As with most articles I read at Insurance Thought Leadership, I enjoyed The Myth of the Protection Gap. I do agree with the author (Paul Carroll) that not everything that can produce a negative outcome or loss needs to be insured. In fact, we are now in an era where we can buy insurance for nearly any property we own with a swipe of an app on a smartphone. Assuming that these companies are not charities, this approach is counterproductive, simply because it forces users to waste time having to remember to insure the thousands of small dollar items we own, when we can just afford to replace them. So place me in the camp that says insurance is for instances where we could not otherwise reasonably expect to be made whole again.
But the protection gap itself is very real. I will use Paul’s hypothetical example to illustrate a counterpoint to his conclusion:
“To make the math simple, let’s pick a country at random and make up some numbers out of whole cloth. Let’s imagine we’re Gabon, and we, as a nation, incur $1.5 billion of losses a year, while only $500 million is covered by insurance. We’re told we have a protection gap of $1 billion. We should buy $1 billion of additional coverage.
It’ll only cost us $1.3 billion.
That’s because — again, in very rough numbers — the insurer has to tack on 20% on top of the losses to cover expenses and needs its 10% profit margin to keep shareholders happy.”
Let’s break this down: If the losses for Gabon are $1.5 billion per year, with $500 million covered, then how much insurance do they need to buy? The article is suggesting the answer would be an additional $1 billion.
But that is not the right answer. The right answer is that Gabon should not buy any insurance!
How is that possible? Well, if I know with certainty that my losses over time will be $1.5 billion, then instead of buying insurance I can set aside funds to pay those anticipated losses. To put it another way, if I were insuring an entity that will have $1.5 billion losses each year, then the premium I would charge MUST start at $1.5 billion (because I know for sure that those will be the losses ) and then tack on expenses for managing those claims, issuing paper and, of course, my profit margin.
Am I nitpicking? Yes, I am.
The hypothetical example likely meant that losses would average $1.5 billion per year and not BE $1.5 billion. But words matter, and, in this hypothetical example, the word “average” changes enough of the example to magically make the protection gap appear in full vengeance.
Well, averaging $1.5 billion per year in losses can mean lots of things. It could mean $1.5 billion each year, every year, OR it could mean a $30 billion loss happening exactly once in the next 20 years (or an infinite set of other combinations).
It is this uncertainty in the losses that makes insurance such a valuable tool for risk management. Insurance is that tool that allows Gabon to manage its cash flows in such a way that it can function day after day and not have to worry about finding $30 billion at a moment’s notice. Insurance is not about paying for the average annual losses, it is about paying for the extreme losses and avoiding the cash flow crunch associated with that. The smoothing out of volatile cash flows IS the peace of mind that is often marketed to consumers of insurance.
90% of California homeowners lack earthquake insurance. The take-up for flood coverage is similar. These perils have caused hundreds of billions of dollars in property loss, the bulk of which were uninsured. Tens of thousands of families became homeless. We’ve seen it In Louisiana after Katrina and in the tri-state area after Sandy, and we will see it again. The protection gap is not a myth, it is very real, and these perils will continue to cause hundreds of billions of dollars in damage. These are losses that homeowners and businesses cannot fund themselves. They require insurance to protect them from these catastrophes.
This fact alone provides a wonderful opportunity for our entire industry to grow by solving huge and emerging problems faced by societies. This is why we exist; this is our irreplaceable contribution to society.