Insurance is an economic service based on the pooling of the risk encountered by individuals and spreading this risk over a larger group of people. This risk pooling effectively takes the risk facing individuals and transfers it to the larger group. Each member of the group pays a relatively small insurance premium, resulting in a guaranteed loss of income, but in so doing the risk of incurring a larger loss is avoided.
The demand side of this service is primarily populated by those who are risk averse, who prefer certain income to risky income. The risk averse are willing to pay to avoid a risky situation, a payment that is needed by insurance providers to provide insurance.
On the supply side of insurance is both private and public providers. For-profit, private companies provide auto, health, life, and property insurance. A number of public, government agencies also provide insurance services, including Medicare, Medicaid, Social Security, and the Federal Deposit Insurance Corporation. In fact, a great deal of what government does is to provide "last-resort" insurance.
Legal Claim ExchangeInsurance is a financial service that exchanges legal claims. Legal claims represent ownership of goods, services, resources, or other real assets. For insurance, the legal claim is the promise of future payment should a loss of goods, services, resources, or other real assets occur. In the insurance market, a provider receives payment from the customer and the customer receives a legal claim of future payment from the insurance provider.
The provision of insurance is one part of the broader financial, or paper, side of the economy that deals in the exchange of legal claims. Other financial markets include stock markets, credit markets, and banking. Stock markets trade stocks, legal claims on the ownership of corporations. Credit markets exchange loans, legal claims of future repayment from businesses and governments. And banking deals in bank accounts, legal claims by banks with the promise to return money to customers.
A key to financial markets, insurance included, is trust that the legal claims will be honored, that the promise of future payment will in fact be fulfilled. This doesn't always happen. A stock might be worthless when the company shuts down. A borrower might default on loan repayment. A bank might close down without returning customer deposits. And an insurance provider might not pay off an insurance claim for a storm damaged house.
Of course, if legal claims are not honored, then the system breaks down. Buyers won't buy if they have no expectations of receiving future payments.
Risk Averse BuyersThe buying side of the market for insurance is primarily occupied by those who are risk averse. People have three alternative views of risk -- risk aversion, risk neutrality, and risk loving. While most people are risk averse most of the time, others are risk neutral or risk loving. The risk averse prefer certain income over risky income and, most important to insurance, are willing to pay to avoid risk. In contrast, risk loving prefer risky income over certain income and risk neutral are indifferent between the two.
Risk averse people are most inclined to purchase insurance. Because they prefer certain income over risky income, because they are willing to pay to avoid risk, they are prime candidates for insurance. They pay a small premium, which gives them a lesser amount of guaranteed, certain income, but in so doing they do not face the risk of a larger loss of income.
Actually, all three risk preferences are willing to buy insurance... if the price is right. Suppose, for example, the risk of encountering an illness that incurs $10,000 worth of health care expenses is 1%. That is, 1 person out of 100 incurs this expense. For a given person, the expected cost of this expense is $100. If a person lives 100 lifetimes, one of those will incur the $10,000 expense, which works out to an average expense of $100 over those 100 lifetimes.
A risk neutral person is indifferent between paying $100 for insurance or risking the 1% chance of incurring a $10,000 expense. A risk loving person would be willing to pay somewhat less than $100 to avoid the expense. And a risk averse person would be willing to pay more than $100. How much more or how much less a person is willing to pay depends on the degree of risk aversion or risk loving. A moderately risk averse person might be willing to pay $101, an extremely risk averse person might be willing to pay $150, and a risk loving person might be willing to pay only $90.
Risk Pooling SellersOn the supply side, the provision of insurance is undertaken by those who pool risk. Risk pooling is the process of combining the risks facing individuals into larger groups. This process can be used effectively to transfer individual risks to the entire group. While the risk of loss facing one person is likely unknown, the risk for the larger group can be calculated with a great deal of certainty.
For example, the single flip of a single coin could come up heads or tails. Which one occurs on that flip is unknown and unknowable. It could go either way. However, flipping 10,000 coins is virtually guaranteed to produce 5,000 heads and 5,000 tails.
Risk pooling allows an insurance provider to calculate, with near certainty, the total losses incurred by a group. This total loss can then be pooled and divided among members of the group.
Once again, suppose that the risk of encountering an illness that will incur $10,000 worth of health care expenses is 1%. That is, in a group of 100,000 people this $10,000 illness expense will fall on 1,000 people, 1% of the total. An insurance provider can insure this group of 100,000 against individual expenses through risk pooling, by spreading the expense over the entire group.
Here's how. If 1,000 people incur an expense of $10,000 each, the total expense is $10 million. Dividing this total $10 million expense over the 100,000 people works out to $100 per person. If the insurance provider collects $100 per person, then it can cover the $10 million total expense incurred by the group.
An AgreementThe minimum amount that the insurance company needs to collect from each one of the 100,000 people is $100. This amount just covers the total expense of the illness. However, the insurance provider, whether for-profit private or not-for-profit public, incurs additional expenses in the administration of the insurance services, the opportunity cost of using scarce resources. The provider thus needs to add a few dollars to this $100 per person price to cover these additional expenses, say an extra $10.
This extra is what separates risk averse from risk neutral and risk loving. Risk neutral and risk loving people are willing to pay less than or equal to the average or expected value of the expense. They are willing to pay up to, but no more than, $100. Risk averse people, in contrast, are willing to pay more than $100. This extra payment enables the insurance provider to cover the additional resource expense. As such, risk averse are those most likely to purchase insurance.
However, risk neutral and risk loving would be inclined to purchase insurance if they have different perceptions of the risk. If they think the risk of illness is 2% rather than 1%, then they would be willing to pay up to $200 rather than $100. Of course, insurance providers are not included to discourage this misperception.
Problems Along the WayThe voluntary provision and purchase of insurance encounters a few flaws that can limit efficiency and effectiveness.
The problem with voluntary insurance is that providers want to cover only those with lowest risk. But only those with the highest risk are inclined to buy. Both of these self-interest motivations can be countered with mandatory insurance. Everyone pays into the pool and everyone is covered.
- First: As noted, risk neutral and risk loving are not inclined to voluntarily purchase insurance if they have accurate information about risk. This limits the size of the pool of people who share the risk.
- Second: If the risk that specific individuals face can be accurately determined, then risk pooling doesn't happen. From the previous example, suppose that each of the 1,000 people who will incur the $10,000 expense can be accurately identified by both insurance providers and members of the 100,000 person group. That is, 1,000 people have a 100% chance of incurring the expense and 99,000 have a 0% chance. If so, the insurance provider will want to charge these 1,000 people the full cost of this expense. And the other 99,000 will have no reason to pay for insurance that is known with absolute certainty will not be needed. As a result, there is no risk pooling and no insurance.
- Third: On the buying side the problem of moral hazard can also prevent the efficient provision of insurance. Moral hazard is a situation in which one person undertakes an action that is detrimental to another person after the two people have entered into an agreement. A insured person, for example, is motivated to take more risks because the insurance provider incurs the cost. Knowing that the expense of $10,000 illness is transferred to the insurance provider and the larger group, a given individual might not take actions needed to prevent the illness and expense.
Some insurance is mandatory. States require that every automobile driver is covered with insurance. Most companies require that all employees are covered by health insurance. Of course, making insurance mandatory requires government involvement. Not only does government regulate insurance provision, it often undertakes the provision directly.
Private and PublicInsurance is provided not just by for-profit, private companies, but also by government, or public, agencies. The private providers offer "standard" insurance services to consumers and businesses, including health, automobile, life, and property.
The public providers include assorted government agencies that administer programs such as Medicare, Medicaid, Social Security, and bank deposit insurance. However, much of what governments do actually can be thought of as insurance.
Much like insurance companies collect premiums with the promise of compensating customers for losses, governments collect taxes with the promise of addressing problems encountered by citizens. In the same way that some insurance customers receive more benefits than their premiums and others receive less, some citizens receive government benefits that exceed taxes and others receive less.
INSURANCE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2020. [Accessed: April 2, 2020].