If they paid by PayPal they will automatically get a refund if you didn't send the phone by tracking, such as recorded delivery. PayPal want proof of receipt (a signature) not proof of delivery.
If the phone is lost, and you can't prove it isn't, you must refund regardless.
Postal insurance is to protect the seller, not the buyer.
It is a fact that many parcels and letters get lost in the post. As the contract is between you and the post office it is your responsibility to refund the buyer and claim from the Post Office. You can't claim from the PO in this instance as ordinary post only covers up to �32, so I am afraid you have lost out on this one.
If you were a buyer, you would give a total stranger �100 in the vague hope you got your goods. You would expect either the goods or a refund.
In a nutshell, refund.