Insurance Activity Extends Far Beyond Traditional Insurance Companies.
When you hear the word ‘insurance’, you may imagine something boring like car or fire insurance. But insurance is actually a much broader, exciting field at the heart of finance. Insurance serves a crucial role in our modern society, enabling productive risk-taking, financial planning, and security. In this article, I will try to broaden your idea of what insurance is and give concrete examples of lesser-known insurances that benefit society. I will also tell you how you can become an insurer today. But to be sure we have the basics covered, I will start with a short paragraph about the boring insurance model, which is about risk sharing.
Boring Insurance – Risk Sharing
The better-known, boring insurance schemes are the ones offered by traditional insurance companies. Think of insurance for a car, a home, or a life. The business models of these companies are very similar. They take on different risks of events that would be catastrophic for any individual customer (e.g., home burns down), pool these risks together, and pay out if something happens to one of the customers. The assumption is that among a large customer base, these incidences happen with a predictable frequency, even if it is unpredictable when or to whom. On average, the insurance company earns a small margin of around 4% on every policy. These traditional insurance companies are all interconnected through various re-insurance schemes that allow them to further spread risk between them.
These traditional insurance schemes are about risk sharing and have existed for a long time. But today, non-insurance companies and individual investors can also become insurers.
When you buy insurance for your car, it is the insurance company (the intermediary) that pays out if your car crashes. You can then use that money to buy a new car from a car company. If the car only needs a new bumper, you go to a car repair shop and the insurance company will reimburse you. Financially, the insurer sits between you can the car company as an intermediary. The car company and insurance company are entirely separate. But it is also possible for a car company to disintermediate the insurer, and start offering insurance themselves. If that were the case, then you might buy a car and a five-year insurance that goes with it. That means the car company successfully disintermediated the insurer.
Apple is an example of a company that actively disintermediates computer and phone insurance companies. If you buy an iPhone or Mac computer from Apple, you can purchase an “AppleCare Protection Plan” with it. This is a multi-year insurance policy for your device, offered by the manufacturer of the product, without an insurance company acting as intermediary. With this AppleCare Protection Plan, you get a high-quality insurance from a trusted brand. It is in Apple’s interest to provide a no-hassle insurance to provide the best customer experience. This is different from traditional insurance companies, who will try to avoid paying out or who might let you wait a few months to get your phone back. Apple offers quality insurance that helps to build a long-term relationship between the brand and the customer.
Another example of a brand disintermediating traditional insurance companies is Airbnb. On the Airbnb platform, hosts can rent out their room or apartment to short-stay guests. But this activity creates the (small) risk of vandalism or theft of host property. Airbnb wants to take away this risk to make hosting more appealing and strengthen their brand by directly providing hosts with insurance against their guests’ potential misbehavior. Not only is this insurance good for the brand, but Airbnb (like Apple) can also make a small profit by offering this insurance, which is easy for them to sell together with their other products and services.
Only businesses that sell products can disintermediate insurance companies and start insuring the products they produce. But with derivatives, anyone is able to insure virtually any event.
Derivatives are financial contracts that promise a future pay. The payout amount is derived from the value of an underlying asset or an event. These underlying assets can be commodities like energy (e.g., crude oil, gas, coal), foods (sugar, coffee, wheat), or raw materials (copper, gold, wood). But the derivative can also be based on (government) debt, the amount of rainfall, or an election outcome. The derivatives of these assets and events are a type of insurance contract.
On the derivatives market, derivatives (insurance contracts) are freely traded, just as other financial contracts like government debt. Although it is mainly businesses that trade these insurances, anyone can take out or give out all kinds of insurance on the derivatives market. You can take out or sell these insurances through a stock broker.
How Insurance Through Derivatives Works
The price for wheat and other commodities (like oil or copper) fluctuates all the time based on things like weather and people’s changing preferences. This makes it difficult to invest in the production of wheat and other commodities.
Say you are a farmer and you want to plant your field with wheat. The cost of producing wheat might be USD $100, but the wheat will only be ready 9 months from now. The price after 9 months could be anywhere between $80 and $130. If the farmer is unlucky, they have worked the land for $100 and can only sell the wheat for $90. That would be a huge risk to the farmer, who might go bankrupt if the price of wheat is too low. Luckily, the farmer can choose to take out insurance on the price of wheat 9 months from now. For say $6, the farmer can buy the right to sell his wheat to the insurer for $110 in 9 months. This increases the cost from $100 to $106, but the farmer gets a ‘guaranteed’ return of $110 – $106 = $4. If the price of wheat is higher, then the farmer can choose to sell to someone else and the person who offered the wheat price insurance still made $6. If the actual price of wheat is lower than $110 (say $95), then the insurer still has to buy the wheat for $110 and will sell it again for the real price of $95. In that case, the insurer made $6 but lost $15 nine months later, for a net loss of $9. The insurer will, on average, make a small fee on the insurance, and the farmer does not have to worry what the price of wheat will be.
The Taxi Driver And The Oil Producer
Here is an example where two companies have ‘opposite’ risk profiles and insure each other through derivatives: a taxi driver and an oil company.
The taxi driver wants to purchase a new and expensive Mercedes as an investment in his taxi driving business. After two years, the taxi driver will have made enough rides and earned back the investment they made in the Mercedes. But there is one caveat. The price of oil is a major cost in the taxi business, and it could go up 50% in a year. If the price of oil goes up, then the cost for the taxi driver of each ride goes up. This makes the investment in the taxi driving business very uncertain and this might be a reason for the taxi driver not to invest in the expensive Mercedes.
Then there is the oil company. The oil company considers investing in equipment to extract oil. But if the price of oil goes down, then the investment will not have been worth it. These two companies, the taxi driver and the oil company, have opposite risks. One is afraid of oil prices rising, and one is afraid of oil prices falling. They can choose to insure each other, and fix the future price of oil between themselves. In this case, they both give out and take out insurance on the future oil price, in a way that benefits them both. Through derivative contracts, they agree that if oil becomes more expensive, the oil company pays the taxi driver. But if oil becomes cheaper, then the taxi driver must pay the oil company! This means that the future oil-price risk that both companies face are cancelled out. Although potential profits are lower for each company, the potential losses are lower, too. If these companies could not take out this derivative insurance, then they might not dare to invest in their respective businesses at all. But because they can use derivatives, they are now able to more safely invest in productive activity.
The Orange Farmer and the Juice Company
An analogous example can be made for a farmer who wants to farm oranges and a juice company who wants to invest in an orange juice squeezing factory. The farmer wants to insure against a drop in the price of the oranges he will produce, and the juice company wants to insure against oranges becoming more expensive.
The Derivatives Market
The design of these derivatives is such that the taxi driver and oil producer, the farmer and the juice company don’t even need to know each other. Instead, they trade oil futures contracts on the open derivatives market, without actually knowing who is giving out or buying the contracts. And once the contracts are traded, they can also be traded again to transfer the risk to other insurers. Speculators can also trade these contracts, and will do lots of analysis to try to price the insurance and re-insure the insurance more accurately than other market participants. These speculators help to accurately price the insurance contracts and make sure that there is always someone to trade with. These derivatives markets exist for things like the future price of oil, soy beans, aluminum, and even more abstract products like government debt.
Insure Home Prices
Derivates can also be used to insure home prices across the U.S. or in specific metropolitan areas, such as Boston. Through derivatives, you can ensure yourself against a drop in the value of house prices. Or, if you think that prices will rise or fall, you can speculate on the future prices of homes. By buying and selling multiple insurance contracts, you can even speculate that one area will see a price increase or decrease relative to the rest of the country.
These house-price insurance contracts could even be sold together with mortgages, which should lower the interest paid on the mortgage because there is less risk to the bank. Firms that specialize in offering just these products to customers who are not yet familiar with derivatives could spring up and help people insure against home price declines. If such an insurance had been common in 2007 in the U.S., then fewer people would have lost their homes and the recession would have been less severe. A widespread use of this insurance could even affect home prices themselves. They might become less volatile as there would be less need for country-wide fire sales of homes if more people were insured.
Insurance And Society
I hope that this article has convinced you that insurance is an interesting field that extends well beyond the boring, traditional insurance companies. Brands such as Airbnb and Apple are offering insurances themselves to strengthen their brands and expand their business operations. Through the open derivatives market, anyone can become an insurer and insure odd things like the future price of houses or wheat. Insurance is not just the transfer of risk from one party to another in a zero-sum game, but risks can cancel each other out to the benefit of everyone. Insurance through derivatives can enable productive activity such as investing in taxi driving or building an orange juice factory, which might be too risky if it was not insured.
Now that you know how broad insurance is, what things would you like to have insured? Leave a comment to tell us about any non-conventional insurance schemes that you would like to buy or sell!