Marine Insurance, General Average, Mesopotamia, Genoa, Middle Class, Capitalism, London Coffeehouses and Lloyd’s of London

Posted by PITHOCRATES - April 3rd, 2012

History 101

It was in Genoa that Marine Insurance became a Standalone Industry

Risk management dates back to the dawn of civilization.  Perhaps the earliest device we used was fire.  Fire lit up the caves we moved into.  And scared the predators out.  As we transitioned from hunting and gathering to farming we gathered and stored food surpluses to help us through less bountiful times.  To avoid famine.  As artisans rose up and created a prosperous middle class we also created defensive military forces.  To protect that prosperous middle class from outsiders looking to plunder it.

As we put valuable cargoes on ships and sent them long distances over the water we encountered a new kind of risk.  The risk that these cargoes wouldn’t make it to their destinations.  So we created marine insurance.  Including something called ‘general average’.  An agreement where the several shippers shared the cost of any loss of cargo.  If they had to jettison some cargo overboard to save the rest of the cargo or to save the ship.  Some of the proceeds from the cargo they delivered paid for the cargo they didn’t deliver.  Some merchants who borrowed money to finance a shipment paid a little extra.  A risk ‘premium’.  Should the shipment not reach its destination the lender would forgive the loan.

So how long has marine insurance been around?  A long time.  Some of these practices were noted in the Code of Hammurabi (circa 1755 B.C.).  For ancient Mesopotamia was a trading civilization.  That shipped on the Tigris and Euphrates and their tributaries.  Out into the Arabian sea.  And beyond.  Following the coasts until advances in navigation and sail power took them farther from land.  The Greeks and Romans insured their valuable cargoes, too.  As did the Italian city-states that followed them.  Who ruled Mediterranean trade.  And it was in Genoa that marine insurance became a standalone industry.  No longer bundled with other contracts for an additional fee.

As the British Maritime Industry took off so did Lloyd’s of London

But the cargoes got larger.  And the voyages went farther.  Until they were crossing the great oceans.  Increasing the chances that this cargo wasn’t going to make it to its destination.  And when they didn’t the financial losses were larger than ever before.  Because the ships were larger than ever before.  So as the center of shipping moved from the Mediterranean to the ocean trade routes plied by the Europeans (Portugal, Spain, France, the Netherlands and England) the insurance industry followed.  And took the concept of risk management to new levels.

With trade came a prosperous middle class.  Where wealth was no longer the privilege of landholders.  Capitalism transferred that wealth to manufacturers, bankers, merchants, ship owners and, of course, insurers.  You didn’t have to own land anymore to be rich.  All you needed was skill, ability and drive.  It was a brave new world.  And these new capitalists gathered together in London coffeehouses to discuss business.  Including one owned by Edward Lloyd.  On Tower Street.  Where those particularly interested in shipping came to learn the latest in this industry.  And it was where shippers and merchants came to find underwriters to insure their ships and cargoes.

This was the birth of Lloyd’s of London.  And as the British maritime industry took off so did Lloyd’s of London.  As the British Empire spread across the globe international trade grew to new heights.  The Royal Navy protected the sea lanes for that trade.  The British Army protected their far-flung empire.  And Lloyd’s of London insured that valuable cargo.  It was a very symbiotic relationship.  All together they made the British Empire rich.  To show their appreciation of the Royal Navy making this possible Lloyd’s set up a fund to provide for those wounded in the service of their county following Lord Nelson’s victory over the combined French and Spanish fleets at the Battle of Trafalgar.  They continue to provide support for veterans today.  In short, Lloyd’s of London was the place to go to meet your global insurance needs.  From marine insurance they branched into providing ‘inland marine’ insurance needs.  Providing risk management to property beyond ships plying the world’s oceans. 

The Purpose of Insurance is to Let Life Go On after Unexpected and Catastrophic Events

Cuthbert Heath led Lloyd’s in the development of the non-marine insurance business.  Underwriting policies for among other things earthquake and hurricane insurance coverage.   And Lloyd’s helped to rebuild San Francisco after the 1906 earthquake.  With Heath ordering that they pay all of their policies in full irrespective of their policy terms.  They could do that because they were profitable.  Which is a good thing.  Insurers need to be profitable to pay these large claims without being forced out of business.  Which is why when the Titanic sunk in 1912 they were able to pay all policies in full.  And to continue on insuring the shippers and merchants that followed Titanic.  To allow life to proceed after these great tragedies.  And they would do it time and again.  Following 9/11.  And Hurricane Katrina.

This is the purpose of insurance.  Risk management.  So unexpected and catastrophic events don’t end life as we know it.  But, instead, it allows us to carry on.  Even after some of the worst disasters.  Because life must go on.  And that’s what insurance does.  Even people who rely on a particular body part for their livelihood have gone to Lloyd’s to buy insurance.  Perhaps the most famous being Betty Grable.  Who insured her legs for $1 million in 1940.  Pittsburgh Steeler Troy Polamalu has a lucrative endorsement with a shampoo company.  And insured his long hair for $1 million.  Rolling Stones guitarist Keith Richards insured his hands for $1.6 million.  America Ferrera (Ugly Betty) has an endorsement deal with a toothpaste company.  And they insured her smile for $10 million.  Even ‘the Boss’ Bruce Springsteen insured his voice for $6 million. 

People hate insurance companies.  Because they don’t understand how insurance works.  For they only know that they pay a lot in premiums and never receive anything in return.  But this is the way risk management is supposed to work.  And we need risk management.  We need insurance companies.  And we need insurance companies to be profitable.  Meaning that most of us will never see anything in return for all of our premium payments.  So these companies can pay for the large losses of the few who sadly do see something in return for all of their payments.  For insurance companies protect our wealth.  And earning potential.  So life can go on.  Whether we’re raising a family and planning for our children’s future.  Or taking precautions for some unforeseen accident to one of our body parts that may limit our future earning potential.

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Insurance and Risk Management

Posted by PITHOCRATES - April 2nd, 2012

Economics 101

By collecting a Small Fee from Many Policy Holders Insurance Companies can Afford to Pay for the Large Losses of a Few

Insurance has one purpose.  To protect wealth.  People work hard accruing wealth.  Buying a house.  Cars.  College fund for the kids.  Retirement 401(k)s and IRAs.  It takes a long time to earn the money that lets us have these things.  And they take a constant stream of payments to sustain them.  And we are always at risk of losing them.  Something can interrupt that stream of payments to sustain them.  An accident or illness that prevents us from working.  Burying us in a stack of unexpected bills.  A tree could fall onto the house during a bad storm.  You could total your car while driving to work in a thick fog.  A wife could lose her husband leaving her to raise their children on her own.

These are very real risks that we must manage.  Because we need to protect our wealth.  We buy house and car insurance so we can keep or replace our houses and cars because we can’t afford to buy new ones should we lose the old ones.  We buy life insurance to provide for our families should we die.  We buy health insurance so an accident or disease doesn’t wipe out our savings, college fund and retirement investments.  Because we do do these things we can manage the risks in life.  So that something unexpected and incredibly expensive doesn’t take everything away that we worked so hard for.

Managing our risks allows us to live our lives.  To plan for the future.  A future that has a price tag.  A future that takes a lifetime of accumulating wealth to pay for.  And to protect the wealth that provides for our families and our retirements we buy insurance.  Groups of people join together and pay a small fee for an insurance policy that will protect a very large amount of wealth.  So if we have an unexpected and very expensive event in our lives our insurance will protect our wealth by paying for our losses.  By collecting a small fee from hundreds of thousands of policy holders insurance companies can afford to pay for the large losses of a few.  Allowing life to go on.  As best as it can following these  unexpected events.  So even in the worst of events families can keep their homes.  Keep their kids in their schools.  Protect their kids’ future by keeping their college fund intact.  Replace their property.  Allowing life to go on as close to what it was before the event.  All thanks to insurance.

Bad Insurance Risks have an Advantage over Insurance Companies due to Asymmetric Information and Adverse Selection

Insurance companies provide this valuable service.  But it isn’t easy.  Because insurance isn’t a science.  But statistical analysis.  And risk analysis.  Which is how they determine the cost of their insurance policies.  A critical part for the survival of insurance companies.  So they can continue to provide this valuable service.

Insurance companies are at a disadvantage because of asymmetric information.  Meaning their customers know more about how great a risk they are than the insurance company.  For example, reckless drivers don’t offer that information when someone is quoting a policy for them.  For they want a low price.  Not a high price that reckless drivers normally get charged.  This is a problem mostly with young drivers.  Older drivers have a driving record.  If it’s a safe record they get a low quote.  If the record includes many points and at-fault accidents they will get a high quote.  Young drivers, though, don’t have a driving record yet.  This is where the statistical analysis comes in.  On average young men drive more recklessly than young women.  Based on the statistical evidence.  So they charge young men higher rates than they charge young women.  Problem solved.  But this causes another problem.

Not all young women are good drivers.  But by charging young women lower rates some bad women drivers are getting a rate lower than their risk warrants.  Which means insurance companies will lose money insuring these drivers at rates below their risk level.  In fact, this will attract more high-risk drivers.  Thus increasing an insurance company’s risk exposure.  And as they pay out claims that exceed the premiums they collect they have to raise insurance rates for all women drivers.  Thus discouraging some good drivers from buying insurance because of the higher premiums.  Thus increasing the percentage of high-risk drivers.  Which forces the insurance companies to raise their premiums again to cover these higher losses.  We call this problem adverse selection.  Where pricing plans to manage risk ends up increasing risk.  One way around this is by group coverage.  Like in health insurance.  Where everyone at a company buys insurance in exchange for a lower group rate.  Including the high-risk people.  And the low-risk people.  Thus avoiding adverse selection.

Economic Growth is the Creation of Wealth and our Insurance Protects that Wealth

When is insurance not insurance?  When it is health insurance.  At least as it is today.  It still acts like insurance for the unexpected and catastrophic accident or illness.  But it is anything but insurance for most everything else.  The latest example in the media these days being birth control.  Which is neither an unexpected nor a catastrophic expense.  For there are few expenses that are more expected and more affordable than birth control.  Unlike, say, chemotherapy.  Or trauma care in the emergency room.  Both of which are unexpected.  And very, very expensive.

When insurance pays for everything for everybody it is no longer managing risk.  Insurance companies are no longer collecting a small fee from all policy holders to pay for the large losses of a few.  Instead they’re collecting a large fee from everyone to pay for the costs of everyone.  Or more precisely, they’re collecting a large fee from the employers who provide health insurance to their employees.  So the recipients of all those free health care goodies don’t see their costs.  Which is how they’ve been able to include everything but the kitchen sink in today’s health care insurance policies.  Causing the price of health insurance to soar.  Hurting families.  Businesses.  And the economy as a whole.

A healthy economy allocates scarce resources to where we use them most efficiently.  When we do we create the most goods possible from these scarce resources.  Making society as a whole better off.  By improving the standard of living for society as a whole.  But by turning health insurance into a welfare program it increases the cost of doing business.  Which puts downward pressures on wages.  Preventing real wages from keeping pace with the rise in consumer prices.  Leaving workers with less disposable income.  Which translates into weak economic growth.  And a stagnant or declining standard of living.

Economic growth is the creation of wealth.  And our insurance protects that wealth.  When we convert that insurance into welfare, though, we put our wealth at risk.  By putting greater pressures on that stream of payments to sustain our wealth.  Our future plans.  And our families.

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FUNDAMENTAL TRUTH #21: “The reason why health insurance is so expensive is because it is not insurance.” -Old Pithy

Posted by PITHOCRATES - July 6th, 2010

YOU CAME IN with a grand ‘to lose’ but have been riding a hot streak.  You’re up 5 grand.  And feeling luckier still.  You came in with a grand, you think, so you can just as well leave with a grand.  So you bet 5 grand.  Cause those cards have been so good to you tonight.  And there it is.  Blackjack!  And just as you’re about to shout to the heavens you see the dealer throw an ace on his down card.  The dealer asks, “Insurance?”   

You don’t want to but you just KNOW what’s under that ace.  All of a sudden you’re not so cavalier about losing 5 grand.  Too many friends have told you the same story.  “I was up 5 grand until that last hand.”   You could cry.  You don’t buy insurance.  Only suckers buy insurance.  That’s what you’ve always said.  But when you’ve got 5 grand on the table, the dealer can’t have anything but blackjack.  You know it.  He knows it.  And your wife knows it even though she’s off playing the slots somewhere.  You pull out $2,500 from your ‘do not touch’ money and buy the insurance.  (Let’s end this on a happy note.  The down card was a queen.  You walk away as if that last hand never happened, $5,000 richer.  Less taxes, of course.)

LIFE’S BEEN GOOD.  You’re making good money.  You have a beautiful wife and 3 great kids.  You just sold that small house and moved into that big house you always wanted for the holidays.  Cost a pretty penny.  But you had $75,000 in equity in the old home.  And cashed in a CD to furnish the new one with some nice new toys.  After all, life has been good.

The mortgage stings a little, but not too much.  You’ll get by.  You got all the big things you’ve wanted.  Now you can settle in and live modestly in your new home.  And you bought insurance up the wazoo.  If there is fire, flood, theft or death, no worries.  Well, there’ll be some worry, but you won’t financially ruin your family.  They’ll keep the house.  And there will be college for the kids.  Because you were responsible.  You protected the greatest investment of your life.  Yes, things have been good.  But not good enough to pay for everything twice.

TRADE EXPLODED IN the 17th century as little wooden ships crossed the oceans.  Storms and rough seas, though, toss around little wooden ships.  A lot of them sank.  With their cargoes.  But they didn’t all sink.  So owners insured their ships and cargoes.  For a nominal fee, they protected their investment.  For those that didn’t sink, the insurance wasn’t much of an added expense.  For those that did sink, it paid to replace the lost ship and cargo. 

YOU’VE ALWAYS WANTED to open a restaurant.  And your dream finally came true.  You saved for years.  You scrimped on vacations.  Didn’t by a new car.  Expensive toys.  No.  Your years of denying yourself the little pleasures in life saved up enough money to buy that restaurant.  To put enough money down to borrow to fit out the kitchen and dining area.  To stock your fridge, freezer and pantry.  You maxed out your credit and sunk your life savings into your dream.  And you’re loving it.  But you don’t want to lose it.  So you have all the insurances.  Fire.  Property.  Workers’ comp.  Liability.  So in case of fire, celebrating students (who trash the town after winning the championship), a strained employee back or an E. coli outbreak (because an employee didn’t wash his hands after using the toilet), you’re protected.  Your business may suffer, as they are wont to do after an E. coli outbreak, but the lawsuits won’t leave you destitute.

BEING IN THE NFL is a dream come true to many athletes.  But it can be a brutal occupation.  Compared to other professional sports, it has a short season.  Why?  Attrition.  Concussions, broken bones, torn ligaments and contusions take their toll.  The short season allows a longer healing period.  And time for surgeries.

Players can make obscene amounts of money.  But they can also suffer a career-ending injury in the first year of a multi-year contract. Great playing potential means great earning potential.  If you stay healthy and play.  Of course, if injured, all gone.  Some players insure against a career-ending injury.  Lloyd’s of London will insure an athlete.  For a price.  It ain’t cheap.  But if it keeps you from losing, say, 20 million in earnings, it could turn out to be quite the bargain.  If you’ve got huge potential.

THE MOST PRECIOUS gift we all have is our life.  So we take care of it.  We watch what we eat, don’t drink, don’t smoke, don’t take drugs, don’t speed in our cars or while on our motorcycles, don’t drink and drive, don’t drive around flashing railroad crossing barriers, don’t binge drink, don’t have unprotected sex, don’t play with matches or run with scissors and don’t do that thing where you jump up on a railing with a skateboard and fall, crushing your testicles on the railing and hitting your head on the concrete step.  No, we exercise, go to bed early and eat a lot of bran. 

All right, we probably don’t eat as much bran as we should.  And maybe we do a risky thing or two.  But we understand that those risky things we DO do can cost us.  Could wipe us out financially.  So we buy insurance to protect our life savings in the event of a catastrophic event that could be medically very expensive.

Or do we?

EVERYONE THAT HAS ever bought blackjack insurance didn’t get a winning blackjack hand.  Everyone that has ever bought homeowner’s insurance didn’t get a new home with their policy.  Everyone that has ever bought mariner’s insurance didn’t get a ship and a cargo of goodies with their premium payment.  Everyone that has ever bought business insurance didn’t get a business with their payment.  And an NFL player doesn’t get a dime from Lloyd’s of London until something pretty horrible happens first.  No.  These purchases were ‘just in case’.  Most people will never get anything for their payments (other than peace of mind).  Only those who suffer a loss will.  And those that do will have mitigated their financial losses with the insurance they so wisely purchased.  And they will get on with their lives.

This is insurance.   We use it to protect our wealth.  It takes a lot of time to accrue it.  So when we have it, we tend to protect it.  We do risky things.  And insurance manages that risk.  So we don’t lose everything we have because of a catastrophic event. 

We don’t think like this when it comes to health insurance, though.  We don’t think of health insurance as a way to manage our risk.  We look at it as a free ride.  If we have it, we expect free health care.  We want everything.  But we don’t want to pay for anything.  Free mammograms.  Those blue pills for the old johnson.  Heart valves.  Prenatal care.  Child vaccination.  Etc.

The problem is, these things cost.  A lot.  And if anybody can have them, those who actually pay for insurance have to pay for them.  And they’ll be paying for things they aren’t using.  All those things listed above mean nothing to a young single male.  But he’s helping to pay for that stuff.  Either by his premium contribution.  Or in lost wages.  Because an employer can’t afford such quality health insurance AND high wages.

Health insurance has become nothing more than a wealth transfer.  It’s like a Ponzi scheme.  A large and ‘growing’ group of healthy young people pay into the system and collect few benefits.  The ‘fewer’, older, sicker people pay little into the system but consume the lion’s share of the benefits.  At least in theory.  But like social security, and all Ponzi schemes, the theory doesn’t work in practice.

AMERICA HAS THE best health care in the world.  If you judge by where the affluent go for their health care.  They go to America.  And the best is never cheap.  You get what you pay for.  And if you want the best, expect to pay.  A lot.

All right, we have the best and some of the most expensive health care in the world.  Add to that an aging population.  What do you get?  A shrinking group of people (the young and healthy) paying for a growing group of people (the old and sick).  That means the burden on those paying into the system has to what?  It has to keep getting bigger.

But it can’t.  The young and healthy will just opt out.  Eventually.  When it gets to the point that it’s a car payment or a health insurance payment, what do you think they’ll choose?  Their annual health care expenses for an entire year may not equal one premium payment.  So they’ll say screw that.  And do.  A lot of young do not have health insurance because they choose not.  It’s just too fricking expensive.  And this just shrinks the shrinking group more.  Which increases the amount those with insurance pay.  And so it goes.

AND YOU DON’T fix this problem by nationalizing health care.  That doesn’t address the problem.  You have to tie the cost to the benefit.  People only chose to pay for things they get.  Those receiving the benefit, then, need to pay its cost.  Like we do with every other thing in our lives.  You want a TV you pay for a TV.  You don’t pay for one so your neighbor can have one.  TV prices are very reasonable, too.  They keep coming down.  The quality is fantastic.  And so it would be in health care.

Single payer health care insurance ain’t the answer either.  Because it’s not insurance.  It’s a wealth transfer.  That means it’s political.  It will serve political ends.  Not make good health care.  First of all, they’ll force the young and healthy to pay for insurance under penalty of law.  Or they’ll raise taxes until it hurts.  Then they’ll cut costs.  First by limiting what doctors can earn.  Then they’ll limit the profits the pharmaceuticals can make.  Then the medical device makers will have their turn.  Soon, people won’t want to be doctors any more.  Or make new and life saving drugs.  Or make medical devices.  So when the supply of these things falls, rationing must follow.  And if you really want to cut costs, there’s really only one place to do it.  The really sick and the really old.  These people, after all, consume the lion’s share of health care services. 

We don’t have a health care problem.  People are living longer than ever.  We have a dependency problem.  The current system has made us dependent on others for our health care.  And dependency kills.  It cowers a people.  Takes away their dignity.  Makes them subservient.  People live in fear.  Of what they may lose.  Nationalizing health care will only make us more dependent.  It’s not the answer.  Unless you want to conquer and subjugate a people.  I mean, how many of you have stayed at job you absolutely hated because of the health insurance?  If that ain’t subjugated, I don’t know what is.  As bad as that was, at least you got something for it.  Good health care.  If you think you’re going to get that under a national system, think again.  Or ask those people with a national system that come to this country for better care.

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