Wednesday, April 19, 2006

Reverse Insurance Part 1: What it is

What is traditional insurance? Traditional insurance is the kind of insurance that the average Joe is most familiar with. In traditional insurance, a consumer (policyholder) and a coverage provider (the insurance company) set up a contract where the consumer perpetually pays a premium amount at regular intervals (usually monthly, but sometimes quarterly or annually etc.) to the coverage provider, and the coverage provider promises to pay for the costs of a given accident or situation, should the accident or situation occur. The consumer gets financial protection from the sudden and unexpected cost of an accident, while the insurance company gets money.

With traditional insurance, the consumer is essentially betting money that he will have a specific kind of accident and need a large sum of money to pay for it, while the insurance company is betting that he will not get in an accident. Actually, it's a bit more complex than that. The insurance company is actually betting that in a given group or category (example: 18-25 year old white male, nonsmoker, etc.) only X number of people in the group will have a given accident, and that if the company charges Y amount of dollars for each person in the group, it will be able to pay for all the accidents likely to happen and still make a profit. Even that explanation is a bit simplified, but it will do for our purposes here.

In this way, a traditional insurance company is analogous to a casino. Yes that's right: a casino. You see, like an insurance company, a casino is betting that you will not get in a proverbial "accident" by winning the crapshoot or card hand. Or to be more specific, the Casino is making a bet that over the long run, your losses will outweigh your wins. In other words, it is betting that the premium you pay at regular intervals will be greater than the amount of wins that you have, and therefore make a profit.

The consumer (policyholder or gambler) wants the financial value of their wins or accidents to outweigh the premiums or bets that they pay, while the insurance company or casino wants the incoming premiums to outweigh payouts. Accordingly, both the insurance company and the casino will "stack the decks" by setting the percentages or premium amounts in a way that virtually guarantees a profit. With a casino, they make the payout ratios and house advantages favored to bring in a given percentage of profit. With an insurance company, they make the coverage provisions and premium payment amounts also favored to bring in a given percentage of profit.

With both a traditional insurance company and a casino, the incentives - and vulnerabilities - are the same. In the same way that an unscrupulous gambler may try to cheat to win more bets, the unscrupulous policyholder will cause an accident or fake an injury to get a big insurance payout. This is why insurance fraud is a problem for insurance companies, and why cheating is a problem for casinos. Both insurance companies and casinos spend big bucks to fight fraud and cheating, which results in higher premiums for the consumer - not to mention the casino cheaters and insurance fraudsters themselves, which raise the premium amounts for the consumer even more.

The similarities between traditional insurance and casinos continue: If the consumer never wins a bet or gets in an accident, they never get any of their money back. Conversely, if the consumers win more bets than they lose or if they get more money in accident payouts than they pay in premiums, they do not have to pay back the difference. Both systems are a gamble, and in both systems, the house usually wins. If the house didn't win most of the time, then casinos and insurance companies wouldn't exist. But they do exist, and they make a lot of money. While making a profit for providing a desired service is all well and good, there is a better bet for consumers that will still make big bucks for providers. That bet is reverse insurance.

What is reverse insurance? Reverse insurance is a bet that you make where you don't pay any premiums unless - and until - you get in an accident. In this way, a reverse insurance company more closely resembles a bank or loan company. Unlike in casinos and traditional insurance, the consumer has to pay back all the money (over regular payment intervals) that was used for the accident. Accordingly, if the accident never occurs, or the loan is never taken out, then the consumer has no payments to make! The reverse insurance company will guarantee a loan that is payable over a certain time frame at regular intervals, with an interest rate that would be based on the policyholder's credit rating. It’s just like a bank loan!

There are of course some fundamental limitations to reverse insurance. It will not work for coverages that involve the consumer's ability to produce future earnings and make payments. Coverages like long-term disability and accidental death will not be workable in a reverse insurance system because a consumer cannot bet his future earnings against his ability to make future earnings!

So what is reverse insurance good for? Everything else! This includes personal coverages that do not involve future earning capability, like short-term disability, dental coverage, cosmetic coverage, and others. It also includes all property coverages, like automotive, home, flood, and fire, just to name a few. Business can even reverse insure themselves against property loss or even place-of-operation (location) and business continuity loss. For the business can be covered for the loss of its center of operation, relocate or rebuild it with the payout money, and then use its future earnings to pay the loan back.

The reverse insurance system has a very important advantage over traditional insurance: the incentives are reversed. Unlike a traditional insurance company or casino, the payment scheme is "reversed" from before-the-fact to after-the-fact. This requires a more direct application of risk assignment to the consumer in the form of a specific contract between the consumer and the coverage provider that all money paid out must be paid back, plus interest. That means that the more money the reverse insurance company pays out, the more it stands to profit. It also means that the unscrupulous policyholder cannot stage a big accident, receive a payout, and then cancel their policy, free from having to pay back the money received. Therefore, the unscrupulous policyholder has virtually nothing to gain by staging an accident, and the reverse insurance company has virtually nothing to lose by handing out cash.

While fraud will undoubtedly still exist in a reverse insurance system, it would likely be in much smaller amounts. The traditional insurance industry in America today loses billions of dollars annually to insurance fraud. How much money does the bank loan industry lose annually to fraud or failure to collect? Not nearly as much as the traditional insurance industry loses. That is because not only are incentives reversed for both policyholder and coverage provider, but traditional insurance companies specifically allow for a policyholder to collect more money than they pay in premiums when a legitimate accident occurs; reverse insurance companies specifically do not make this allowance. It is much easier to fake an accident and pass it off as legitimate than it is to fake an identity or disappear from collectors and investigators.

I am no insurance hater. Traditional insurance is a good idea in many situations. But reverse insurance is also a good idea in many situations, and it is sorely underutilized in today's insurance market.

27 comments:

Andrew Greve said...

Great entry Aaron. Do you know why reverse insurance doesn't exist in today's economy?

Aaron Kinney said...

Thanks Andrew.

Yes I have a few reasons why RI is not as common as it should be, and I will write about them in part 2.

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calvin.foo said...

when is part 2 coming?

Anonymous said...

I have a friend who keeps talking about reversal insurance. I haven't all the details but she thinks she is getting this big payout of 1 million dollars very soon and it's some kind of draw. My personal though is she has become involved in a pyramid scheme and will see no money. I t is all done on the internet and they get little e-mails confirming there turn is coming up. When I googled the term reversal insurance you came up.

Aaron Kinney said...

Anonymous,

Sorry but what your friend is talking about has nothing to do with what Im talking about.

My "reverse insurance" is a serious business tool for financially protecting oneself from accidents and other risks. What your friend is talking about sounds like its probably a pyramid scheme or some other fraudulent activity, and it sounds like their labeling of it as "reverse insurance" is a lie.

Reverse insurance has nothing to do with big payouts beyond what you are obligated to pay back. Reverse insurance is a loan that is promised and garunteed in the event of particular kind of accident. As it is a LOAN, and not a straight payout, the principle is paid back over regular payments plus a given interest rate.

Like any loan, reverse insurance is a financial obligation, not some kind of award or lottery winnings.

I suggest you warn your friend, and have her read this article. If you dont have to pay it back plus interest, then its not "reverse insurance."

Gabe said...

Great article/blog entry - I was doing a bit of research to get myself started on my finances for the first time, and I randomly thought to myself:

"Hmm, insurance companies sure make a ton of money because of the way their system is set up. There should be something called reverse insurance, that way, I'm not wasting all that money if I'm not even going to get into an accident anyway."

I googled "reverse insurance" and up popped your article, which elaborately explained my thought and worded it perfectly.

I especially liked your analogy with the casinos - made me understand our current insurance system much better.

Hope to see more entries someday.

Anonymous said...

HI Aaron, just foudn your post and interested in your second edition that I cant seem to find.

You raise a very intersting point more so now than ever with global crisis, and insurance costs rising not to the favour of the policy holder.
Assurance rather than insurance is somenting we arelookign at as a very real business opportunity.

Again very keen to possibly discuss and se ejust what is happening in the US, I keen for a revolution down under ( Australia).

Anonymous said...

Should check spellign before I push send, apologies.

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