This is part of a mini-series I hope to continue about breaking down how insurance works. If there are any topics people would like to see covered, please let me know. I hope to cover a lot of different topics, as insurance is a major contributor to the U.S. economy. About 1% of the U.S. population is employed by some type of insurance organization. With that being said, I'll jump right in...
How Insurance Works:
The model for insurance is simple. Many pay for the losses of the few. Everyone that is part of an insured group contributes a certain amount to a group fund (a premium). From this group fund, loss payments are made, expenses are met, taxes are paid, and assets are set aside to pay for future losses.
Why Insurance Can Be Handy
Imagine a village of 1,000 families with homes each valued at $100,000. Suppose, on average, one home is destroyed by fire annually. If each household pooled $100 a year into a group fund, this would cover the value of the destroyed home each year. In essence, each villager is paying $100 a year to waive the chance of being without a home. Insurance is a win for all parties involved in this village.
The Challenge of Insurance:
The village described above is not perfect by any means. Losses will vary by frequency (it is not set in stone that one home will be destroyed each year) and magnitude (you can lose more, or less, than the $100,000 value of the home). Not everyone is the same, and eventually people will need to be classified by loss behavior in order to rate each member of the village properly. The challenge is classifying each prospective policyholder properly with other policyholders having similar loss potentials, so that the rate for the group would be sufficient for covering its losses. $100 might be able to cover the average house in the village, but what if someone builds a New House that is worth $200,000? Realistically, a New House is less likely to burn down in a year than an old house. Each classification of villager represents a refinement of the rate for each group member. The principle is the same: many pay for the losses of the few.
How Do We Define Insurance?
The best way I have seen insurance described is in Insurance Words and Their Meanings by Robert Strain. He breaks insurance down into 10 parts:
The transfer of risk (the chance of loss) from one party (the insured) to another party (the insurer) in which the insurer promises (as usually specified in a written contract or insurance policy) to pay the insured (or to pay others on the insured's behalf) an amount of money (or to supply the insured with insurer-paid-for services, or both) for economic losses sustained from an unexpected (accidental) event, during a period of time for which the insured makes a premium payment to the insurer
When the villager purchases insurance, he is exchanging the certainty of a small loss (the guaranteed payment of $100) for the uncertainty of a large loss (the event he is insured against--his house burning down). This membership fee seems pretty reasonable for removing the uncertainty of such a large loss. In fact, it sounds like a bargain.
Certainty
When you merge a multitude of individual uncertainties into a group of policyholders, they are converted into "predictable certainty" for a group by the law of large numbers (I'll let you google that). Combining individual uncertainties into a group doesn't achieve perfect certainty, you get "near certainty" -- and there are certain criteria that need to be more before achieving "near certainty".
The Requirements (according to Casualty Insurance, An Analysis of Hazards, Policies, Insurers, and Rates)
- Homogenity of Exposure Units: Everyone in the group should have the same exposure to loss, or as similar as possible. Otherwise, the average loss per group member isn't useful in determining the average insurance rate per member. The number of people in the group must also be large enough for the law of large numbers to apply.
- Measurable Loss: The loss must somehow be measurable/quantifiable in nature. A measure of time, place, and dollar amount.
- Accidental Loss: The insured loss must be an accident to the insured party. To cover an insured member in a plan for intentional destruction of insured property would cause bankruptcy for the plan (and is illegal).
- No Incalculable Catastrophe Risk: An insurance plan should not be exposed to some catastrophe risk that cannot be measured.
Will do my best to answer any questions.
Thank you for the post :).
I think it's spot on the basics of insurance. However my problem with insurance is that you usually pay more for the risk it covers. Correct me if I'm wrong:
Continuing your example above with a premium of 100$ each for 1000 houses worth 100,000$ each and of which 1 house is destroyed per year.
In reality you need to pay for the underwriting expenses (administrative and sales commission expenses) and most often that is around 30% of premiums (in the case of large insurers). So the insurer needs to price his insurance product to cover that as well.
Considering a underwriting expenses of 30% * 100,000$ = 30,000$ This means that total costs for the insurer is: 100,000$ + 30,000$ = 130,000$ Since we have 1000 clients this means that each will have to pay 130$.
The problem is that his risk is equal to 1/1000 (one house per year out of 1000) * 100,000$ (the value of his house) = 100$.
So technically he pays 130$ for just 100$ of value.
That's how I view insurance. Could you correct me if my way if thinking is inaccurate?
Yes and no. I would break down insurance costs into two buckets.
Underwriting Expenses - The expenses the business incurs to actually write a policy (think marketing, employee salary, commissions, etc.)
Loss Expenses - The expenses the business incurs due to policyholder claims.
Combined, these costs can exceed the total amount of premiums. There's also a strong chance that an area where an insurer does business has a natural disaster occur, in which case there's going to be much more claims in a given year than usual.
Insurers manage this by investing their cash base accumulated from previous years when there were a lack of claims, and their float, which is the cash on hand from premiums but has yet to be paid out in claims (the float is Warren Buffett's particular obsession).
He is paying $130 to offset a low probability but devasting loss of $100,000. The $30 difference to the purchaser is marginal in context. On the aggregate, it makes it a worthwhile business venture for the insure, who always runs the risk that claims will exceed actuarial expectations - especially in P&C, where the timing and amount of external cash flows are highly uncertain.
Not sure how this is a problem for the purchaser.
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He is paying $130 to offset a low probability but devastating loss of $100,000Asset Management arms, etc. When you have $900 bn of life insurance in-force for a single company (MetLife), companies have to find a way to diversify their assets.
Most insurance companies only make money from their Asset Management operation and actually break-even/lose money on the core-insurance business if you want to see it this way. There are several drivers in the industry but clearly the market performance is a huge exogenous variable in these type of companies which is why I'm a little bit skeptic to buying insurance companies unless its a real bargain
very accurate. it depends how their investment income came up. Everyone invests differently. But underwriting is just about breaking even for the risks they took, otherwise they can't sell premiums
Definitely interested in reading more.
The only thing you need to remember about insurance companies are they are not in the business to pay claims.
Some guy in Canada forgot to mention that he smoked cigarettes. He died in a car crash (totally unrelated to smoking). The insurance company proved that he smoked a cigarette within 2 years of the signing of the contract, and thus, breached the contract. They won in court and didn't pay his wife.
Most insurance companies invest in about 90% bonds, then the rest of their investments are in more volatile risks from what I understand.
Also insurance companies break out their costs of acquiring customers and spread that out over their estimated life of the contract. This is also know as DAC(Deferred Acquisition Costs) which helps tends to reduce the policy’s first year strain and generally produces a better pattern of earnings. These costs are then recognized on the income statement as they are amortized, or reduced over the years of the contract.
What I'm interested in is, how do insurance companies manage the risk of hereditary diseases? Here's a plausible scenario:
Healthy guy wants to buy a life insurance. Everything looks fine and finds an insurer. Thing is, his family carries a hereditary disease that for now, shows no symptom. So he has an information advantage over the insurer. How do they account for this information asymmetry?
When I worked as an intern for a large life insurance companies the actuaries built models for scenarios like the one you described and the underwriters would just plug and play.
Thanks for the article. It came at the perfect moment for me. If u intend to write more on this subject and u'r willing to hear the potential readers, these are the things that I would be eager to learn more about: Main fundamentals specific to insurance industry. More about the economics and the main drivers of profitability and frowth of the business (you mentioned Buffet in a comment, and I think in one of his letters he said the insurance business is quite competitive and may not be very profitable, but he succeeded with GEICO....why and how?). I may come with other questions and suggestions after more articles. Thanks a lot ;)
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