In 1897 Travelers wrote their very first auto insurance policy to Richard Loomis. Gilbert J. Loomis, of Westfield, Mass., was a mechanic and early auto pioneer. Loomis actually built the vehicle he insured. Loomis bought his first policy from Travelers in 1897 and remained a Travelers policyholder for more than 60 years. The cost of his original policy was $7.50. For this premium, Loomis purchased $1,000 in liability coverage.
SOURCE: Travelers Property Casualty
The interesting thing about the car in the photo is that If I owned this Automobile today, Travelers probably would not insure it. I would have to go to a specialty insurance company.
Classic risk management acknowledges four ways of dealing with risk after establishing a risk matrix: Avoid, Reduce, Transfer and Retain or Accept.
Reference:
De Loach, J. W. (2000). Enterprise-wide Risk Management: Strategies for linking risk and opportunity. London: Financial Times/Prentice Hall.
As a consumer, when we purchase insurance, these are factors to determine our premiums. Insurance companies make an offer based on your risk, and then determine how much you are willing to retain. There are then factors like the probability of there being a claim, and at what impact. Insurance companies then spread this risk across multiple policies using the law of averages. The more premiums brought in, and the less money paid out is part of what determines the profitability of an insurance company.
The more risk the insured is willing to take, the less the premiums. This would be an example or “retaining” the risk.
“Avoiding” risk would be not having the ability to have a claim completely. For example: Selling your car. Now you do not need the insurance.
If one decided to take out a policy with 100% coverage, that would “transfer” risk.
If the insured decided to have a deductible or retention, this means they are willing to “reduce” their risk to a certain predetermined amount while paying a premium to let the insurance company retain that risk.
Understanding risk is forgotten by consumers in today’s world. Extremely low deductible and retentions are used to keep from coming “out of pocket” to pay a claim. While doing this the insured is potentially prepaying for expenses that could occur.
PROBLEM 1: OPTIONS
I met with a client recently who has a 3.5-million-dollar home, and then he own’s another 3-million-dollar vacation home. His premiums were almost $40,000 a year with a 1% deductible. The client was not willing to take much of the risk. With a 2% deductible, the client would have lowered his insurance premiums to $10,000. That is a $30,000 savings.
Let’s do the math. That is $30,000 in savings. If the client has a claim, he will have an out of pocket for $60,000 which is a 2% deductible.
If the client kept his original policy, he would have had a $30,000 out of pocket deductible which is 1%. However, the client had to pay the addition $30,000 in premium to get to the 1% deductible! So, the conclusion is the client is giving capital to the insurance company to hold because he has never been shown another way to have put the savings aside and not spend it.
Over 20 years, the savings would be $600,000 just in premium cost. With the lost opportunity of the money at 6%, it would have grown to $1,103,567.74!
The client was willing to give up $1,103,567 as has not made a claim in over 20 years. Not only has he transferred the risk, but he has also transferred over a million in capital to the insurance company.
Understanding risk and things one can do is detrimental to achieving financial success. What if there was a way to go to a 2% deductible to reduce cost and have a liquid place to save the difference to cover an unexpected tragedy, while creating a system that allows one to reduce insurance cost, finance charge, and creating wealth? Such a thing does exist, and we will talk about it in the next few topics.
PROBLEM 2: MINDSET
The second problem the client has is that he pays a monthly premium for the policy. Some carriers will pay as much as 10% for a discount on an annual payment.
In reality, you are financing your policy over the 12-month period of the policy. 10% interest, correct? The answer is no that is not correct. That is a little over 11% of an increase. If the premium is $10,000 a year, but if one pays in full there is a 10% discount. That makes the premium $9,000. $10,000 x .10 = $9,000. The problem with the human mind is that we are trained to think we get a discount if we pay in full. The truth is, there is a finance charge if we pay it over time. Our minds are trained to think the opposite. The premium is $9,000. If we pay over twelve months, the premium is $10,000. A 10% finance charge on $9,000 would only be $9,900. We are still $100 short of $10,000. The percentage rate is 11.11% of the $9,000 which is $10,000. The point is our minds are not trained to look for finance charges. In reality finance charges are associated with everything we pay for.
Have you ever heard someone say they got 0% interest on the new car purchase? There is not such a thing. It is usually 0% or a rebate. If the advertisement reads: 0% interest or $3,000 cash back for approved buyers, then the cost to get 0% was $3,000 plus your good credit. If it were a Ford advertisement, then you also would have to finance with Ford Financial. It is also usually a specific number of months, Like 36 months for example. It is important to understand that it is not “free money.”
Changing your mind to look at things differently is not easy. Insurance and Finance companies are trained to trick your mind into thinking you are getting a discount for paying for something in full. In reality, that is the actual sales price, and you are paying finance and interest fees if you pay overtime.
PROBLEM 3: LIQUIDITY
Being a business owner, I realize that cash flow is the key to the success of my company. I do not want to tie up large sums of money that I cannot access. Owning a backyard patio business for year, I would much rather build 1 small pergola per day and make $500 per job then build a giant covered patio and make $10,000 in a month. It is the same amount of profit in each case however what if the large job falls through? What if the weather pushes the crew back a couple of weeks? What if the client cannot pay at the end of the job? All of these factors can completely destroy the cash flow of the business. The first scenario has less risk but consistent cash flow. It is a lot easier as an owner to make long term decisions knowing there is daily cash flow. Walmart doesn’t just open on Saturdays!
In problem 2, the client was willing to give up his cash for what he thought was lower risk. Remember the safe place we talked about to place our money? Over time he gave away over a million dollars. If I owned a restaurant and I had a large expense, such as a piece of kitchen equipment fail on me, I would have access to cash to buy a new piece of equipment without interrupting the cash flow of my business. If I had placed this capital in a government sponsored qualified plan, I probably would not have access to the funds without interest or penalties. Liquidity is buying power.
PROBLEM 4: GOOD INVESTMENT
Now that we know we need a safe and liquid place to park our capital, what are other features that we are looking for?
- Good returns
- Guarantees
- Flexibility
- Creditor Protection
- Works in high and low interest rate conditions
- Stock market proof: No volatility
- Outside of government sponsored programs
These may be a few of the qualities someone would look for in a safe place to put capital.
There is a big difference between investments and somewhere safe to place capital. Invests involve risk. They involve a product such as a stock or a real estate. An investment can be a commodity such as gold or even baseball cards. They involve buying something and holding it for a period of time, and then selling it or generating income from it. There is a time and place for all these things, however that is not what we are talking about. Investments typically mean tying up capital. Usually in a place where there is no liquidity. There is usually some risk involved.
We want a place to put capital to get a safe rate of return that we can access without asking for permission.
PROBLEM 4: EARMARKING CAPITAL
The most common mistake that most business owners make is “earmarking” their capital. What that means is they set money aside for a specific purpose. For example, a business owner may have a savings account specifically for a piece of equipment that they may need in the future. While this may seem like a good business practice, it is most likely costing you money over time.
Example:
Option #1: A business owner is saving $5,000 a year for 5 years for a total of $25,000 to purchase a piece of equipment. The same business owner has earmarked another bucket of money to buy and sell merchandise. The merchandise cost $5,000 also, and every time it is sold there is a profit of 25% per year. Each year the owner turns this inventory. The business owner will need a total of $10,000 to get this plan started. $5,000 for the equipment and $5,000 for the inventory. At the end of the plan the business owner will have $25,000 plus the $5,000 they used to buy and sell with, plus the 25% profit on buying and selling they product. That part would grow to $15,258, giving us a grand total of $40,258.
Option 2: What if during those 5 years, a business owner could use that saved $5,000 that was earmarked for equipment but buy and sell merchandise for a 25% profit? In addition, we get to add the $5000 that we use for inventory. Just like the 1st option, we start with a total of $10,000. Now every time we turn our inventory at 25% just as example 1, however we get to start with a larger number working for us. The total after 5 years is $53,342. We now can then take our $25,000 out and pay for the piece of equipment we had been saving for. What has happened is that when we earmark our money, we restrict its ability to make more money. Option 2 we are able to make an extra $13,000, and we are still able to buy the equipment that we have been wanting.
This works with insurance and finance as well. We have finance charge in almost everything we do. Property and Casualty insurance has some of the highest finance charges in the industry, and it seems to be just accepted. I have seen as high as 22% on some of the finance charges for a business owner when the premium finance. It is very common to see 10 to 12%. This is pandemic for one as a business owner to understand that these interests are the most common reasons that business owners fail.
It is not because you had a bad idea, or bad business model. It is because you had a bad execution of your finances.
In 2021, we watched as restaurants closed their doors to never reopen. The covid pandemic stopped the flow of traffic to a lot of these restaurants, and they had to adapt. Some restaurants switched to a take-out menu or used uber eats. Others dumbed down their menu and shortened their staff to lower costs. Alot of business owners we able to use PPP loans to help pay for wages and salaries. Some landlords gave businesses a break during covid because they did not want empty buildings when the pandemic was over. The one expense that a business owner did not receive help with was their insurance premiums. Insurance companies we not calling clients and saying to them not to worry about their premiums this year. As a matter of fact, most business owners had to add food delivery coverages to their plans. The pandemic for business owners has been going on for over 100 years, and it is right under their noses. It is hiding in plain sight, with the highest finance charges in any industry.
PROBLEM 4: CUTTING COVERAGES
to be continued…
