What do Investing and Insurance have in Common?

We came across an interesting product recently launched by a South African company – the world’s first equity fraud insurance. This insurance covers investors against losses suffered as a result of fraud or management impropriety. The idea is that investors pay a small percentage of their portfolio value as a regular premium, and are then covered against losses suffered within that portfolio which stem from fraud/accounting related issues. Sounds good, right? Wrong.

To understand why equity insurance is a bad idea, one first needs to understand why traditional insurance adds value. Take life insurance as an example: An individual has only one life, which if lost could have serious financial consequences for his/her dependents. The timing of the loss of life is usually unpredictable. The only way an individual can manage this risk is through life insurance.

Why does traditional insurance work?

A life insurance company essentially builds a portfolio of 1 000s of insured lives, something that no individual can do. While the risks are unpredictable on an individual basis, the aggregated risks are far more predictable. The insurance company can thus set an accurate premium across its portfolio of risks, which allows it to pay claims as they arise, cover its costs and earn a profit. Homeowners insurance, hospital plans and car insurance all work on the same principle.

Insurance companies are in the business of selling diversification for a profit. This only makes sense when a) the risk being insured is significant, and b) the risk cannot be freely diversified on an individual basis.

How is equity fraud insurance different?

This is why equity insurance doesn’t work. Regardless of the terms and conditions of the specific cover, the reality is that an individual can achieve diversification for free. The premiums paid to an insurer will exceed insured losses for a diversified portfolio over time, so it makes no sense to buy insurance against an already diversified portfolio.

This raises some important questions: Why insurance against fraud specifically? Surely there are other risks that investors could insure against. Why is this world-first being launched in South Africa, and why now? The answer is, of course, Steinhoff. To a lesser extent Resilient and Capitec have also played their part. This is the opportune time to launch a product like this, following a flurry of typically rare events that are still fresh in everyone’s mind. Clever timing, but ultimately a flawed product.

Global diversification beats equity insurance

For an equity portfolio, diversification is actually much better than fraud insurance. First, it’s free. Second, it covers much more than just the risk associated with fraud. With a broad enough opportunity set it can cover political risk, currency risk, balance sheet risk, event risk, etc.

For South African investors, political and currency risk are far more relevant concerns than fraud. The best insurance against these risks is to invest globally. This has the added benefit of a much wider opportunity set, allowing investors to be far more selective in terms of the quality of assets they invest in and the price they pay, without sacrificing diversification.

Risk and reward

Finally, the point of investment isn’t to eliminate risk, because without risk there is no reward. The point is to bear good risks in exchange for a return. In this sense, investing is exactly like insurance:

  • Insurers write policies subject to certain underwriting criteria. Investors make investments subject to certain quality/valuation criteria;
  • Insurers accept that despite their underwriting, there will be claims. Investors know that despite their process, they cannot eliminate risks associated with individual holdings;
  • Insurers manage individual risks by aggregating them. Investors manage individual risks through diversification;
  • Insurers earn a profit because they charge more in premiums than they pay to claimants. Investors earn a return because their successful investments outweigh their losses.

The keys to success in both of these models are a good underwriting/selection process and adequate diversification. Where they differ is that insurance relies more heavily on diversification, while selection process is far more important in investing.