- We want protection from catastrophic loss
- We’re willing to overpay for this protection
- Insurance companies rely on the Law of Large Numbers
1. Insurance companies are unlikely to win any popularity contests. Why then are there so many of them? The answer is as old as time: we want to buy protection from the risk of catastrophic losses. These catastrophes could affect our health, our homes, our family, our livelihoods — and, in so doing, wipe out our life-long savings. Even the mere possibility of such losses weighs on our peace of mind.
2. The risk of such losses might be slim, but we’re willing to pay for protection against them. In fact, we’re willing to overpay. If, for example, the chance of a million-dollar loss is only 1/10 of one percent, the expected loss is $1000. But people might be willing to pay twice that amount to avoid the possibility of a financial catastrophe. In this sense, people are risk averse.
3. By offering protection against losses, an insurance company takes on the risk of each individual. By offering insurance policies to many people, however, the company actually reduces its total risk.
Although there is no way to know if any particular individual will suffer a loss, the total amount which must be paid every year is fairly predictable. This is because of the Law of Large Numbers. The same reasoning applies to a flip of a coin: if you flip it once, it will be either 100% heads or 100% tails; if you flip it one thousand times, you can predict within a percent that the results will be 50% each way.
- The combined ratio
- The benefits of timing
- Buyer beware
1. Insurance companies write policies and receive revenues, known as premiums. These premiums must cover two types of expenses: the costs of selling the policies and the costs of paying customers when losses are incurred.
If you compare the two costs against the revenues from premiums, you have the combined ratio. Let’s say, for example, that an insurance company pays out 40% of revenues to its salesforce/staff and it pays out 50% of revenues to its policyholders. Ninety cents of every revenue dollar are spent on expenses, and the combined ratio would be 90.
2. Several decades ago, insurance companies were permitted to get together and set their policy rates such that the combined ratio was 100. Since a ratio of 100 means that each dollar of revenue is spent on costs, this doesn’t sound like a great deal for the companies — but it was!
How can a company prosper if all the money it receives is paid out in expenses? By taking in the money now and paying it out much later. Money received now, known as the insurance float, can be invested — and the profits from those investments stay with the company. It’s as if you borrowed money at a 0% interest rate, invested that money, and were allowed to keep whatever you earned from the investments.
3. Because of timing — revenues received now, expenses paid later — a combined ratio of 100 is a license to print money. But the industry has become intensely competitive and combined ratios well over 100 are now common. Since insurance companies have less control over their revenues, they have become increasingly focused on controlling their expenses.
Always bear in mind that, when you buy insurance, you are buying a promise to pay — and you should be very careful whose promises you rely upon. Make certain that the insurance companies with which you deal have strong financial ratings from A.M.
Best and other rating agencies. Also, look for companies which spend a lower percentage of earnings on sales commissions and administrative expenses — these companies can afford to give you better rates on their insurance policies.