Proofiness - Charles Seife [31]
As an example, imagine that you want to sell fire insurance. You need to have a good estimate for the risk of a house fire (say that there’s about a 1 in 250 chance that a typical American home experiences a fire in a year) and how much damage the average house fire causes (say $20,000). These two pieces of information tell you how much money you’ll be paying out in claims, and thus how much you need to charge for the insurance. Indeed, given these numbers, you can make a very nice living by charging your customers $100 a year in premiums.
Because the risk of a fire is 1 in 250, for every 10,000 clients you have, you can expect roughly forty of them to have a fire in a given year. Each of those forty fires costs you roughly $20,000—a grand total of $800,000 in damage that your company has to cover. But at the same time, your clients are paying you $1,000,000 in premiums, leaving you with a handsome profit of roughly $200,000. All you do is sit in the middle and watch the money pour in, making the occasional payoff. To make money in this way, though, you really have to know your risks. If your risk estimates are off, if there are sixty fires in a year instead of forty, you’ll have to pay off $1,200,000 in claims—$200,000 more than you collect in premiums, which means that you’ll go bankrupt. So you do all you can to keep the risk of fire in your client base—your “risk pool”—as low as possible. You might encourage them to install sprinkler systems. Or you might insure only nonsmokers, as they are at less risk of setting a fire than the general population. Your survival as an insurer depends on understanding your clients’ risks and reducing them.
That’s the theory anyhow. Reality, though, is a lot more complicated. Say you don’t want to be bothered with all the paperwork and hassle of handling insurance claims and making payoffs to clients. If so, you can pass the risk on to a bigger company, just as your clients passed the risk to you. You could take the bundle of 10,000 insurance contracts and sell them to another firm for, say, $100,000. You make less money than you’d get if you handled claims yourself, but you no longer have to worry about paying out claims. It’s pure profit for you. And the big firm is happy too, because it also makes money on the deal—$100,000. That is, it makes money if your risk estimate is correct. If your risk estimate is off and, say, sixty clients burn their homes down, the firm loses a lot of money on the deal ($300,000 to be precise). As for you, the extra fires don’t bother you at all! You no longer have a stake in how many clients make a claim on the insurance contracts you sold them. Regardless of what happens to their homes, you still make a profit of $100,000. Even if there’s an epidemic of house fires, you can laugh all the way to the bank; you sold a firm bad risk for a nice little profit.
You can probably see where this is going. The moment you sold your insurance contracts to another firm, you stopped caring whether those contracts were risky or not. Your income depends only on the number of clients you sign up, not on whether or not they burn down their houses and make claims. You no longer have any incentive to maintain a safe risk pool; just the opposite, in fact. If you sell only to nonsmokers, you have fewer clients to choose from, and fewer contracts to sell to the big insurance firm. Instead, you should sell to smokers as well as nonsmokers, the better to drive the number of contracts up. You’ll make more money that way. Heck, you can make a profit by selling insurance to fire-eaters, people who try to deep-fry turkeys every Thanksgiving, and serial arsonists. So long as you dump the contracts to an unsuspecting firm before your clients immolate their houses,