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Why do corporations buy insurance?
Yesterday I wondered:
Why do corporations by insurance for fire damage and such? It seems to me that maybe the oughtn’t, since the cost of insurance is greater than the expected payouts (due to administrative costs, asymmetric information, moral hazards etc). Investors should presumably prefer corporations to be pure bets, and reduce risk and volatility by holding suitably diversified portfolios.
Today my colleague Peter Taylor, who worked in the insurance industry for many years, replied (reproduced here with permission):
Corporations certainly do buy insurance against fire and very good value it proves to be for them I must say when a large-scale fire does occur. Your argument was adopted by some large corporations going "self-insured" or creating their own "captives" but generally it takes one large loss and they are back in the insurance market. Moreover, the argument for self-insurance can be about saving a few pennies off expenses rather than assessing the real risk – a recent example was Hull Council deciding to self-insure with its own fund against flood rather than pay the market price – underestimating the losses by an order of magnitude. The reversion to the insurance market is partly to do with shareholders’ wish for stable results as well as their reluctance to accept bad luck. Shareholders don’t seem to accept that accidents/fires/whatever happen and blame the management (Napoleon’s unlucky generals) so from a management point of view it is much easier to buy the insurance year on year and avoid getting caned when a loss does occur.
I’m still not sure I completely understand why insurance is bought. It might be that shareholders are biased (which seems to be what Peter suggests). If so, is this a recognized failing? Do sophisticated institutional investors also prefer that the companies they own stock in buy fire insurance?
If so, is there an alternative explanation other than that they are biased?
(a) Maybe shareholders don’t want management to be able to blame poor results on bad luck due to fires etc? But it seems relatively easy to check if accidents of this sort were responsible for big losses – easier, e.g., than to check whether competition has been unusually difficult.
(b) Maybe shareholders prefer to make certain pure bets: whether company X has a good business plan, for example, rather than whether company X will also be lucky with regard to fires, floods, etc.
(c) Maybe the amounts spent on insurance are so small that shareholders just don’t care. But in some cases I would think insurance costs are substantial, e.g. for shipping firms or transport of hazardous materials. Do such companies not buy insurance?
(d) Maybe costumers and suppliers want to know that the company will not suddenly go bankrupt because of a plant fire. But I doubt that these constituencies ever check how much fire insurance a corporation has bought.
(e) Maybe when making long-term plans, it is valuable to reduce uncertainty as much as possible. So a corporation might insure against big fires for the same reason that it hedges against currency risks. But hedging currency risk may not be as expensive as insuring against plant accidents (given thick, efficient currency markets). And where capital markets are sufficiently efficient, couldn’t a previously profitable firm with good prospects simply raise more capital if it unexpectedly needed to rebuild a burnt down factory?
Or is loss aversion bias partially responsible?