Wednesday, May 9, 2012

The 80/20 Rule

In Playing with statistics (Cranky old man's blog) I wrote:

" ..... Hmmmmm! There are lies, damned lies and then there's statistics.
Highly paid statisticians and mathematicians analyse trends in the insurance market to assess what the 'Risk Rate' should be anything that is "insured".
Risk Managers look at the analysts results and apply the 80/20 rule - something that has no scientific foundation but has ruled insurance for decades. 
What is it? Well, 80% of policies are "safe" and are pure money earners. The other 20% are risky but some are higher risk than others -(in fact, 80% of the 20% are relatively low risk and the remainder 20% are outrageously high risk!) 
So what do the portfolio managers do - they average out the potential losses from that 20% of 20% and load it on to the bulk of the no risk and low risk claims so that you, the policy holder, carries "The Risk" and the insurers collect both ways! ..."
May 8, 2012 3:27 PM
Actuaries are a breed all of their own. They spend their lifetime talking to each other in mysterious and secretive cabals using an algorithmic tongue which only they understand. Their whole purpose in life is to reduce everything in the world to base numbers, thus believing that it is then all understandable.

Insurers pay actuaries big bikkies to provide them with advice on the "value" of  "things" so that they can correctly write insurance policies for a whole population of those"things" and cover any potential financial loss, or, to be able to use any financial losses - e.g. in a major disaster - to explain away to their policy holders why their premiums needed to be increase post-disaster (to recover their losses, of course, you silly thing!)

Now Risk Managers are more pragmatic! They take the actuaries advice on board and say : 

"Well! We aren't going to have ANY losses, whatsoever!" and they apply "The 80/20 Rule!" 

Let's see if I can explain this in simple terms.

Let's say an insurers Risk Manager is going to underwrite 100 brand new  Chevrolet  Compacts in 2012. The actuaries have already told him that their analysis is that  Chevrolet  owners are careful drivers, low accident risk, as they like to 'turn-over' their  Chevrolet  every two-three years on another  Chevrolet  and that  Chevrolet  dealers have a distinctive list of repeat buyers, so they saturate their 2012 Chevvie owners in 2014-2015 with all the "Why you should buy a new Chevvie" dealers info!

As a result you end up with a heap of cautious  Chevrolet  owners who take care of the vehicles.

(Mind you, that's all bull dust, 'cos I've never seen a 'safe' Chevvie driver in my life. But you get the drift,ehhh?)

Now, the Risk Manager knows he's on a good thing : two-to-three years of repeat insurance policy premiums x 100 and an 80% reduced risk of claim. So he pulls the old "80/20 Rule" out and reckons he'll take the odds that 80 of his Chevrolet  owners will never make a claim and that, at most, only 20  Chevrolet  owners will make a claim, 12 of which will be 'little dingles', 4 will be serious dingles and 4 will be "write-ofs".

His biggest problem is working out how much to 'load up' the whole 100 policy premiums over three years to ensure that all 100  Chevrolet  owners pay for the costs he incurs from the 20 who do have accidents and he is still  to make a profit on the whole 100 deal! Usually, 20% of all premiums received will cover his outgoings on the repairs to the 20 Chevrolet's that have accidents and he pockets the other 80% of revenue.

And you reckon insurers are their to help YOU?

The 80/20 rule apples to any situation where a 'risk' of 'loss' is involved and that 'loss' will result in someone having to pay - one way or another. 

Workplace injury? 

  • 80% of workers who sustain an injury will be back at work in a brief period of time after minimum treatment. 
  • 12% will lose a bit more time and have a slightly higher medical bill. 
  • 4% will sustain a serious injury (or death- hope that they die, 'cos its cheaper and less fuss!).
  • 4% will bludge on the system until the employer's insurance cover runs out - then the employee is likely to go to the civil court and sue for employer negligence. 

All of this is factored into workers compensation insurance payments so that low risk employee groups will cover the insurers loss to high risk employees and give the insurer grounds to increase the premiums to cover workers in that industry.

Same with house insurance.

About the only exception is life insurance 'cos they already know we are all going to die! The insurer just hopes that 80% of you all will default on your life insurance premiums before you 'kick the bucket'!


joeh said...

OK, I understand about 20% of that.


JohnD said...

Ahhhh! So you fall into the minority (20%) that have only a little, or, no understanding, at all! lol!

Its easy, really - you have an 80% chance of being right and an 80% chance of wearing the consequence for being right! (Ask Mrs Cranky! )

John Gray said...

I'm with joe!

JohnD said...

Ahh! 80% of your patients will survive, unharmed from their experience. 12% will have minor setbacks before they eventually recover. A further 4% to 8% will suffer serious complications which, in all probability, will be likely to kill them - if you were a betting man! lol!

Is that a "fair" estimate?

Annmarie Pipa said...

my daughter said 80% of statistics are made up..everyone believed her and she made that up!

JohnD said...

So was The 80/20 Rule - ".... Risk Managers look at the analysts results and apply the 80/20 rule - something that has no scientific foundation but has ruled insurance for decades. ..." - so, you may now tell your daughter that it works and has only a 20% chance of error! lol!