Insuring a risk

If you face a risk with possible losses ranging from $0 to $10,000 and an expected loss of $500, will you pay $700 to insure the risk?

The answer should be "yes". Although the expected loss is $500, the actual loss can be as high as $10,000.

The difference of $200 (about 30% of $700) represents the cost of providing the insurance protection. It goes to cover the marketing, underwriting and claim processing cost of the insurance company. An expense margin of 30% is fair, in the case of an insurance contract that provide indemnity for losses. For a competitively priced insurance, the ratio of losses to premiums should be around 70%.

In the case of a life insurance contract that accumulate savings for the future, the expense ratio should be much lower, say from 5% to 10%.