A Beginner’s Guide to the Principles of Insurance

This blog posts will help you understand why blockchain is bringing such a profound transformation to the insurance industry.

Risk pooling at work

Needless negative experience

If you are not yet familiar with Etherisc, we’re developing a platform based on blockchain technology for decentralized insurance applications (meaning the user data will be his/her own to control). This blog post is intended for readers to be able to better understand why blockchain is bringing such a profound transformation to the insurance industry.

Numbers, accounting, policies, fine print, struggling to get the money locked in your policy … these are the things most people probably first think of when they hear the word insurance. Looking past the initial apprehension, insurance is in fact quite good for everyone. And the needless negative association can be drastically improved with a little touch of blockchain technology, as we’ll see through the blog post.

We can demonstrate the basic principles of insurance with a simple example. Let’s say you’re a homeowner and you want to insure your $100,000 home against a catastrophic event, be it flood, fire, earthquake — you name it. A chance of a devastating event wrecking your house is usually pretty small, around 0.01% per year or about one out of every 10,000 houses.

Now, some easy math. For our fictional example, we’ll presume a world where no insurance exists. So, if you want to insure your house against a disaster, you’ll need at least $100,000 to buy a new one in case it gets destroyed. Usually, you would get the money from a bank, with an annual interest rate of maybe 1%. At the end of the year, this type of insurance would lighten your wallet by $1,100 ($100,000 loan * 1% interest rate + $100 annual redemption for the principal = $1100.00).

Shared risk, lower cost

Paying $1,100 per year is a manageable but not negligible amount. These costs can be reduced dramatically by pooling risks into so-called risk pools through an insurance scheme.

Here’s how it works: a risk pool is made up of a large number of cases with similar possibilities of a risk event (a risk event is a specific occurrence with a negative effect). We assume that our risk pool is made up of 100,000 homeowners. But unlike our previous example, they’re now paying an annual amount of only $100. This $100 is called a “premium” and is intended to insure against catastrophes and the collected total of premiums suddenly jumps to $10M.

Because of the law of large numbers, there’s a high probability there will only be about 100 fires, destroying 0.01% of all the homes in our risk pool and causing damage of approximately $10M! That’s also the sum of all premiums paid by the homeowners. This way the total cost of a disastrous event is covered by the collected premiums. At the same time, homeowners don’t have to take out a loan because pool participants are taking care of each other, and the costs are now reduced from $1,100 to $100. Any surplus of money also stays in the pool because premiums are collected at the beginning of the year, and the “burning” of houses happens more or less equally over the year(s). This excess is the primary source of revenue for insurance companies.

But risk pools don’t benefit insurance companies alone, they bring several benefits to the customers as well:

1. A large pool of financial liquidity is available to the participants.

2. They have a guaranteed access to this financial pool in case of a catastrophe.

3. Damages are mutually subsidized (solidarity of participants).

Pools could also be designed as “profitless” endeavors. If this kind of pool were to generate profits, they could be returned to the participants, reducing premiums to a level where, again, no profits are made. Such insurance would have a loss ratio of 100% because all premiums would be used to pay the losses. It’s the fundamental effect of risk transfer in insurance and the effect increases with pool size.

Still, this is not the whole story…

In some years there are more fires than in others and these need to be covered with, for example, another $10M. If we presume that the pool raises this additional sum at an exceptionally high interest rate, e.g. 20%, it brings the total costs to $12M. The extra overall costs of $2M are distributed among all 100,000 homeowners, ramping up the premium by $20/homeowner/year.

The premiums go up, but there is also protection against so-called “long tail risks” or “black swan events” (devastating events that are extremely hard to foresee), at the cost of $20 per house owner. Overall, participants now pay $120 per year for their house insurance while the loss ratio is reduced to 83% because of the capital costs ($100 for covering the risk against $120 premium => 100/120 loss ratio = 83%).

A reason to be

Organizing 100,000 people in a pool is not an easy or cheap feat. That’s why we have insurance companies. They decrease transaction costs for the participants of the pool, create colossal customer bases and in the process achieve capitalizations which can cover even global catastrophic events. Such a professional risk management structure adds steep costs to the premium; on average they can amount up to 34%!

Together with smaller transaction costs that insurance companies bring into the mix, comes an asymmetry in information. Big insurers use it to obscure the real costs of transactions and profit tremendously from it. They collect unlimited amounts of customer data and reserve the rights to its exclusive exploitation. This is a direct consequence of an imbalanced relationship. It creates an “unfair competitive advantage” for existing companies; companies with big data vaults can offer better products, and thus further optimize their database.

But there is hope around the corner. The solution lies in the blockchain. Blockchain can right the wrongs and create an alignment of incentives, where consumers have greater control and influence. The advent of this new technology has for the first time given us the tool to dismantle centralized incumbents and offered us a decentralized solution for a new type of insurance. Blockchain, with its automation capabilities, lowers costs and facilitates the cheaper pooling of risk. Our platform brings a shake-up to the industry while giving customers back the ownership of their data. Etherisc offers the opportunity to create an insurance policy that perfectly fits their needs.