Insurance as a Form of Capital

Your building is on fire!” Terrible words to hear late at night — or anytime for that matter. Without warning, a portion of your invested capital can disappear in a matter of minutes.

Both private and public companies require capital to operate and grow. There are many aspects of risk that companies face in the course of acquiring, selling, managing, developing or owning property. Risk managers, along with their consultative brokers, identify the risks and then design, negotiate and implement insurance programs that can provide the capital to rebuild, replace and continue operations. Companies can spend a significant amount of money to mitigate risk by crafting contractual language to address their concerns, which may address some of the exposure, but not all. The use of insurance programs are designed to provide protection as a backstop to contractual language, as well as to provide coverage for those areas where contractual wording may not go far enough.

Capital, in the most basic terms, is money. All businesses must have capital to purchase assets and maintain their operations. Most companies maintain their liquidity or capital through earnings and cash flow. Companies with predictable earnings will maintain their valuation either through potential value in the marketplace if they are a private company or through increased stock value if they are a public company. Higher market valuation or stock prices are a form of currency the company can use to grow and expand.

In the case of debt capital, the cost is the interest rate that the firm must pay to borrow funds. For equity capital, the cost is the returns that must be paid to investors in the form of dividends and capital gains. In the case of insurance capital, it is the premiums paid for the limits of insurance purchased to protect against catastrophic losses.

Avoiding interruptions in earnings or reducing volatility in earnings has the potential to help companies maintain a predicable source and cost of capital. Companies that are able to maintain a strong balance sheet will generally be able to obtain funds under more reasonable terms than other companies during an economic downturn or catastrophic loss.

Companies can protect themselves against unexpected events that could have a negative impact on expected earnings. They can tighten their budgets, establish conservative cash reserves, or limit customer credit; lower borrowing costs; seek to obtain better credit terms from their vendors; cut expenses; institute safety programs throughout operations; or outsource dangerous activities. However, accidents and large, unanticipated negative financial events can still occur and affect earnings. What are the options?

Businesses can look to fund the event through additional debt capital or raise equity capital. In many cases, the most overlooked form of capital is insurance. If a company has the correct types of insurance, it can use it as a source of capital to the extent it applies to the loss, to the level of the policy limits. Insurance is a form of risk-management used to hedge against the risk of a contingent, uncertain loss. It can be a very effective hedge against volatility of expected earnings due to a catastrophic corporate loss.

Topics Profit Loss