Insurance Example

Shown above is a price chart of a commodity. It could be any commodity but for the sake of this example, we will just look at prices.

Imagine the conversation presented below:

Let’s say that you want protection against prices moving higher than 77 (point 4 on the chart).

You could then approach your insurance broker and have the following conversation:

You: “Mr. Broker, you know, I am about to enter into a business transaction and I am really scared that prices will move above 77.  Can you provide me with insurance against prices rising above 77?..”

So your broker will then take out his calculator and ask you:

Broker: ‘Ok.. so for how long do you need this protection for?’

You: “Ahh, I guess about 6 months”

Then he presses a few more buttons and says:

Broker: ‘OK, I can give you the insurance for six months for X amount and I will give you a guarantee that if prices move above 77, that I will sell you the commodity at 77’

You: “geez hmm… that is a bit steep”

Broker: ‘You know, I am the one sticking out my neck here, giving you a guarantee. This commodity is known for moving higher during the second half of the year and if that happens I will be in trouble here but if you were to only look at 3 months of protection instead, then I can reduce the price for you, but 6 months, that’s too risky for me. I’m sorry but that is the price I would have to charge you.’

‘You can always approach another insurance broker – maybe he is willing to give you the same insurance at a better price, but for me… well this is the best I can do.’

It’s now up to you. Do you want that insurance or not? Are you willing to pay the required premium offered or not?

If you do however take the insurance, and prices do rise to let’s say 80, then the insurance company has to pay you out. They have to sell you the commodity at a price of 77 – that was the agreed on insured price.

On the other hand, if prices never reach 77, then the insurer is safe – however, he still took on all the risk.

Regardless of what happens, the premium you paid for the policy is non-refundable – that was the money the insurer collected for being willing to take on the risk in this position.