“There ain’t no such thing as a free lunch” is often attributed to Walter Morrow, editor??in??chief of The Southwestern Group of Scripps??Howard Newspapers. The acronym for this phrase (TANSTAAFL) has been popularized by science fiction writer Robert Heinlein in his novel The Moon is a Harsh Mistress. The phrase and the wisdom behind it is much older; the Latin phrase “Nullum Gratuitum Prandium” means the same thing.
What is the connection to insurance? There is an implicit comparison in both phrases. If consultants, brokers, capacity providers and MGAs are pitching their risk transfer solutions to potential clients and one of the solutions stands out by far, then this should trigger an in depth analysis of the policy which stands out as “too good to be true”. I am not saying that all solutions to an insurance question are the same, or must cost more or less the same.
Most often when a client tells us that he has equivalent offers for a cover, he means that the policies provide the same capacity or limit over the same period of time. Since most buyers are price sensitive, a very low price, i.e. premium, is a good way to attract a buyer’s attention and signal that he can make a deal. Hence, the “too good to be true solution” is normally the one which is massively cheaper than the rest.
Here is a short guide of what you should ask the provider of the massively cheaper solution. Some of them sound obvious. I can assure you that I have met clients who have not checked a single one of them.
Is the provider a regulated insurance company or does he just use the words insurance?
Insurance is a highly regulated industry (for good reasons) and thus, the latter is illegal. Exposed as a not being an insurance company, the provider might say: “It does not really matter as their solution provides the same outcome as insurance.” Regulation is a pain for the insurers, but it protects the clients (see the next point). And if a provider does not have to comply with capital requirements, then it can offer much cheaper solutions. The downside is that you have to check very carefully whether such a provider has the capital to pay a big claim. It is insufficient to check this once before the start date of the policy; it has to be checked in regular intervals. For regulated insurance companies the regulator does this.
Have you ever paid any claims? Do you have any open disputes about claims?
It is part of the business model of an insurance company to pay claims. We are not talking about motor, hull claims or home damage. That is mass business and in these lines of businesses there are always some claims which are refused and legally challenged. We are talking about prize indemnity claims. They happen relatively rarely, but if they happen, then they are in the hundreds of thousands or even millions. And the operators truly depend on these claims being paid – of course, given that the loss verifier confirms the legality and validity of the claim.
I probably hold the claim to fame of having settled some of the largest prize indemnity claims in the market. And I have spoken to colleagues who have tried to settle claims from unregulated “looks like an insurance” provider. It worked as long as these claims were small and infrequent. As soon as the claims were more frequent or bigger, then the disputes started.
Can there still be a massive difference if the solution satisfies the above two conditions? Yes, because the legal form by which the insurance solution is provided plays a central role. At this point credit risk enters.
The highest security is provided by collateralized insurance policies, typically in the form of an Insurance-Linked Security (ILS). In the current high interest rate environment there is a significant cost linked to collateralization.
The next lower level of security is provided by regulated insurance companies who operate in an established solvency regime. The solvency regime ensures the client that the insurance company can fulfil its obligation with a very high probability – the regulatory solvency regime. An insurance company’s solvency ratios are indirectly linked to their credit rating. Depending on how much capital these companies hold, they are rated differently by S&P, Moody or Fitch. And the capital they hold for their rating is the cause of small price differences.
The credit rating is less important for prize indemnity than for product liability for which claims may surface years after the damage happened. Nevertheless, rated insurance companies are good solutions for prize indemnity covers.
In some regulations it is possible to run partially or even unfunded insurance companies. They usually have some form of a guarantee from an investor that he will fund the company, if there is a claim which exceeds the existing minimal available capital. These insurance companies are obviously not rated. Most of them don’t have access to the reinsurance market to manage excess risks. They do not have to be spooky or bad, but some of them are.
Let me be blunt: This can be used as an easy and almost sure way to mislead a client. If you are getting a policy from an unfunded insurance vehicle, then you are advised to involve an expert to check the funding guarantee. Who says that the same guarantee is not used to back other risk positions? Or that the funding is held in illiquid assets or even withdrawn after the policy is issued. A non-expert cannot easily distinguish potentially fraudulent set ups from safe ones. The full spectrum exists: from fraudulent to as safe as rated insurance companies.
Some of these vehicles can offer a slight price advantage. If the price advantage is huge, then it is a good indication that it is a risky counterparty at best and at worst a potentially fraudulent set up.
If it is too good to be true, then misrepresentation, hiding some facts, or simply a fake may be involved. Stay away; there ain’t no such thing as a free lunch.
Markus Stricker