Track 10 · Ruin · lesson 7
Buying back the tail
12 min
Track 10 · Ruin · lesson 7
12 min
Back in track 4 you sat on the other side of this table. You set premiums, paid claims, watched the underwriting result sit stubbornly at a small loss, and still finished the decade richer because of what the float earned while it waited.
Everything you learned there still holds. The only thing that changes now is which chair you are in.
A premium is built from four parts, and the insurer knows all four.
The expected claim — what an average customer like you costs them. The expenses — selling the policy, assessing the claim, keeping the lights on. The margin — what they intend to earn for taking the risk. And a deduction for the float, because they hold your money for months or years before any claim arrives and it earns something in the meantime.
Add the first three, subtract the fourth. The number is necessarily larger than the expected claim, or the business would not exist.
This follows from the arithmetic and it surprises people, so it is worth saying plainly.
If the premium exceeds the expected claim, then averaged over everyone who buys the policy, buyers pay more than they get back. Insurance has a negative expected value for the customer, by construction, always.
Predict
Once you know the average is against you, the rule almost writes itself. Every unit of risk you transfer costs you the margin and the expenses. So transfer only the units where the alternative is unacceptable, and carry the rest.
Transfer the tail. Events that would end the position: the house, the liability claim, the long illness, the death of an earner with dependants. Rare, severe, and impossible to self-fund.
Carry the middle. Events that would be irritating: the phone, the appliance, the small excess. Frequent, cheap, and self-funded out of a reserve. Every policy covering these charges you a margin for handling money you could have handled yourself.
The excess is the dial between the two. Raising it hands the frequent, cheap part of the risk back to yourself and keeps the rare, expensive part with the insurer, which is the shape you wanted.
What would you do
A household is renewing cover on a thing worth about 25,000. Three quotes, differing only in the excess — the amount they pay themselves before the insurer pays anything.
Excess 250 costs 620 a year. Excess 1,000 costs 430 a year. Excess 3,000 costs 290 a year. They have made roughly one claim in the last decade.
The harder version of the decision is not the excess. It is choosing which risks get transferred at all, when the money available to spend on premiums is finite.
What would you do
A household with two children, one earner bringing in 55,000, savings of about 20,000, and a home with a large loan against it.
Four risks are uncovered, and quotes exist for all of them: cover for the earner dying, cover for the earner being unable to work for a long period, cover for the home burning down, and cover for the contents.
Adverse selection. The people most eager to buy a specific cover are disproportionately the ones who expect to claim on it. Insurers price for this, which means the honest, low-risk buyer subsidises it. On a policy where self-selection is strong, the premium is worse relative to your own risk than the headline suggests.
Claim friction. The expected claim in the pricing is what the insurer expects to pay, not what customers expect to receive. Exclusions, evidence requirements and the sheer effort of claiming all sit between the two. Cover that is difficult to claim on is cheaper for a reason, and the reason is not generosity.