Basics of Insurance

The purpose of insurance is to transfer to an insurer the policyholder's risk of suffering a monetary loss should an unpredictable event happen. For example, fire insurance protects you from a large monetary loss should your house burn down. Insurance companies are able to provide such a service by correctly estimating the chances of such an accident happening and charging each customer an amount that is equal to the expected loss from an accident.

The expected loss is equal to the probability that a loss will occur times the cost of the loss. For example, if there is a 1 percent chance that your house will burn down during the year, and it will cost $100,000 if it does burn down, then the expected loss is equal to 1 percent of $100,000, or $1,000 per year. Most people are risk-averse and therefore will purchase insurance even if the premium is a little more than the expected loss, rather than self-insure or take on the risk themselves. This is generally the case because individuals cannot easily spread the risk of the loss on their own. While the chance of your house burning down is small, if it does you may not be able to replace it, so you buy insurance.

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Insurance companies earn a profit by spreading the risk and charging a little more than the expected loss. If an insurer has 1 million customers, then it can expect that a large number of houses will burn down, but if it has calculated the risk correctly, then it can expect to have enough money from premiums to make the payments.

Insurers may charge premiums that are less than the expected loss if they can invest the premiums and the losses occur much later. Insurance companies primarily invest in fixed-income securities, which have a return that is generally less than the equity market, but carry much less risk. (Bonds still involve risk, including the solvency of the borrower and price volatility if the bond cannot be held to maturity due to cash flow problems.) Because the rate of return on investment is not risk-free, it is important that companies correctly estimate the probability and cost of an accident.

For an insurance company to cover its costs, and thus provide insurance in the first place, it must use whatever information it has available to help it better calculate expected losses from accidents-not only for its entire customer base, but also for smaller groups within its customer base that have different expected losses. For example, suppose that we know that people who have accumulated speeding tickets are more likely than drivers who have not received a ticket to have an accident. Successful insurance companies will use this information when setting premiums that are sufficient to cover their expected costs.

Conversely, were government policies to preclude auto insurers from using this information, then the insurers will take on more risk than they would otherwise have to, and would have to charge higher premiums for everybody. Such policies make it more expensive to provide insurance, and thus lead to higher premiums and encourage those who have low income, low expected losses, or both, to avoid purchasing insurance.

Another way to raise insurance premiums is to require insurance companies to offer only policies that provide high amounts of coverage. For example, if insurers could only sell fire insurance policies that had no deductible, they would have to charge much higher premiums in order to stay in business, since the loss to be covered would be greater than if the individual policy holders had the option of paying a deductible.

An important consideration to keep in mind when discussing insurance is the problem known as moral hazard. This is the problem that arises when a person is insured against a specific risk and the security provided by that insurance discourages him or her from taking optimal precautions against incurring an accident. For instance, if you have car insurance, then you may be less likely to drive as carefully as you would if you did not have insurance. (In the automobile insurance market this is likely mitigated by the fact that a car accident may cause physical damage or bodily injury that the driver may wish to avoid even if he was compensated for the financial cost of the accident.)

There is a related problem to moral hazard, which studies have found to have a significant effect on insurance premiums — third party payment. This problem particularly besets medical insurance. When an individual suffers an injury and the insurance company must pay all — or nearly all — medical costs, both the injured party and those who are delivering treatment will have every incentive to choose very expensive treatments even if the added value of those treatments is small. We have all seen the advertisement for the motorized wheel chair that we are told is "free" to individuals covered by Medicare. With a price of zero, people who have no idea what the cost of these wheelchairs actually is will be more likely to demand them.

This encourages the use of very expensive treatments and makes it difficult for insurance companies to figure out the expected loss from an accident because the insurer's liability is not limited. As noted above, the insurer must correctly estimate the probability and cost of an accident in order to set a premium that allows it to stay in business. If the insurer does not know what the liability will be then it will not be able to set premiums with any degree of accuracy, and in order to protect itself from bankruptcy will set premiums higher than if the liability were limited.