Skip to main content

The risk library  /  Where the premium goes

Art. 14 · Where the premium goes · 3 min read

The lottery lesson

If the other side of a transaction is profitable on average, you are unprofitable on average. This is not an argument against insurance. It is an argument for buying less of it, better.

A lottery ticket is the cleanest example of a bad trade that feels good. Roughly half the money that goes in comes back out as prizes; the rest goes to good causes, tax, retailers and the operator. Buy a ticket every week for forty years and the arithmetic is not in doubt. The jackpot's job is to make you feel the arithmetic doesn't apply to you.

WHERE £1 OF TICKET MONEY GOES back out as prizes everything else Approximate, and public: the split is published. The point is that it is knowable, and that nobody buying a ticket is thinking about it.
Fig. 15 · A transaction where the expected return is negative and everybody knows it. Insurance is a much better trade than this, but it points the same way, and for the same reason.

Insurance is a far better deal than a lottery. A much larger share of premium comes back as claims, and, unlike a lottery ticket, you are getting something real for the difference. But the direction is identical: on average, over time, you pay in more than you get out. That is what the loading factor in Article 02 was.

So what are you buying with the gap? You are buying a change in the shape of your outcomes.

the tail that ends businesses average average, insured: slightly worse cheaper years a very bad year WHAT THIS YEAR COSTS YOU
  • Uninsured: better on average, occasionally catastrophic
  • Insured: slightly worse on average, almost never catastrophic
Fig. 16 · Insurance does not make you richer on average. It takes the long right-hand tail, the years that end businesses, and converts it into a small, predictable, permanent cost.

That trade is superb when the tail is fatal and poor when it isn't. Paying a loading to remove a risk that could close you is one of the best purchases a business makes. Paying the same loading to remove a risk you could settle from petty cash is a slow, quiet transfer of your margin to someone else.

Use it

  • Ask one question per policy. "If this loss happened uninsured, would it threaten the business, or would it just annoy me?"
  • Expect to lose money on insurance, and be glad. The years you don't claim are the product working.
  • Spend the loading where the tail is. Concentrate premium on the few risks that could end you, and stop spreading it thinly over the ones that couldn't.

Want this run against your own numbers?

We put ranges, not single figures, against the risks your business actually carries.

Speak with an expert

Explanatory content only. This article describes how insurance and risk decisions work in general terms; it is not insurance, legal, actuarial, or investment advice, and it is not a recommendation to buy, keep or cancel any cover. Every figure and diagram is illustrative, chosen to make a mechanism visible, not to describe any particular business.