How Can Insurance be Good for Both Sides?
Happy Canada Day! This is a special Canada Day version of the usual Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.
Insurance is a financial matter and doesn’t actually do anything to prevent accidents. So, if insurance is just about trading money back and forth, how can it be a good deal for both the insurance company and the person buying the insurance?
When it comes to buying goods like food, it is easy to see why an apple is more valuable to a person buying one than it is to the farmer who owns an orchard full of apples. I’m quite happy to part with 50 cents for an apple when I’m hungry, and farmers are willing to take less than 50 cents for each of their apples. So, in this case, it is possible for both sides to win. When it comes to insurance, it isn’t as obvious that both sides can benefit.
To keep things simple, imagine that a car insurance company has worked out that they will have to pay out an average of $600 per driver in claims for car accidents next year. If they charge each driver $1000 for the insurance, then they will make a $400 profit on each driver minus administrative costs. But, doesn’t this mean that each driver is making a bad deal and is wasting $400? Not exactly.
If we knew that each driver would claim exactly $600 for accidents during the year, then it would be a bad deal for the drivers. But, the majority of drivers will make no claims, and a small number will make large claims. If two cars are totalled, the claim could be $50,000 or more, and if people are injured, the claim could be $1,000,000 or more. Losses like this for the average person can be devastating financially. It is worth paying a little extra to avoid a small chance of losing everything you have.
This type of reasoning takes the “utility of money” into account. I’ll have more to say about the utility of money on Sunday.
Insurance is a financial matter and doesn’t actually do anything to prevent accidents. So, if insurance is just about trading money back and forth, how can it be a good deal for both the insurance company and the person buying the insurance?
When it comes to buying goods like food, it is easy to see why an apple is more valuable to a person buying one than it is to the farmer who owns an orchard full of apples. I’m quite happy to part with 50 cents for an apple when I’m hungry, and farmers are willing to take less than 50 cents for each of their apples. So, in this case, it is possible for both sides to win. When it comes to insurance, it isn’t as obvious that both sides can benefit.
To keep things simple, imagine that a car insurance company has worked out that they will have to pay out an average of $600 per driver in claims for car accidents next year. If they charge each driver $1000 for the insurance, then they will make a $400 profit on each driver minus administrative costs. But, doesn’t this mean that each driver is making a bad deal and is wasting $400? Not exactly.
If we knew that each driver would claim exactly $600 for accidents during the year, then it would be a bad deal for the drivers. But, the majority of drivers will make no claims, and a small number will make large claims. If two cars are totalled, the claim could be $50,000 or more, and if people are injured, the claim could be $1,000,000 or more. Losses like this for the average person can be devastating financially. It is worth paying a little extra to avoid a small chance of losing everything you have.
This type of reasoning takes the “utility of money” into account. I’ll have more to say about the utility of money on Sunday.
This is topical for me, since I was recently wondering if the super-rich would bother insuring their homes against fire, floods, and theft. I guess if the monetary value of your home and possessions is insignificant to the cash you have in the bank, you might be inclined to self-insure.
ReplyDeleteGene: I agree that it makes sense for the very wealthy to self-insure. I assume that you were thinking about this because you are very wealthy :-)
ReplyDeletelol... I've got my health!
ReplyDelete