As published in The Daily Times (Malawi) on September 4th, 2024
Insurance is not the only risk management tool available. We live in a free-market economy where ideas continue to flow. Competition favors innovative concepts. In the recent past, a number of new products have been introduced as substitutes to insurance in the financial space in Malawi. Some consumers prefer non-insurance risk transfer vehicles because they assume that alternative mechanisms offer better solutions than existing off-the-shelf insurance covers.
You have heard before the expression that too many cooks spoil the pudding. This is why I advocate use of insurance as risk management tool. I always warn consumers of alternative risk transfer products that before they make a choice, they need to question, whether the alternative method is more effective than conventional cover offered by insurers vis-à-vis premium payable, scope of coverage and sustainability.
Today, we discuss some of the products that are available on the market as substitutes to insurance.
Most people are familiar with self-insurance. Self-insurance is the basic and most frequently used form of alternative risk transfer. An organization, when reviewing what has been purchased, may feel that insurance has eaten the organization’s profit. In most cases, such point of view may arise because no claims have occurred.
This also happens, where losses have been predictable over a period. The assumption is that the claims experience trajectory might be expected to continue into the future. Self-insurance is, thus, seen as a vehicle that an organization can use to reduce cash flow. Proponents of self-insurance argue that the mechanism works well, when it is accompanied by comprehensive disaster recovery plan.
Another common alternative risk transfer mechanism is captive. A captive is an insurance company established by a non-insurance company. It is set up and managed to insure risks of a parent company. The captive collects premium from a parent company and invest premiums in high return investment instruments to meet future losses.
Some organizations use financial instruments called derivatives to hedge against future losses. The instruments are often derived from underlying transactions. Parametric risk transfer mechanisms, as derivatives are often referred to, are used to protect against natural catastrophes. Such risks by nature tend to be widespread in effect and cause.
Losses payable on parametric covers are measured against an index. A typical example of a derivative is weather index facility, which provides cover against adverse weather elements, namely excessive rainfall or lack of it (drought).
Other weather elements that can be included in the cover are high speed wind and excessive humidity. Unlike traditional insurance covers that pay only when the subject matter is physically damaged, weather insurance pays out, when certain pre-agreed parameters or points have been triggered.
Clearly, the advantage of index insurance products derives from the objective nature of the settlement basis, which cannot be impacted by insured party’s behavior. This is provided that the index is well constructed and the payout corresponds to the damage suffered by the protected party, especially when the damage is catastrophic.
Index based covers are often used to protect farmers. In Malawi, we have weather index-based cover that is marketed through commercial banks to protect farmers in selected areas. In developed insurance markets, risks such as earthquakes can be insured by index-based products. Perhaps, it is high time the insurance fraternity in Malawi put together earthquake index-based insurance targeting future shocks in Karonga and surrounding areas instead of victims relying on government handouts. Food for thought.
Finite risk contracts are also used as substitute to insurance. Finite risk contracts, popularly referred to as futures, are multi-year programmes, which involve payment of a regular fixed premium. These vehicles are unique, as they combine both risk transfer and risk financing techniques.
In a layman’s vocabulary, the risk is limited - hence finite - to an aggregate limit of liability. The programme works in layers called excess of loss. The risk financing aspect of the contract recognizes time value of money, thus enabling the protected party to partly fund his own loss experience.
I must admit operation of finite risk contracts, which is usually bought outside the traditional insurance market, involves a lot of calculations.
Views from the top are that purchase of insurance, risk management practice and treasury functions are converging. Those of us in insurance practice need to realize that time has come for our products to reflect a combination of insurance, banking and capital market features. Insurers must be thinking of redesigning their business models. The game plan, too, must change. However, be warned - too many cooks spoil the pudding. Talk to us. We are here to serve you.
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