Insurance etymologically and historically has been a byword for risk sharing and management with people assailed by and facing the same risk contributing a premium that is a minuscule fraction of the potential loss arising out of the risk to the insurance company.

The premium is fixed in such a way that the insurer made some profit at the end of the day after meeting claims which itself is in the realm of probability based on past experience and aggravating risk factors.

In a way, therefore, insurance and mutual fund investments have at least one thing in common — sharing and spreading of risks — although on different sides of the income statement with mutual funds mitigating income risks while insurance mitigating expenditure risks.

When premium became prohibitive, outsourcing of insurance, as it were, was discarded in favour of self-insurance which consists in setting aside a reasonable sum from annual profits to meet any exigencies for which insurance policies are taken.

The Railways with it gargantuan size simply cannot afford to take insurance policies for its machinery and rolling stocks and therefore prudently settles for self-insurance.

So do most of the airlines with insurance premium understandably being extremely high considering the attendant risk factors.

Going off at a tangent

While there is an unexceptionable rationale both for outside and self-insurance, the western world seems to have gone overboard in its enthusiasm for insurance to the point that it is perceived as a panacea for all risks.

Insurance to start with was for meeting force majeure situations. Acts of god or force majeure after all are beyond human control and thus need to be provided for either through self-insurance or outside insurance. But somewhere down the line, there was a felt need to rope in insurers for a wide range of purposes.

Thus started fidelity insurance to guard against the cupidity of cashiers and treasurers. Then the harried creditors, tired of pursuing invoices even after the due dates, sought the comfort of insurance. This seemingly innocuous insurance product degenerated into a product close to the hearts of those pioneering financial engineering or derivative products and came to be known as Credit Default Swap (CDS) which was roundly criticised by many in the know.

Insuring neighbours house always has an insincere ring to it with the insured secretly praying for the destruction of the subject matter of insurance so much so that the irrepressible Warren Buffet described it as a financial weapon of mass destruction.

We also have catastrophe insurance that shifts the burden of insurance companies against unpredictable acts of god onto the capital markets which in a way marked the beginning of the reluctance of insurance companies to shoulder insurance responsibilities and instead shifted them to hungry investors seeking higher returns.

Thus investors were sold bonds by insurers on the promise that their returns would heighten with tapering off of the risk for the insurer and would plummet with the heightening of the risks for the insurer. Catastrophe insurance perhaps may be taken as a tacit show of nervousness on the part of the insurers, disabusing the notion that insurance is a panacea for all financial ills.

Straight and the narrow

The recent financial sector reforms ushered in by the Obama administration in the US have curiously bypassed the insurance sector. Banks have been proscribed from doing proprietary trading and derivative products have been mandated to be exchange traded.

One wishes the reforms had also stopped the freeloading of insurance companies both in the interest of insurance companies and also in the interests of investors. It is one thing for a bank to carry out appraisal of the financial strengths and weaknesses of a borrower but quite another for an insurance company to do so.

An insurance company with its eye on profits tends to be lax in its appraisals of creditworthiness in the smug and self-fulfilling belief that the law of probability would come to its rescue at the end of the day.

An insurer wilting under pressure should seek reinsurance and should not pass the buck to the capital market. An insurer's mandate is to evaluate properties and not speculate upon infidelities and on creditworthiness of the debtor of the insured.

The Business Line