The Risky Business Of INSURANCE
We've avoided the clutches of Smilin' Ted, the insurance guy, during our saunter through economy, but our luck has run out. Here he comes, ready to offer you, me, and everyone else within earshot the chance to buy auto, health, life, and property insurance. If you really, REALLY care to ask, I'm sure that Smilin' Ted has other insurance possibilities as well. But, I'm not going to ask. If YOU want to know, then YOU have to ask.
A World Filled with Scaredy Cats
Avoiding Smilin' Ted's sales pitch is one thing, avoiding insurance is something else. We're all likely to buy some insurance during our pedestrian trek through life. Maybe we won't buy it from Smilin' Ted, but we're likely to buy from someone, somewhere, at sometime. Why? Because it fulfills an important need -- to lessen our innermost fears of risk and an uncertain future.
As we saw in Fact 6, Our Unknown Economy, most of us tend to be scaredy cats (or risk averse). We tend to prefer a safe, known, and sure income more than an equal amount of income that involves some degree of risk. Another way of looking at this is that we would be just as happy with a lesser amount of known income than a greater amount of risky income, and we're willing to give up part of our hard-earned income to avoid this uncertainty.
That's exactly what insurance does. We pay premiums to an insurance company, thus leaving us less income to spend on other stuff, but avoiding the adverse financial consequences of illness, accident, fire, theft, or natural catastrophe.
Let's say that you have a 5 percent chance of contracting an illness that would send you to the hospital for a few days and run up a $10,000 bill. The expected cost of this event is $500, or 5 percent of $10,000. In other words, if you live 100 different lifetimes, you have the illness leading to a $10,000 hospital bill in 5 of those lifetimes. The average is then $500.
If you're an in-betweener (risk neutral), you would be just as happy living an uninsured life and risking the $10,000 hospital bill or paying $500 to an insurance company that agreed to pay you bill in the event of an illness. A gambling, risk lover sort of person would be willing to pay something less than $500 for the insurance. If you're risk averse, like many people, then you would be willing to pay more than $500 to avoid the risk. How much more you would be willing to pay depends on your degree of risk aversion. If the price is right, all of us, scaredy cats, gamblers, and in-betweeners, would pay to avoid risk.
Insurance Agents to the Rescue
We buy, but who sells? Fortunately insurance agents in every mini-mall in every city, town, and community across the nation are willing to sell us insurance. But why are they willing to sell? What do they get out of this deal anyway?
One thing they get is access to large sums of money. Insurance companies, like banks and stock brokers, participate in our economy's financial markets. They accumulate premiums from their clients that they invest in assorted capital, or loan out to others, until such time as they need to pay the claims.
But this is not THE reason for the seemingly omnipresent likes of insurance-guys like Smilin' Ted. Insurance itself is a valuable service that insurance companies are happy to provide, given suitable compensation. They provide this service through the magic of risk pooling.Risk pooling occurs when individuals are lumped into large groups, such that the uncertainty for one becomes a calculated risk for the whole group. For example, let's reconsider your 5 percent chance of hospitalization. In fact, let's throw you into a group of 100,000 people, all with the same 5 percent chance of contracting this horrendous $10,000 illness.
We can expect that 5,000 people or 5 percent of 100,000 will get sick. We don't know which 5,000 people, but we're pretty sure that the number will be 5,000. How can we be so darn certain that 5,000 people will get sick? Insurance companies spend a lot of their time keeping records on gadzillions of people to determine what percentage experiences different losses, like our $10,000 illness. (Of course, any miscalculation on their part could be a multi-gadzillion dollar error.)
If 5,000 people do, in fact, contract this $10,000 illness, the total hospital expense is $50 million. Would Smilin' Ted be willing to insure this group of 100,000 people against this debilitating illness? Yes, if the price is right.
By charging each of the 100,000 people $500, Smilin' Ted would generate the $50 million needed to pay the hospital expense. This is, however, the absolute minimum charge. Smilin' Ted would need to tack on a little extra, say $50 per person, for administrative expenses and the profit that makes it worth his while.
Insurance for Everyone?
A few paragraphs back I noted that scaredy cats, gamblers, and in-betweeners would all be willing to buy insurance -- if the price is right! The question is whether Smilin' Ted's $550 charge is the right price for everyone?
Risk lovers aren't viable candidates because they're willing to pay something less than $500 for insurance against a 5 percent chance of loss. They enjoy risky situations and trying to beat the odds. The risk neutral types, who are willing to pay exactly $500 for Smilin' Ted's insurance, also fall short of the $550 insurance premium. That leaves us with the risk averse -- the scaredy cats. They are the only ones who are willing to pay more than $500 for insurance protection against a 5 percent chance of losing $10,000. They are the ones who benefit from insurance and are the ones who buy. Because most of us tend to be risk averse, Smilin' Ted has a large group of potential customers.
Subsidies for the Unlucky
Perhaps you've noticed a feature of Smilin' Ted's insurance coverage -- 95 percent of our group (95,000) pay their $550 premiums, but get no benefits. More importantly, these 95,000 healthy people are the ones who ultimately pay the hospital bills of the 5,000 sickly ones. The insurance company is really just a go-between. Feel free to point this out the next time those you know who smoke heavily, drink a lot, drive fast, eat fatty foods, ride motorcycles without helmets, or hang glide tell you it's their life to live as they please. When they crash and burn, the rest of us foot the bill.
Why then would those 95,000 who don't get sick be willing to subsidize those 5,000 who do? The answer, of course, lies with uncertainty. As far as we know, any of our 100,000 could get sick. It might be you. It might be me. We just don't know who it will be. This is the essence of insurance -- protection against uncertainty. In fact, you might want to think of an insurance premium as the price you pay for being lucky.
But, is everyone equally lucky, with an equal chance of getting ill, being in a car wreck, or having their house burn to the ground?
Some Make Their Own Luck
Risk can be divided into a part that's purely random -- it could happen to anyone at anytime -- and part that is controllable. Anyone could have a heart attack, but overweight smokers have a higher risk. Anyone could get into a car wreck, but drunk drivers stand a better chance.
- Given a preference, insurance companies would only insure healthy, excellent drivers, who don't drink or smoke, exercise regularly, eat well-balanced meals, and have weekly home safety inspections. In short, they would insure only people with a low risk of suffering a loss and filing an insurance claim.
- However, if consumers are given a choice, the healthy, excellent drivers, who don't drink or smoke, exercise regularly, eat well-balanced meals, and have weekly home safety inspections wouldn't buy any insurance at the going rate if they knew their minuscule risk of loss. The only ones who would buy are those most likely to suffer a loss.
We're getting into a real sticky problem here. If insurance companies are left to their own devices, they will cover only low-risk people. If people are given a choice, however, only those with a high risk will willing pay the premiums.
That's one reason why many types of insurance are mandatory. In most states, car insurance is mandatory. Many businesses require all employees to participate in company health care insurance. And when you think about it, we're all covered by several sorts of mandatory government insurance programs like welfare, unemployment compensation, and social security. The working folk in the country pay into these systems, in part, just in case they're needed in the future. In fact, a lot of what the government does is sort of insurance. We pay our taxes, often begrudgingly, just in case we need government to "fix" some unexpected problem that arises.Let's throw this valuable insurance knowledge into three tips:
Insurance Tips for the Healthy, Wealthy, and Wise
- For nonmandatory insurance, like life insurance or dental plans, try to evaluate your own personal risk. Are you a prudent driver who lives a healthy lifestyle? Then you might not need a lot of insurance.
- With this in mind, be wary of slick-talking insurance agents. Remember, insurance companies make the most profit by selling insurance to people who need it least. The more they try to sell, the less you probably need.
- If you must have insurance, large group plans tend to be best, because administrative expenses and claims are spread out over more people. It's probably not a real good idea to join a group health care plan with only two other people if one has cancer and the other has a chronic heart condition.