VIEW 33 Cost of capital factors

33. Cost of captial factors

In View #32 we examined the underreporting of cyber incidents amongst small and medium sized companies (SMEs), which may explain the lack of insurance cover in that segment of the market. Here we explore a different reason why it is a good idea for smaller companies to get coverage. It is an argument based on cost of capital illustrated on the right.

33. Cost of captial factors

The orange line on the diagram shows, in conceptual terms, how insurance costs change as you move up the tower. An insurance coverage tower is made up of several layers of underwriters. The underwriter at the bottom of the tower (known as the primary) is first in line for any claims that might be made. Underwriters on layers higher up the tower are less likely to have to pay out claims because the other underwriters will be liable before any claim gets to them. Lower claim risk means cheaper pricing. So the orange line is a curve that flattens out; the higher up the tower you go the cheaper the cost to insure.

Large companies with plenty of capital often decide to self-insure, sometimes through a captive in-house entity, because the bottom layers of the tower can be expensive. The decision for large multinationals hinges around how their cost of capital compares with the cost of insurance. At a certain point up the tower, marked by a pink circle in the diagram, it makes sense to start buying insurance because the costs from that point on are relatively cheap.

33. Cost of captial factors

Steeper lines mean higher costs of capital
Smaller companies tend to have higher costs of capital than large multinationals. This is represented in the diagram by the fact that the dark blue line is steeper than the light blue one. If an SME has a high cost of capital, the dark blue line might never intersect the orange one meaning that self-insurance would be a poor choice. So, following this line of argument, it makes more sense for a small company to buy insurance that attaches at a lower point than a larger one.