Truth: How insurance companies make money
The Sunday Nation
Nairobi,
20 July 2014
The insurance
business is a game of numbers…and chance. A company convinces a number
of people to give it a small amount of money each and promises to
compensate them by a comparatively huge sum if certain calamities befall
them within a certain period of time, say, a year.
If no calamity comes
by, the agreement lapses and the company keeps the little monies that
the customers paid. This is how insurance companies make money: they
hope (and praying) that during the year, there will be fewer
compensation claims than the money paid in by customers.
Clearly, then, this
game only works if the insurance company has a large number of
customers. Take, for example the case of motor vehicle insurance: the
average market rate of premiums is about five percent of the value
insured for a comprehensive cover.
The promised
compensation includes loss of the insured vehicle and other losses that
may be suffered by third parties. Cumulatively, these may easily be more
than double the insured value.
Therefore, for a
vehicle worth, say, Sh1,000,000, the insurance company may be looking at
potential compensation claims of up to Sh3,000,000; that is, Sh1,000,000
for the insured vehicle plus Sh2,000,000 from third parties. For all
this, the company charges only Sh50,000!
So, to be able to pay
up all the potential claims, the insurance company hopes that only one
vehicle will meet a calamity out of every 60 in their portfolio. But to
meet other running expenses (salaries and commissions for agents,
administrative costs, etc) and make a profit, the insurer must have even
fewer claims than that – perhaps one in 100.
With that in mind, I
find it strange that whenever I go to buy insurance for my car, no one
asks me about where I park the car at night. The person who parks his at
an open public area and the other who keeps hers in a locked car-port
under 24-hour watch with electrified fencing are both charged the same
percentage premium!
It is no wonder that
the public doesn’t take insurance seriously – most people buy it simply
because it is a legal requirement! It is a sad state of affairs. I think
our insurance professionals (especially actuaries) are sleeping on the
job or, worse, they don’t know what they are supposed to be doing.
But there is another
way of looking at this game of numbers. If you buy insurance regularly –
especially the short-term general covers for health, motor vehicles, etc
– you must come to terms two inescapable truths: firstly, in the long
term, you will pay more in premiums than the claims that you will make.
Secondly, the vast
majority of insurance customers never consume the service that they
bought. If this wasn’t so, the whole insurance industry would collapse!
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