Why the insurers of the NZ International Convention Centre that recently caught fire should be ‘happy’ about the claim
Insurance as a product transfers the risk of loss from the insured to the insurer. However, insurance as a business is about much more than that; it is primarily about balancing a key ratio. It must be, otherwise for the reasons set out below the business would no longer exist.
The balancing act
The risks that insurers take on must be risks that consumers and businesses feel a real exposure to. If the chance of a loss resulting from an insured risk is too remote, no one will want to pay money to transfer it. Every time a loss occurs as a result of an insured risk, the insurance product is validated. The need for it is reinforced. Sales are encouraged.
On the other hand, insurers don’t want the incidences of losses resulting from that risk to be too high, otherwise, they won’t make a profit, or worse, they will become insolvent. Where a risk is so great or the size of the losses arising from it are so large that they can’t be successfully spread amongst the insurance/reinsurance world without risking insolvency, the risk is uninsurable.
There are many uninsurable risks and there always will be – think of the common ones of war/nuclear/terrorism. A concern is that the effects of the climate crisis may be joining that list, which will have far-reaching consequences for businesses and consumers. However, addressing that concern is not the purpose of this newsletter.
It is easy to see that to some extent there is a potential conflict between wanting to insure risks that have a realistic likelihood of losses occurring and not receiving too many claims. Getting the balance right is critical and for this reason, it is the essence of insurance as a business.
That balance is reflected in the key ratio of premiums to claims – known in the industry as the loss ratio. Ignoring business expenses, if a product’s loss ratio is 100%, the insurer paid out the entire premium received in claims.
When you add expenses to the equation, the ratio is called the combined operating ratio (COR). If the COR is 100% the entire premium received equalled all the claims paid and all the expenses incurred – the insurer just broke even. Insurance is a business and insurers must achieve a COR under 100% in order to pay a dividend to their shareholders. This is no easy task.
Insurance is intangible; you can’t feel the transference of the risk so demonstrating its worth when there has been no need to claim is a challenge. This makes the product very price sensitive. Market forces can drive the premium down to levels that are unsustainable long term for insurers. Insurers have to control expenses tightly to ensure this part of the COR remains competitive. Lastly, the impact of claims has to be carefully managed by deciding how much of a risk to take on in the first place (100%, or less requiring other co-insurers to take up the balance) and how much to retain before transferring the balance of the risk off to a reinsurer. One of the factors behind AMI’s insolvency was that it tried to save on its reinsurance premiums (expenses) by purchasing too little reinsurance. Its retention was too high.
The reason for setting all this out is to demonstrate that in a perverse way, insurers should welcome claims. They are a sales aid. Insurers need claims to demonstrate the need for businesses and consumers to pay good money to transfer the risk to them in the first place.
The graphic fire at the New Zealand International Convention Centre has now reminded the owner of every construction site in New Zealand of what apparently can so easily go wrong, and the size of the loss that can result from it.
The fire has promoted the need for adequate construction insurance and liability insurance in a very public way. This is a good thing, as the industry needs this to survive.
Please feel free to contact us if you require any further information.