Lloyd's of London: What's an Insurance Market?

Everybody knows what a stock market is, a physical or virtual space where people buy and sell ownership shares of companies. So what's an insurance market? Well, it's a bit different. The first share of Google is identical to the last share of Google. But, insurance doesn't work that way because every insurance policy, whether it's for J-Lo's best attribute, Danica Patrick's hands and eyes, or protection against business disruption due to natural causes (i.e., hurricanes, tornadoes, floods, etc.) is different. Which means they can't be traded. So, how can you "make" a market if you can't "trade" insurance stock like company stock?


Well, you can by bringing buyers and sellers together. The buyers at Lloyd's are companies or organizations looking for some kind of insurance or risk coverage. For instance, Wimbledon buys insurance that protects it from the losses that would occur if most of its matches were rained out and the 2-week tournament took 3-weeks instead, or even had to be shortened (Obviously, with the new retractable roof at center court, the risk is smaller than it used to be, but all of the other Wimbledon courts can be rained out). Likewise, oil companies buy insurance to protect the losses that would occur if one of their tankers sank or leaked crude oil.



The sellers are various insurance companies or individuals who are willing to purchase the risk for a particular price. Usually what happens is that one company or person takes the lead in negotiating the price and particulars of the policy, and then shops it around to others who then buy small parts of the risk. Once 100% of the risk is covered, the buyer than starts paying the policy premium. If the risk is avoided, the buyer loses the premium and the sellers keep it. If the risk is incurred, the buyer is reimbursed for their losses as specified in the policy and the sellers have to cover those financial losses.



Think of it this way, 300+ years in Edward Lloyd's coffee shop, sea-based entrepreneurs would come in wanting to insure the risk of sending a ship or ships to Asia to bring back tea and other traded goods. However, the risks were very high that the ship or ships would sink, be damaged, or suffer losses through piracy. Since few people could risk shouldering the entire loss themselves, they diversified their risk, and thus their potential losses, buy only signing on for part of the risk.



In this way, insurance markets are made.



On Thursday, our students will get a detailed explanation of how Lloyd's market works, of brokers, syndicates, secondary risk markets, etc. While it sounds highly technical, what goes on at Lloyd's today isn't all that different from what happened in Edward Lloyd's coffee shop 300 years ago.