The Theory of Insurance

I think people would better understand the complicated topic of insurance if they learned a little more about it. For example, why do people get insurance? Here's a brief summary on the theory of insurance.

Insurance is there to protect against unexpected large losses. For example, homeowner's insurance protects against loss from fire, wind damage, and theft. You don't use homeowner's insurance to protect against the food in your refrigerator going bad... it's a trivial loss. And you don't use homeowner's insurance to pay for repainting your house. Though it is quite expensive, it's not an unanticipated cost. Through insurance, you replace an uncertain large loss with certain smaller losses.

How is insurance priced? There's the net premium, which covers the cost of the expected loss. For example, if you had a 0.1% chance of having a $100,000 loss tomorrow, the net premium would be $100. However, you wouldn't be able to purchase this insurance for $100, as the insurance company has its own expenses, overhead, and profit requirements. The gross premium, which is higher, accounts for that.

Despite the fact that you're paying more for insurance than the expected value of your loss, it's still an advantageous transaction for both parties. The reason for this situation is a concept called utility of wealth. Your first dollars are the most important to you, as they provide food, clothing, and shelter. Beyond that, the money purchases less and less important things. You're willing to give $120 out of the last, least important dollars in order to protect you against a loss that would take away your important first dollars. In other words, you are risk-averse. If you have a net worth of $100,000, you would not be willing to bet $100,000 on the flip of a coin, as the benefit of another $100,000 isn't as large as the penalty of losing $100,000. The person with a net worth in the billions of dollars, however, might bet that amount on a visit to the casino, on less than even odds.

If you think to the insurance you have, you might see some coverage for non-insurable events. A yearly checkup at the doctors, or semiannual teeth cleaning at the dentist, really aren't insurable events, as they're anticipated. Roughly speaking, you could pay on your own two $50 dentist bills a year and pay $100 less for your dental insurance.

That's not to say it's bad for insurance to offer these types of coverage. For one, it's a selling point for the insurance product. (Independent agents tend to drive what features get put in companies' products, by demanding these features in companies' next generation products.) Consider a product targeted to seniors; if it offers a "free" MedicAlert (a.k.a. "I've fallen, and I can't get up!") subscription, it would possibly have a competitive advantage. And benefits such as these might be expected to lower costs. Preventative care, like an annual checkup, can lead to finding diseases early, when they are easier, safer, and cheaper to treat. (Before you nod your head in agreement, note that it's also a theory on how HMOs reduce costs. Weigh that fact when you try to decide how big the impact really is.)

Update: A couple of other points I'd like to make:

First, you don't "waste your money" if you buy insurance and don't need to file a claim. That would be like betting red in roulette, and complaining that you wasted your money every time the ball landed on black or green. Your premium purchases insurance protection, which is of value in and of itself, even if subsequently ending coverage gives you no money in return.

Second, the local newspaper (like many others) has an anonymous comment column, where readers contribute brief comments. It's remarkable how many of them juxtapose their health insurance premiums and executive pay. "My premium is going up 12%, and the CEO is getting a $20 million bonus." These two items have nothing to do with each other! Health insurance premium rates are reviewed by the state, and are adjusted based on a combination of actual experience and trend.

One kind of insurance, long term care insurance, had premium levels regulated by the lifetime loss ratio (the present value of claims divided by the present value of premiums), with the ability to raise rates if the lifetime loss ratio exceeded the standard set by state regulation. You will note that overhead does not factor into that equation. A company could give each of its employees a $20 million bonus, and that would not allow the company to justify a rate increase.

And, do check the comments for a nice addition from The Probligo.