Self-Insuring
During my career on Wall Street, I had occasion to become an expert of hedging and insurance. Let’s be clear about what I mean by an expert. I founded and ran our futures and options subsidiary thirty-five years ago when hardly anyone understood futures and options and very few in the financial world other than traders and commodities people even understood what hedging really was all about. This was the precursor to the derivatives market, which began in the late eighties and has soared from there. What was hedging? It was insurance that the price of what you held would not go down or the price of what you needed to buy would not go up. Obviously that’s a purposefully simplistic explanation, but it more of less covers it nonetheless.
Then about thirty years ago, some of us got to thinking about the similarities between hedging and insurance and wondered why the insurance industry did everything quite differently than those of us on the trading floor. The fundamental difference was that while we both used statistical models to estimate the likelihood of certain events, the trading floor priced risk based on what are called closed-form mathematical models while insurance used actuarial models, which used the laws of large numbers and were also probabilistic, but used very different math to come to a conclusion. On Wall Street, when two people are trying to price something in two different ways, someone is bound to think there is an arbitrage play around the corner. And sure enough, the two businesses looked at risk and priced it quite differently to the point where many of us thought there was a business to be had in bringing those methods together somehow.
That is when I got into the insurance business (still wearing a banker’s hat). I either started or bought seven different insurance companies that were registered as insurance companies in an array of arenas. Insurance is broken into Life and property & casualty (P&C) and then between direct and what is called re-insurance (think wholesale versus retail). These all underwrite different risks in different ways. But my goal in this story is not to teach you about insurance at a granular level, but to explain something that impacts all of our lives this moment.
We all buy insurance by necessity to live a modern life. Assuming we are not determined to be off-the-grid, we need insurance to drive a car and to mortgage a house at very least. Those are both P&C and the world wants to know that if you crash in the car or in your financial life, there is some protection for those around you that are affected by the crash. This is all highly regulated stuff (consumer protection being what it is…thank you Elizabeth Warren) so that everyone has a level playing field to buy this required insurance. As for Life, it is more optional, but since your employer probably give you some and offers you more, you have to al least be conversant about it. And once you get married or have a kid, the world looks at you funny if you haven’t loaded up to insure everyone’s continued happy future if you are not around to provide it. There are also a boatload of tax-related advantages to insurance, not for any logical reason, but because the insurance lobbying efforts are so very powerful and have secured a special place in the tax firmament for its vaunted products. I know exactly what you are thinking right now. You think this is getting complicated and may be more than you care to learn about a dry and uninteresting thing like insurance. That is exactly the thinking that the insurance companies count on, so you are right on track.
I have an MBA in finance from a top school. I have worked at the highest levels of banking for 45 years, I have bought, built, run and sold seven insurance companies, and I have been a Clinical Professor of Finance for over ten years at the graduate level. And here’s the thing, I can barely understand my own insurance policies, especially the Life ones (whole, hybrid or term). I have, over the years, sat down with countless insurance salesmen and executives (even a few actuaries) and they are little or no help. They can tell me how to build the watch, but they can’t tell me the time. None of this is an accident. It is all designed to obfuscate, just like that word is. You being confused more often than not makes you a great client and a lousy consumer of insurance. Don’t believe Sy Sims, an educated consumer is NOT their best customer.
So, back to hedging and insurance. Neither of them protect you from what everyone knows and thinks might happen. If there is a 10% chance that you can take a loss of $100, no one is selling you that hedge or insurance for less than $10. Add administrative costs, capital costs and profit margin and you’ll be lucky to buy that for $20. When the perception of risk goes up, the “rate on line” goes up. No one is quicker to reassess risks than insurance people. There really is no free lunch in buying insurance or hedging your risk. Contrary to popular thought, you cannot lock in todays’ price of something by hedging or insuring it. The best you can do is lock in the markets forward perception of that value. In other words, any risk everyone knows gets priced in and there is no free lunch. If the market is feeling skittish, they will over-price the risk. If they are feeling confident, they might underprice the risk…but very rarely.
As a long-time hedging and insurance “expert”, the one thing I know is that I prefer not to buy either if I can help it. Sometimes a loss is too big to suffer without some risk-sharing (law of large numbers comes back into play here). Now let’s talk about what I came to address, and that is trip insurance.
Generally I ignore warranty extensions and product fix-it insurance. It’s usually a small enough item that I can afford to self-insure it. But how about a trip with the whole family. That’s a bigger nut for sure, but does trip insurance make sense? Like particularly with this whole Coronavirus thing running around and disrupting all our plans? I remain firm in my resolve that it does not and here’s my reasons why:
1. The risk, as best it is known, is already priced into the market and the rate on line reflects that.
2. If you die there is little doubt you are dead, but if you have to cancel a trip, how easy do you think it will be to make the claim that you should have been covered because Spain is near Italy and Italy has a big warning sign on it for Coronavirus at this moment and you’re not comfortable traveling to Spain under these iffy circumstances?
3. A trip is a play thing. It involves discretionary funds. If I break my toy, I live without it. I do not insure my toys, I self-insure.
So, Rich’s rules of hedging and insurance…don’t do it unless you absolutely cannot afford the loss and if your view of the world is worse than the guys pricing the insurance or hedge. Since the second part is very hard to figure out, I will shorten it to just don’t hedge or insure if you can possibly avoid it.