Pretty much any investing you do houses, sports cards, gold, stock bonds. You are taking on risk for some expected rate of return. The key point is you are moving your cash to a risky asset. This asset or investment may have extremely low risk like toll roads or could have extremely high risk like penny stocks but both share the commonality of taking on some bit of risk for a bit of return.
Insurance is the exact opposite side of the coin, the yang to the yin. With insurance, you are paying a stated premium to transfer risk off of you. This risk transference off of you can come in the form of averting unexpected hospital bills via health insurance, not outliving your money implementing an annuity, or protecting your house in case something gets damaged or stolen.
Just like yin cannot exist without yang as long as there are assets that add risk the counterweight of insurance will exist. In the investment space, this counterweight is often called hedging. Money managers often buy investment products to curtail their risk, the worst example of this insurance gone wrong being the Credit Default Swap market that exploded in 2008 and 2009. Everyone piled up on insurance but the insurance company backing the contracts wasn’t bulletproof proof and many purchasing the insurance were using it as a speculative investment vehicle rather than insurance.
In some areas of your life, you transfer risk-off and in some areas of your life, you take a risk on. This is normal, healthy, and natural. As a general contractor, you build buildings, you have the uncertainty of the risk of finding the client and putting together a well-constructed building. However, no matter what your intentions as a builder are the building built could have included a bad piece of steel or wood that nobody saw that makes one of the pillars collapse. As a responsible builder, you will want insurance to protect against these unforeseen events. In one area you are taking the risk of the profession for an expected reward but you are simultaneously transferring some of that risk you don’t want. In Hammurabi’s code one of the oldest documented codified law if a builder built a building which collapsed on someone, the builder responsible was put to death. The development of insurance has helped transfer many of these bleak outcomes to create a more balanced risk-return for someone.
Give another example comparing to people on the same side of the coin, return. Let’s say person A is a police officer with a very fixed and known career path. Person A knows exactly what pay increases they expect over their career but has a lot of uncertainty with regard to their physical health. Person A may want to invest very aggressively taking on lots of risk in their investment portfolio knowing they have a very stable source of cash flow. Person A has very little risk in their fluctuating pay but they have a very different risk that looms large and that’s a physical risk. Person A may get injured on the job putting them completely out of work and halting their income stream. They may want to transfer this potential risk by purchasing insurance that protects their lifestyle in case if such an event happens.
Person B is a high-end real estate broker. They commute to the office to show houses and have very little risk of injury. Sure, they could trip on a staircase while working and this could significantly hamper the ability to do their job but they keep this risk by opting out of an accidental insurance policy. However, unlike Person A; Person B has a very lumpy and volatile income they sell 2 to 3 houses a year and the income they receive from these sales varies greatly. Person B may want to invest as well but they may be better suited with a less risky investment portfolio since they have risky cashflows.
Both individuals taking on returns in very different ways due to their other life risks.
Where the traveling insurance man gets a bad rep is trying to transfer risk that maybe someone should retain or try to have insurance fit both sides of the coin. Just like yin cannot also be yang, insurance cannot be both. In our earlier example, the real estate agent could still slip and fall but the payment of transferring that risk may not make sense unless it’s extremely cheap, so they retain this risk.
We all know a story where someone receives a life insurance policy or after they put in an insurance claim, they end up better financially then they were before, isn’t this return? Insurance is based on the principle of indemnity when someone loses something, they are meant to be made whole but not better off than they were before. How do we view this potential upside on the insurance side of the coin? Well, this is difficult to quantify and this is where the world isn’t perfect… Say you receive $1million dollars from someone passing, if they were alive and they worked working all their living years they may have made the same $1 million dollars. The insurance policy in this scenario is simply substituting and protecting against the possible lost wages. What if the policy is still $1 million dollars but they are expected to only earn $500 thousand dollars? This is where the lines blur of finite dollar amounts and sometimes more intangible costs. Maybe the person alive only has estimated lifetime earnings of $500 thousand but when they pass you have added expenses that close some of that gap but that still doesn’t explain everything. That additional money to close the gap is the substitute for that person not being in your life which is truly unquantifiable. However, quantifying unquantifiable things is not new. In a courtroom when someone is scalded by hot coffee and has burn marks for the rest of their life how do we say with precision what dollar value properly compensates that person. Though, there may be situations where insurance can be viewed on the return side of the coin it is by large the risk transference side of the coin.
Both sides of the coin are indispensable and would not exist without the other just like yin is to yang.
