities, endowed with a pool of recurrent needs, and recurrent, yet diffuse fears as for the future.
With insurance, we walk down a fourth avenue. There are some future capital outlays that will compensate a clear, measurable, future loss that we know is bound to happen at a certain level of social aggregation. This aggregate loss decomposes into a set of individual s**t happening to individual people, in a heterogenous manner. It is important, once again: what you can predict quite accurately is the aggregate amount of trouble, but it is much harder to predict individual occurrences inside this aggregate. What you need is a floating mass of capital, ready to rush into whatever individual situation it is needed to compensate for. We call this type of capital a pooled fund. Insurance is sort of opposite of equity or debt. With the latter two, we expect something positive to happen. With the former, we know something bad is going to occur.
According to the basic logic of finance, you look for people who will put money in this pooled fund. Let’s take those 500 000 people threatened by a hurricane and the resulting aggregate loss of $5 000 000. Let’s say that 24% of them think about insuring their property, which makes 24%*500 000 = 120 000. In order to secure the $5 000 000 we need, the basic scheme is to make those people contribute an average of $5 000 000/ 120 000 = $41,67 of insurance premium each. Now, if you take a really simplistic path of thinking, you will say: wait, $5 000 000 divided by 500 000 folks exposed makes $10 per capita, which is clearly less than the $41,67 of insurance premium to pay. Where is my gain? Rightful question, indeed. Tangible gains appear where the possible, individual loss is clearly greater than the insurance premium to pay. Those $5 000 000 of aggregate loss in property are not made as $10 times 500 000 people. It is rather made as 0,005% likelihood in each of those people to incur an individual loss of $200 000 in property. That makes 0,005%*500 000 (remember? the banana skin) = 25. Thus, we have 25 people who will certainly lose property in that hurricane. We just don’t know which 25 out of the general population 500 000 will they be. If you are likely, just likely, to lose $200 000, will you not pay $41,67 of insurance premium? Sounds more reasonable, doesn’t it?
You are not quite following my path of thinking? Calm down, I do not always do, either. Still, this time, I can explain. There are 500 000 people, right? There is a hurricane coming, and according to all the science we have, it is going to hit badly 0,005% of that population, i.e. 25 households, and the individual loss will be $200 000 on average. That makes 25*$200 000 = $5 000 000. In the total population of 500 000, some people acknowledge this logic, some others not really. Those who do are 120 000. Each of them is aware they could be among the 25 really harmed. They want to sign an insurance contract. Their contracts taken together need to secure the $5 000 000. Thus, each of them has to contribute $41,67 of insurance premium.
At this very basic level, the whole business of insurance is sort of a balance between the real, actual risk we are exposed to, and our behavioural take on that risk. Insurance works in populations where the subset of people who really need capital to compensate damages is much smaller than the population of those who are keen to contribute to the pooled fund.
Interestingly, people are not really keen on insuring things that happen quite frequently. There is high likelihood, although lower that absolute certainty, that someone in the street will stick an old chewing gum on the seat, on a bus, and then you sit on that chewing gum and have your brand-new woollen pants badly stained. Will you insure against it? Probably not. Sort of not exactly the kind of catastrophe one should insure against. There is a certain type of risks we insure against. They need to be spectacular and measurable, and, in the same time, they need to be sufficiently uncertain so as to give us a sense of false security. That kind of trouble is certainly not going to happen to me, still, just in case, I buy that insurance.
We can behaviourally narrow the catalogue of insurable risks, by comparing insurance to hedging, which is an alternative way to shield against risk. When I hedge against a risk, I need to know what amount of capital, in some assets of mine, is exposed to possible loss. When I know that, I acquire other assets, devoid of the same risk, for a similar amount of capital. I have that house, worth $200 000, in a zone exposed to hurricanes. I face the risk of seeing my house destroyed. I buy sovereign bonds of the Federal Republic of Germany, for another $200 000. Rock solid, these ones. They will hold value for years, and can even bring me some profits. My portfolio of German bonds hedges the risk of having my house destroyed by a hurricane.
Thus, here is my choice as for shielding my $200 000 house against hurricane-related risks. Option #1: I hedge with equity in valuable assets worth $200 000 or so. Option #2: I insure, i.e. I buy a conditional claim on an insurer, for the price of $41,67. Hedging looks sort of more solid, and indeed it is. Yet, you need a lot of capital to hedge efficiently. For every penny exposed to a definite risk, you need to hedge with another penny free of that risk. Every penny doubles, sort of. Besides, the assets you hedge with can have their own, intrinsic risk, or, if they haven’t, like German sovereign bonds, you need to pay a juicy discount (price, in financial tongue) for acquiring them. Insurance is cheaper than hedging.
My intuitive perception of the financial market tells me that if somebody has enough capital to hedge efficiently against major risks, and there are assets in view, to hedge with, people will hedge rather than insure. They insure when they either have no big capital reserves at all, when they have run out of such reserves with the hedging they have already done, or when they have no assets to hedge with. When I run a pharmaceutical company and I am launching a new drug at high risk, I will probably hedge with another factory that makes plain, low risk aspirin. That makes sense. It is a sensible allocation of my capital. On the other hand, when I have a fleet of company cars worth $5 000 000, I would rather insure than hedge.
This is what people do in the presence of risk: they insure, and they hedge. They create pooled capital funds for insurance, and they make differentiated portfolios of investments for hedging. Once again: this is what people do, like really. This is how financial markets work, and this is a big reason why they exist.
As I talk about how it works, let’s have a closer look. It is finance and it is business, so what we need is a balance sheet. When, as an insurer, I collect $5 000 000 in insurance premiums to cover $5 000 000 of future damages, I have a potential liability. Here, it becomes a little tricky. Those damages have not taken place yet, and I do not need to pay them now. I am not liable yet to people I signed those insurance contracts with. Still, the hurricane is going to hit, and it is going to destroy property for $5 000 000, and then I will be liable. All in all, the principles of accounting specifically made for the insurance business impose an obligation, upon insurers, to account the insured value as a liability.
Now, a big thing. I mean, really big. Economically, most of what we call ‘public sector’ or ‘political organisations’ are pooled funds. The constitutional state can be seen as a huge pooled fund. We pay our taxes into it, and in exchange we receive security, healthcare, infrastructure, bullshit, enlightened guidance of our leaders etc. Just some of us can really experience that payoff, and, strangely enough, we don’t always want to. Yes, we all want to drive on good roads, but we don’t want to be in a situation when the assistance of a police officer is needed. Most of us wants to have nothing to do with prisons, which are also part of what this pooled fund finances.
There is a pattern in the way that pooled funds work. That pattern sums up to the residual difference between the insurance premiums actually collected, and the actual damages to be paid. A successful insurer manages to market his contracts in sufficiently big an amount so as to have a surplus of premiums collected over the damages to be paid. The part of premiums collected, which is supposed to pay for damages, is the technical reserve of the pooled fund. The residual surplus of premiums collected, over the technical reserve for damages, is de facto an investment fund, which brings a financial yield.
Most types of insurance are based on the scarcity of occurrence across space. Hurricanes do damage to just some of us, but many are willing to insure against.
There is a special type of insurance, usually observable as those special contracts called ‘life insurance’. Life insurance contracts are about death and severe illness rather than about life. When you think about it, those contracts insure a type of events, which are certainly going to happen. In ‘ordinary’ insurance we pool funds for events scarce across space: we don’t know where the hurricane is going to hit. In life insurance, we pool funds for financing occurrences 100% bound to happen to everyone, we just don’t know when.
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