Simple Ideas Explain How Insurance Works

Everyone knows about insurance, but few understand it. That’s why people tend to underinsure real risks and overinsure spurious ones. Remember when you could buy insurance at Blockbuster to avoid the risk of damaging a videotape.

There are four general descriptions of risk situations.

  1. They are Low cost / Low Probability. Like the videotape. Tiny cost, tiny probability and a premium that is mostly administrative costs.
  2. The next is Low cost / high probability. Things like dental insurance. Most plans have low maximum payouts, and a large share of the cost is for routine treatment like cleaning and the odd cavity. Group insurance operates on the premise that if you send us four quarters, we will send you back seven dimes. The administration makes up the rest. On average it works like that. You can minimize your premium by accepting a deductible. If $100 of cleaning is certain why pay the insurers overhead for that. In some cases, a deductible reduces the premium by more than the deductible itself.

Neither of these is true insurance. They are more of a convenience thing.

The other cases involve high costs.

High cost /  high probability. This is the situation where there is no insurance at all. Underwriting removes the opportunity to own it. Buying life insurance when you have stage IV pancreatic cancer is not possible although someone would quote you a price if you had to have it. That price would be very close to $1,000 of premium per $1,000 of coverage. There are others. Shipping into a warzone involves massive premiums. I saw one quoted at 20% of the value of the ship and its cargo for five days of coverage. The client found an alternative method. If the insurer knows you are making crystal meth in your basement, you will find no house insurance is available.

For price purposes, this is not an insurance situation.

High cost / Low probability is, excluding convenience, the only situation where insurance is valuable. There are many forms and they all have the same high cost / low probability risk profile:

  1. Life insurance
  2. Disability insurance
  3. Critical illness insurance
  4. Home insurance includes fire, natural disaster, vandalism, theft, and public liability coverages.
  5. Cari insurance which overs several coverages in one package
  6. Errors and Omissions insurance for professionals.
  7. Businesses may have in addition to fire, vandalism and theft, coverages for public and product liability, environmental degradation, director’s liability, and much more complicated vehicle coverages.

In all cases, the expectation is there won’t be a claim. Where the risk is that there might be one with higher than normal risk, the premium will be made larger to accommodate the risk.

Where does the premium come from?

Premium is composed of several factors:

  1. On average, the likelihood of an insured incident and when it will occur. For life insurance, they usually use the life expectancy tables. The probability of a young healthy person dying soon is near zero and the premiums reflect that.
  2. The amount of coverage in the event of an event. Fire insurance usually has rules around partial losses. If your coverage is too low for the value of the building partial losses will pay an equivalent percentage of value. That doesn’t happen with life insurance.
  3. The amount of investment earnings that can be achieved on the entire pool of premiums less the claims paid in the year.
  4. The cost to acquire the business, costs for underwriting new business, administering continuing coverages, income taxes, corporate overhead, in some cases sales taxes, and corporate profit.
  5. The cost to guarantee future premiums is common with life, disability, and critical illness insurance. The ability to change rates as events develop reduces the insurer’s risk. The Covid events may change the price of group insurance.
  6. The cost to guarantee coverage remains available. If the insurer can quit when they want, their risk is less and so will be the premium.
  7. Any optional add-ons, like the right to buy more coverage without medical underwriting.

The cost decision with insurance is to buy what you need in the insured event occurs, but other premium changing options only when they have a net beneficial effect on your financial situation. Return of premium is one such. Level cost life coverage can be a cost-saving tool if the cash needed at death will always be there. Tax liabilities are a common cause.

When the context changes so do premiums.

Over the last thiry years or so some life coverages have dramatically increased in priceTerm to 100 being the one most affected. Why? Because the source of the money to pay claims on average is funded mostly with investment earnings. If you are 30 years old and the premium is level at $1,000 per year, the insurer could expect to be able to pay a claim for $500,000 at average life expectancy if bond interest rates are 8% and only $125,000 if the rate is 4%. That assumes everyone who starts the plan stays with it.

The other factor they consider is “lapse.”  You overpay for the annual risk in the early years with level premiums, so if you quit early they get to keep the accumulation. That lapse factor is often significant and it can cause serious problems if they guess wrong.

Suppose you had a policy issued in 1980 when bond rates were 15% or more and the lapse factor based on you being young was quite high. Young people lapse more products because their circumstances change. Older people have much lower lapse factors. When rates fall from 15% to 5%, premiums go up a lot. So no one quits the plan. I have a client whose cost to replace their coverage just seven years after purchase would have been almost four times greater. It has become a high-yield investment instead of insurance.

The insurers who had a large share of guaranteed premium Term to 100 in their early 80s portfolio, nearly all went out of business by 1990.

When your revenue falls by two-thirds, your expected lapse rate drops to zero, and your costs remain the same or go up, you have a short life expectancy as a company.

When you understand what drives the premium you can make adjustments to get better rates.

The bits to takeaway

If you are insuring convenience be sure you know the price.

Level cost insurance is a form of income-splitting tax shelter. Insurers pay less income tax on investment earnings than you do.

Get the coverage right and the simplest policy that will let you achieve the reason you are buying it. Sometimes more than one reason.

For coverages issued by life insurers, be a non-smoker.

Pay annually instead of monthly. Other than for universal life, you will save almost one month’s premium a year.

Understand the difference between coverages you own and control and the ones you don’t like group insurance or creditor insurance. Individual coverages are often priced lower. Be very careful with coverages from a bank to pay off your loan. They are relatively very expensive.

Insurers have immense amounts of data. All insurance costs the same if it covers the same thing. Your chances of dying don’t change depending on which company you use. Their risk, their investment earnings, and their costs of doing business are virtually identical. If a premium is much higher or lower, there is a reason. You should know the reason before you buy.

Someone is always insurance poor. The premium payer usually because the plan was poorly designed or implemented, or the beneficiary because there was not enough coverage to make their life work.

I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.

Be in touch at 705-927-4770 or by email at

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