Transparency, Premium Rates and Risk Transfer

We live in an age of so called transparency. Being transparent is the new buzz word, with all of the technology available to us there are few places to hide and so everything is transparent, whether you wish it or not.

Everything? Well not perhaps everything. Look at your Insurance Premiums do you know how they are made up? You might know that your Broker charges Commissions or Fees but how much do you really know about how your Insurer arrives at the prices that they charge? Do you know what the Insurer’s profit margin is? Do you even know what your risk rate premium is? Do Insureds even know what a risk rate is?

An Insurance Premium is made up of a number of calculations. The fees charged by the broker has to be taken into consideration. But also the Insurer has to make an allocation for their own running costs. The costs of running an Insurance company has to be paid for and the clients of the insurer are charged for that, then there is the servicing of any loans, investments or debts that an Insurer may have incurred, these need to be paid for and then there is the cost of running a claims department and the accounts department these are not accretive to the bottom line but are costs and run as ‘part of the service’. Then on top of all of this the Insurer has to make a Profit and a return to shareholders. Finally comes the actual calculation of the risk premium. Risk premium? That is the calculation that the business of the client represents to the Insurer. Let’s put it in simple terms – if the Insurer calculates that the Insured will have a total loss every 10 years then the risk rate is obviously 10%. So if the Policy was for $1,000 then the risk premium would be $100 per annum, that is the pure risk premium and then all of the other costs are loaded on to this figure but the Insured always has a basic risk rate of 10%. This means that if this risk rate is right and doesn’t change that over time the Insured will pay their own claims and the Insurer will never pay anything net from their own funds. This brings us to the interesting concept of Risk Transfer. One of the tenets of Insurance is that there is risk transfer. That the Insurer can make a loss. Let us take the above example and just work off the risk rate (forgetting about all of the additional pricing loadings) for the purposes of this example. So the Insured has a policy for $1,000 and pays a risk premium of $100 as he is expected to have a loss every 10 years. The unknown factor is when that loss happens. So in year 2 the Insured suffers a $1,000 claim. The Insurer losses $900 in that year (net of premium) and over the two year period they are $800 down. BUT if the Insured keeps with the Insurer and continues to pay at $100 per annum and suffers no further claims then in 8 additional years the Insurer will be paid back and made whole. In effect the insured has paid for their own claims as well as paid for the Insured’s claims department, accounts department, salaries, loans and shareholders returns! Are Insurers transparent about that? Not at all.

Now let’s take another example with the above figures. Again we have an Insured with a policy of $1,000 and a risk rate unloaded of 10% or $100. But this time the Insured uses a different Insurer each year over a ten year period. In each year the Insured pays the premium of $100 risk rate, so over the 10 year period $1,000 has been paid but it has been paid to 10 different Insurers. Sadly in the 10th year the Insured suffers a claim of $1,000. The Insurer in that case has received only $100 in premium and so is in a loss position of $900 and so feels that the Insured is a poor client. From the Insured’s perspective they have paid $1,000 over 10 years and received $1,000 in claims, they feel that they have behaved well. So who is correct? The answer is that both parties – from their own perspective are correct – the Insured has paid for their risk in full but the 10th Insurer has only received 1 tenth of the premium he requires.

So why do we end up with this situation whereby Insurers feel out of pocket and Insured’s feel aggrieved? Afterall, in the above example the Insured HAS paid $1,000 for the $1,000 policy. It’s because of the habit that Insurers have acquired of thinking that the entire Premium amount is ‘their’ money. Why? Because they aren’t transparent about what is theirs and what is their client’s. so in the above example it could be argued that the risk premium should always remain the property of the Insured, afterall over time if correct, this will result in the Insured paying for their own claims, why should this be the property of the Insurer? The very concept – as we have established above – is that there is no actual risk transfer over time so if that is the case should the Insured not retain possession of their own risk premiums? It would be an extremely easy thing to achieve, for an Insurer to be transparent over the true cost of doing business with their company. Then all that the Insured actually pays is the loading on top of their own risk premium. So now the Insured can make a true assessment of the cost of doing business between one Insurer and another. Now if the Insured moves from Insurer to Insurer then can take their accumulated risk premiums with them and the Insurer would be left with the loadings which should afterall be the true ‘cost’ of the Insurance. So in our above example if the Insured took his $100 with him from Insurer to Insurer then when he joined Insurer Number 10 they would bring a Fund of $900 and pay a risk premium of $100 so now the Insurer would be made whole and there would be no feelings of animosity at all. Every Insurer would receive their Premium loadings and so would be able to service their company and return profits and the Insured would retain control over the accumulated risk fund. The problem comes with lack of transparency from the Insurer. It comes from the Insurer treating all of the premium as being ‘theirs’ and this leads to the feeling that Insurers overcharge and don’t treat their Insureds fairly. At Hartwell we use crowd funding into Guarantee Funds in order to cover clients. The risk transfer is finite – governed by the capacity of the fund but we are completely transparent about what is the property of our client and what is our loading. Every Guarantee Fund that we set up spells out very clearly what is ours and what is the net contribution of the client into the Guarantee Fund. More than that we always undertake that if we ever wind up the Fund, then we will return all of the client contributions net of our (openly declared) costs and of claims costs. We provide total transparency, so everyone can see what our margins are and what the risk premiums are that the clients pay. Hartwell is totally transparent; can you say that about your Insurer?