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.
Insurees are often required to insure by law - usually when someone could be badly damaged or die, and bankruptcy proceeds might not adequately cover the payout.
Your analysis ignores the fact that company's have obligations to debt holders and employees. Unlike equity these groups aren't diversified and do not benefit from the potential upside associated with self insuring
Those lending money to a company would likely charge the company a much higher interest rate to cover the extra risk involved with the company being uninsured. Likewise employees may require higher wages.
Given these additional costs it might be just more efficient to insure.
I believe the main reason is that corporations are primarily concerned with getting obstacles out of the way so they can do business. Many probably only use 1 travel agency. Sure they could save money by having some admin go online and search Orbitz, Hotwire, etc - but it is simpler and easier to just get it done so they can get back to the business of producing and selling widgets.The same goes for insurance. Yes they could spend the time and energy to evaluate their risks and adopt the appropriate self-insurance, but for most companies the savings would not outweigh the hassle.Should my widget company develop its own VOIP system, self fund a health care plan for my workers and keep an in-house group of attorney to handle all lawsuits? The answer depends on the scale of my operations. Ford has its own financing arm, but it would be silly for some $40 million dollar company to do it. There may be biases, but in general I think the realities of a free market do a pretty good job in tearing them down.
Everything above is vague, intuitive, and sadly qualitative. Perhaps you might start with Claude Shannon's publications on Mathematical Portfolio Theory. Or Malliavin caculus with applications to stochastic differential equations, by Marta Sanz-Sole, Fundamental Sciences, EPFL Press, Lausanne, distributed by CRC Press, 2005. Or Paul Malliavin and Anton Thalmaier, Stochastic calculus of variations in Mathematical Finance, Springer, 2006. Or ask my frequent co-author Full Professor Philip V. Fellman, Oh, of course. Eliezer Yudkowsky hypothesizes that Professor Fellman does not exist, despite his offical web page:
Mr. Yudkowsky also denies the existence of Sir Arthur C. Clarke's long time friend and webmaster John Sokol, while ironically screaming abuse at him over the telephone.
Professor Bostrom, out of respect to Oxford, can you please keep your autodidact fellow Mr. Yudkowsky from defaming my coauthors, and myself? If only out of academic protocol and collegiality?
You might also suggest that he telephone the Caltech registrar to verify that I at least existed in 1973 when I earned my first two degrees there. Philosophy should have some routine fact-checking, in the interests of rationality, should it not? Otherwise it is all just language games.
Thank you in advance for your attention and consideration.
I hadn't expected that this question would generate so many thoughtful responses!
The two main *new* ideas that I gleaned from the discussion are (a) to the extent that the insurer provides not just insurance but also expert monitoring, that can clearly account for the phenomenon; and (b) and if management holds large stakes in a company that they cannot diversify out of, they may opt to insure more than shareholders would prefer. Also, if earnings stability has a signal value, as McCluskey suggests, that too could be a factor. In addition to these, there is the possibility of lack of perfect capital markets, which was alluded to in my original list of hypotheses.
As for bankruptcy costs, it seems that this would be a factor that depends on imperfect capital markets. If it were easy for a good company with excellent long-term prospects to raise more cash to make up for a big one-off loss, it wouldn't go bankrupt and hence would not need to insure for that reason.
There may be a legal & commerical compulsion. All lenders, many vendors, all landlords, and many government agencies (not just workers comp) require minimum levels of insurance and may want to be named co-insured. They don't want to examine a service provider's net worth, liquidity, etc. so they just use a simple requirement of a minimum level of coverage.
Also, your question assumes that a corporation shields shareholders from the corporation's liabilities. A plaintiff can "pierce the corporate veil" and sue shareholders by proving up that the corporation wasn't run as a real corporation ans one important factor in that analysis is whether the corp had sufficient funds or insurance to cover its potential lossed.
This place is biased towards attributing everything to bias.
Let's compare 2 companies. Company A makes $200 one year and loses $100 the next year because of some disaster they didn't insure against. Company B makes $50 both years (insurance costs them 150 bucks but they get paid 150 in the event of a disaster). Tax rate is 40%.
Company A pays .4*200 year 1 and no taxes year 2. $80 total.
Company B pays .4*50 + .4*50. $40 total.
Insurance makes tax liabilities less volatile which helps shareholders - if you paid negative taxes when you have negative income, then you wouldn't need it.
To self insure, a company needs to hold highly liquid assests or maintain a workforce and build over-capacity. To do this the company must borrow more, either by issuing stock or debt (or not investing in additional income generating growth or paying out to investers). Therefore, if the cost of insurance is less than the marginal cost of capital for the company, it makes more sense to buy the insurance.
Shareholders don't run corporations -- they hire management for that. If you're looking for biases, that's where you should focus.
To quote from scripture:"We will get hit from time to time with large losses. Charlie and I, however, are quite willing to accept relatively volatile results in exchange for better long-term earnings than we would otherwise have had. In other words, we prefer a lumpy 15% to a smooth 12%. Since most managers opt for smoothness, we are left with a competitive advantage that we try to maximize."From the book of Buffett, year 1995, Ch 4, Verse 12
It is discussed in many more places throughout these holy scriptures, but the short story is that shareholders don't generally analyze things that closely. One big loss draws far more scrutiny than continal small insurance payments over the years. Even though risking the loss may be the intelligent decision, managers have a great dis-incentive to make intelligent choices that will guarantee the occasional large loss. Job security wins over a slight gain to the shareholders.
If the "disruption in service" explanation is correct, it implies a defect in credit markets. Otherwise you should just be able to borrow (or sell stock) to cover your losses. After the fire (or whatever), either there are still a bunch of positive NPV projects available, or there aren't. If there are, someone should be willing to fund them. If there aren't, you should close up shop anyway, insurance or no.
So what are these credit market imperfections, and why do they exist?
There is a very standard explanation for rational insurance purchase by a corporation(not that it explains all insurance purchases by a means). Internaly generated funds are cheaper than external funds to the firm. Thus, the point of insurance is to provide cash flow at exactly those times when the firm would have to turn to external sources. The point of insurance is to align cash flows with cash needs. When my plant burns down and prices rise, that's exactly when I need cash to rebuild.
I've been hanging out at a finance department here in Australia the last week and actually asked a lunch group this question a few days ago. Andy is right that insurance companies can better monitor some activities. But more important, Constant is right that the disappearance of a company disrupts business flows and is a real cost. There are many sunk fixed costs that are also lost when a company goes. So this justifies some risk aversion. But agency failure could still make actual insurance levels be far in excess of what is justified by this risk aversion.
Insurees are often required to insure by law - usually when someone could be badly damaged or die, and bankruptcy proceeds might not adequately cover the payout.
Your analysis ignores the fact that company's have obligations to debt holders and employees. Unlike equity these groups aren't diversified and do not benefit from the potential upside associated with self insuring
Those lending money to a company would likely charge the company a much higher interest rate to cover the extra risk involved with the company being uninsured. Likewise employees may require higher wages.
Given these additional costs it might be just more efficient to insure.
I believe the main reason is that corporations are primarily concerned with getting obstacles out of the way so they can do business. Many probably only use 1 travel agency. Sure they could save money by having some admin go online and search Orbitz, Hotwire, etc - but it is simpler and easier to just get it done so they can get back to the business of producing and selling widgets.The same goes for insurance. Yes they could spend the time and energy to evaluate their risks and adopt the appropriate self-insurance, but for most companies the savings would not outweigh the hassle.Should my widget company develop its own VOIP system, self fund a health care plan for my workers and keep an in-house group of attorney to handle all lawsuits? The answer depends on the scale of my operations. Ford has its own financing arm, but it would be silly for some $40 million dollar company to do it. There may be biases, but in general I think the realities of a free market do a pretty good job in tearing them down.
Most corporation do receive tax refunds when they incur losses by using tax carryforwards and carrybacks.
Everything above is vague, intuitive, and sadly qualitative. Perhaps you might start with Claude Shannon's publications on Mathematical Portfolio Theory. Or Malliavin caculus with applications to stochastic differential equations, by Marta Sanz-Sole, Fundamental Sciences, EPFL Press, Lausanne, distributed by CRC Press, 2005. Or Paul Malliavin and Anton Thalmaier, Stochastic calculus of variations in Mathematical Finance, Springer, 2006. Or ask my frequent co-author Full Professor Philip V. Fellman, Oh, of course. Eliezer Yudkowsky hypothesizes that Professor Fellman does not exist, despite his offical web page:
http://www.snhu.edu/6341.asp
Mr. Yudkowsky also denies the existence of Sir Arthur C. Clarke's long time friend and webmaster John Sokol, while ironically screaming abuse at him over the telephone.
Professor Bostrom, out of respect to Oxford, can you please keep your autodidact fellow Mr. Yudkowsky from defaming my coauthors, and myself? If only out of academic protocol and collegiality?
You might also suggest that he telephone the Caltech registrar to verify that I at least existed in 1973 when I earned my first two degrees there. Philosophy should have some routine fact-checking, in the interests of rationality, should it not? Otherwise it is all just language games.
Thank you in advance for your attention and consideration.
Simple moral hazard: they have private information about the riskiness of their own behavior?
I hadn't expected that this question would generate so many thoughtful responses!
The two main *new* ideas that I gleaned from the discussion are (a) to the extent that the insurer provides not just insurance but also expert monitoring, that can clearly account for the phenomenon; and (b) and if management holds large stakes in a company that they cannot diversify out of, they may opt to insure more than shareholders would prefer. Also, if earnings stability has a signal value, as McCluskey suggests, that too could be a factor. In addition to these, there is the possibility of lack of perfect capital markets, which was alluded to in my original list of hypotheses.
As for bankruptcy costs, it seems that this would be a factor that depends on imperfect capital markets. If it were easy for a good company with excellent long-term prospects to raise more cash to make up for a big one-off loss, it wouldn't go bankrupt and hence would not need to insure for that reason.
There may be a legal & commerical compulsion. All lenders, many vendors, all landlords, and many government agencies (not just workers comp) require minimum levels of insurance and may want to be named co-insured. They don't want to examine a service provider's net worth, liquidity, etc. so they just use a simple requirement of a minimum level of coverage.
Also, your question assumes that a corporation shields shareholders from the corporation's liabilities. A plaintiff can "pierce the corporate veil" and sue shareholders by proving up that the corporation wasn't run as a real corporation ans one important factor in that analysis is whether the corp had sufficient funds or insurance to cover its potential lossed.
This place is biased towards attributing everything to bias.
Let's compare 2 companies. Company A makes $200 one year and loses $100 the next year because of some disaster they didn't insure against. Company B makes $50 both years (insurance costs them 150 bucks but they get paid 150 in the event of a disaster). Tax rate is 40%.
Company A pays .4*200 year 1 and no taxes year 2. $80 total.
Company B pays .4*50 + .4*50. $40 total.
Insurance makes tax liabilities less volatile which helps shareholders - if you paid negative taxes when you have negative income, then you wouldn't need it.
To self insure, a company needs to hold highly liquid assests or maintain a workforce and build over-capacity. To do this the company must borrow more, either by issuing stock or debt (or not investing in additional income generating growth or paying out to investers). Therefore, if the cost of insurance is less than the marginal cost of capital for the company, it makes more sense to buy the insurance.
Shareholders don't run corporations -- they hire management for that. If you're looking for biases, that's where you should focus.
To quote from scripture:"We will get hit from time to time with large losses. Charlie and I, however, are quite willing to accept relatively volatile results in exchange for better long-term earnings than we would otherwise have had. In other words, we prefer a lumpy 15% to a smooth 12%. Since most managers opt for smoothness, we are left with a competitive advantage that we try to maximize."From the book of Buffett, year 1995, Ch 4, Verse 12
It is discussed in many more places throughout these holy scriptures, but the short story is that shareholders don't generally analyze things that closely. One big loss draws far more scrutiny than continal small insurance payments over the years. Even though risking the loss may be the intelligent decision, managers have a great dis-incentive to make intelligent choices that will guarantee the occasional large loss. Job security wins over a slight gain to the shareholders.
I see Jonathan already answered my question, along with providing a great reference.
If the "disruption in service" explanation is correct, it implies a defect in credit markets. Otherwise you should just be able to borrow (or sell stock) to cover your losses. After the fire (or whatever), either there are still a bunch of positive NPV projects available, or there aren't. If there are, someone should be willing to fund them. If there aren't, you should close up shop anyway, insurance or no.
So what are these credit market imperfections, and why do they exist?
There is a very standard explanation for rational insurance purchase by a corporation(not that it explains all insurance purchases by a means). Internaly generated funds are cheaper than external funds to the firm. Thus, the point of insurance is to provide cash flow at exactly those times when the firm would have to turn to external sources. The point of insurance is to align cash flows with cash needs. When my plant burns down and prices rise, that's exactly when I need cash to rebuild.
See for example http://www.nber.org/papers/...
I've been hanging out at a finance department here in Australia the last week and actually asked a lunch group this question a few days ago. Andy is right that insurance companies can better monitor some activities. But more important, Constant is right that the disappearance of a company disrupts business flows and is a real cost. There are many sunk fixed costs that are also lost when a company goes. So this justifies some risk aversion. But agency failure could still make actual insurance levels be far in excess of what is justified by this risk aversion.
Re: SouthwestI don't know what they actually did, but it seems logical to me to hedge demand when doing capital expansions.