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insurance: what it really is (a bit long)

updated tue 31 may 11


James Freeman on mon 30 may 11

This is part 1 of 2:

Sorry, this is long, but it's useful information that few people understand=

I am not in the insurance business, and have never been, but I did take a
few courses in insurance theory and finance in college (Finance major).
This note is not an argument for or against insurance, and should not be
seen as picking on anyone. It's intended only to clarify things a bit.
Insurance, when employed properly, is not a bet for or against an occurrenc=
with the winner keeping the money, as many people believe. It is not at al=
comparable to pulling a slot machine handle in a casino, win or lose.
Rather, it is a sharing (pooling) of risk.

We know that there is a possibility, however remote, of a catastrophic
occurrence, say our house burning down (for the sake of simplicity, we shal=
limit our discussion to this single risk, though there are obviously many
others). Thanks to the work of actuaries (statisticians), we have a fair
idea of how many homes per year will burn down, on average, in a given larg=
pool. While the actuaries are pretty good at making such guesses, they
cannot tell us two important things; which one of us will be the unfortunat=
victim of the fire, and in which years something major and unforeseeable
will occur to cause tremendous "above average" losses.

Let's hypothesize a community (pool) of 1000 families, each with a home tha=
would cost $100,000 to replace. Let's say that statistically, one house pe=
year out of this pool will burn down (It's actually a 1/16,000 chance, but
let's keep the math simple). Therefore, every individual homeowner in our
pool faces the chance of being completely wiped out every year, and though
the odds are small, they know that SOMEONE is going to get the loaded
chamber, so to speak. The homeowners in our pool have two options. They
can just sit there year after year and hope the fire hits someone else.
This is called "assumption of risk", and is, as David points out, a viable
option in some cases (such as young folks opting out of health insurance
based on the odds against a major medical problem at their age). The secon=
option is for each of our 1000 families to kick $100 into a pot each year,
and the pot then paying out the entire collected $100,000 to the one
unfortunate family whose home suffers the fire each year. The families in
our pool have thus traded the slim but real possibility of a $100,000 total
wipe-out in any given year for the much more affordable known loss of only
$100. This is insurance in it's simplest form, but there are four major
factors that creep in to complicate our scenario, each of which affects our
premium (three raise it, one lowers it).

Firstly, someone has to work to collect the premiums, administer the funds,
research and pay the claim, file the proper forms, and other such
administrative duties, and we must pay this person for their efforts. Sinc=
we need the entire $100 per family just to pay our annual claim, it is clea=
that we must collect a bit more from each family, say an extra $2, in order
to have enough to pay our staff and administer our fund. Our premium is no=

Second, while we are pretty sure that an AVERAGE of one home per year will
burn down, it is entirely possible that two will burn down this year, and
none next year. How do we pay for the second loss this year, if we
collected only $100,000 in premiums? We need to fund a "reserve", or a bit
of extra money in our pot that we can tap into in a year of heavier than
normal claims, then replenish in the years of lighter than normal claims.
We decide that if every family kicks in an extra $5 per year, we can build
up our reserve (assuming we get lucky in the first years and don't get that
second claim while our fund is building). Our premium is now $107.

The third complicating factor is the even slimmer, but still real
possibility of a catastrophic loss in a given year, say Mrs. O'Leary's cow
kicking over a lantern resulting in a whole block of houses burning down.
Again, how do we pay for this on the off chance that it occurs one year?
Once more, the answer is to build up our reserve fund a bit more, just in
case. We decide that an extra $5 per year from each family will be enough
to cover this slim, but potentially extremely costly possibility. Our
premium is now $112.

The fourth factor actually serves to decrease our required premium. Our
fund administrator figures out that rather than leaving our $112,000 fund
sitting in a pot on a shelf, the money can be invested, where it can earn u=
some interest and dividends until needed to pay claims. Let's say our
invested fund earns us $8,000 in interest and dividends in any given year
before it is needed to pay claims. This $8,000 is money that we do not nee=
to collect from our homeowners, so we can decrease the required contributio=
from each of our 1000 families by $8 per year. Our premium is now $104, an=
our little non-profit community ("mutual") insurance fund is solvent.

-to be continued-

James Freeman

"...outsider artists, caught in the bog of their own consciousness, too
preciously idiosyncratic to be taken seriously."

"All I say is by way of discourse, and nothing by way of advice. I should
not speak so boldly if it were my due to be believed."
-Michel de Montaigne

James Freeman on mon 30 may 11

Part 2 of 2:

Now, what if no one was willing to do all the work of, and assume all of th=
early financial risk (before the reserves are built up sufficiently) in
organizing the mutual insurance fund in the first place? A group of the
more wealthy families decides to assume the risk and do all of the work.
They would be foolish to put their own families at such financial risk and
devote their own labor to running the fund instead of, say, working their
own farm, unless they had the chance of being compensated for their risk an=
effort. Thus, they decide that they will require an additional $1 from eac=
family each year to compensate them for the risk they have assumed. In thi=
case, ceteris paribus, our premium is $105, and we have a "for profit"
insurance company.

Some will argue that in the real world our insurance companies are charging
far more than they need to and are making obscene profits, but the facts do
not support such a contention. Not only are insurance companies charging
fair rates given the risks they assume, insurance companies on average earn
a return on capital (the investors' money) that is in the lowest or second
lowest quartile (depending on how one looks at it) of all corporations in
every industry. According to an academic study covering a 17 year period,
the average non-insurance corporation earned a return of 12% on their
capital (investors' money), while the average property and casualty
insurance company earned only 10.1% for it's investors. The study compared
the earnings of the property and casualty insurance companies to various
benchmark indices of investment return such as the Standard and Poors 500,
the Standard and Poors Financial Index, and even the risk-free return on
U.S. Treasury bills, and the insurance companies, on average, earned a LOWE=
return than 5 of the 6 benchmark investment indices. They also looked at
financial risk of the earnings, the "variability" (the fact that any given
year's earnings can vary materially from the average, for example earning
way more in years of lower than normal insurance claims but earning way
less, or even losing money, in years of higher than normal claims), and it
turns out that investors in insurance companies face more earnings risk tha=
four of the five benchmark indices. In fact, property and casualty
insurance companies earn for their investors only 1.5% more than they could
have earned by simply investing that money in risk-free 10 year Treasury
bonds, and in 7 of the 17 years covered by the study, insurance companies
earned less than this risk-free Treasury Bond return on their investors'
money through their insurance activities.

David mentioned that after all these years of paying premiums with no
claims, he could have afforded to replace his own house if it burns down.
While this is true, what if his house burned down in year 1, or year 10, or
year 15? Someone's house did burn down in those years, and David's premium
, or at least 90% of it, went to those unfortunate individuals, and in the
year that David's house does burn down, should it ever happen, the money he
gets from his insurance company will have come from his neighbors' premiums=

Insurance premiums are not set based on the risk of your suffering an
individual claim in any given year, but rather on the pooled claims of all
of your neighbors (the other policy holders). Insurance is not a bet, with
you losing and the insurance company winning if you don't make a claim. It
is simply the trading of an unknown major risk for a much smaller known
risk. The "bet" in insurance, to the extent there is one, is in you as an
individual deciding whether to opt out of insurance and assume the risk
yourself (called "going naked" in insurance parlance), or to take the known
hit (the premium) and share the risk with your neighbors. This is a bet fo=
you to take or not as you see fit, but if you do decide to take the bet and
forgo insurance, don't cry to anyone if you lose.

All the best.


James Freeman

"...outsider artists, caught in the bog of their own consciousness, too
preciously idiosyncratic to be taken seriously."

"All I say is by way of discourse, and nothing by way of advice. I should
not speak so boldly if it were my due to be believed."
-Michel de Montaigne

Dinah Snipes Steveni on mon 30 may 11

Good essay. Good job.

Mount Vernon, WA.

"To obtain a certain thing, you have to become a certain person."
Zen Buddhist saying

Patty Kaliher on mon 30 may 11

I recently heard that the behavior of the drivers in your area affects =3D
your car insurance rates. If we all drove less aggressively and focused =
on our driving, we could save money. What a concept.

Patty Kaliher