Commercial Lines Insurance
There are two main types of insurance, with the first one being personal lines insurance, which individuals purchase to hedge against the risks of various events which may represent unacceptable financial burdens if they occur.
Businesses also require this sort of protection, which represents the second major category of insurance, commercial lines insurance. Included within this category is insurance that insurance companies themselves take out to protect themselves from unacceptable risk to them, called reinsurance, but we will be discussing that in a separate, dedicated article.
The way insurance works is that a certain risk gets sold to an insurance company, for a price, and in exchange the insurer will provide financial compensation to the insured if the insured event occurs. This involves a transfer of these risks from one party who are unable to manage the risks comfortably on their own, to one who due to their specialization in handling these risks are in a much better position generally.
It is never a good idea to insure against risks that you can manage yourself without much trouble or consequence, as overall we pay a premium for this protection, meaning that on a balance of probabilities it will cost you more to assign the risk and pay for the hedge, but the potential costs may be greater by assuming the risk yourself due to the impact of the event.
Why Business Insurance Often Makes a Lot of Sense
Business insurance can make this calculation even more clear due to the more financial nature of business. So if it costs more to insure against something, but if the event would cause the profitability of your business to erode, or maybe even put you out of business, it can be far more economical to pay extra for this protection.
The bottom line with all insurance though, including personal insurance, is that you want to avoid a situation where you are unable to cope with a given event, and it always comes down to a financial burden that is too great to bear.
With business insurance, it’s important that businesses not have their operations unduly affected, just like we don’t want to have our personal life unduly affected either, although with personal insurance, costs that aren’t monetary are going to often play a big role in the decision as well.
For instance you may not want to see your family living in squalor should you die prematurely and be unable to provide for them, so you may want to protect the risk to their standard of living by buying life insurance.
With business insurance, the focus is more on the monetary side of things, although if you own the business you may be protecting your standard of living as well should it suffer. So there’s not a lot of difference between the two really, they serve the same goals and seek the same protection basically.
The economic principle that applies to all insurance is that of diminishing marginal utility, where the first dollar is the most valuable and value declines as the amount increases. So when you spend money on insurance, this expenditure has less value to you dollar for dollar than the benefits received if a loss occurs, because the replacement value of the loss is greater dollar for dollar than what could be considered excess dollars expended.
So with business insurance, we could put this as a business spending part of their profits to buy insurance to protect the ability to generate future profits, and if they suffer a significant loss that isn’t compensated for, this could have negative consequences for some time and maybe even permanently.
So some may wonder why large businesses in particular could not handle on their own some of the things that they insure against, and in some cases they might, but this may still end up reducing their profitability such that the insurance becomes the better bargain.