Insurance and Risk Management

Posted by PITHOCRATES - April 2nd, 2012

Economics 101

By collecting a Small Fee from Many Policy Holders Insurance Companies can Afford to Pay for the Large Losses of a Few

Insurance has one purpose.  To protect wealth.  People work hard accruing wealth.  Buying a house.  Cars.  College fund for the kids.  Retirement 401(k)s and IRAs.  It takes a long time to earn the money that lets us have these things.  And they take a constant stream of payments to sustain them.  And we are always at risk of losing them.  Something can interrupt that stream of payments to sustain them.  An accident or illness that prevents us from working.  Burying us in a stack of unexpected bills.  A tree could fall onto the house during a bad storm.  You could total your car while driving to work in a thick fog.  A wife could lose her husband leaving her to raise their children on her own.

These are very real risks that we must manage.  Because we need to protect our wealth.  We buy house and car insurance so we can keep or replace our houses and cars because we can’t afford to buy new ones should we lose the old ones.  We buy life insurance to provide for our families should we die.  We buy health insurance so an accident or disease doesn’t wipe out our savings, college fund and retirement investments.  Because we do do these things we can manage the risks in life.  So that something unexpected and incredibly expensive doesn’t take everything away that we worked so hard for.

Managing our risks allows us to live our lives.  To plan for the future.  A future that has a price tag.  A future that takes a lifetime of accumulating wealth to pay for.  And to protect the wealth that provides for our families and our retirements we buy insurance.  Groups of people join together and pay a small fee for an insurance policy that will protect a very large amount of wealth.  So if we have an unexpected and very expensive event in our lives our insurance will protect our wealth by paying for our losses.  By collecting a small fee from hundreds of thousands of policy holders insurance companies can afford to pay for the large losses of a few.  Allowing life to go on.  As best as it can following these  unexpected events.  So even in the worst of events families can keep their homes.  Keep their kids in their schools.  Protect their kids’ future by keeping their college fund intact.  Replace their property.  Allowing life to go on as close to what it was before the event.  All thanks to insurance.

Bad Insurance Risks have an Advantage over Insurance Companies due to Asymmetric Information and Adverse Selection

Insurance companies provide this valuable service.  But it isn’t easy.  Because insurance isn’t a science.  But statistical analysis.  And risk analysis.  Which is how they determine the cost of their insurance policies.  A critical part for the survival of insurance companies.  So they can continue to provide this valuable service.

Insurance companies are at a disadvantage because of asymmetric information.  Meaning their customers know more about how great a risk they are than the insurance company.  For example, reckless drivers don’t offer that information when someone is quoting a policy for them.  For they want a low price.  Not a high price that reckless drivers normally get charged.  This is a problem mostly with young drivers.  Older drivers have a driving record.  If it’s a safe record they get a low quote.  If the record includes many points and at-fault accidents they will get a high quote.  Young drivers, though, don’t have a driving record yet.  This is where the statistical analysis comes in.  On average young men drive more recklessly than young women.  Based on the statistical evidence.  So they charge young men higher rates than they charge young women.  Problem solved.  But this causes another problem.

Not all young women are good drivers.  But by charging young women lower rates some bad women drivers are getting a rate lower than their risk warrants.  Which means insurance companies will lose money insuring these drivers at rates below their risk level.  In fact, this will attract more high-risk drivers.  Thus increasing an insurance company’s risk exposure.  And as they pay out claims that exceed the premiums they collect they have to raise insurance rates for all women drivers.  Thus discouraging some good drivers from buying insurance because of the higher premiums.  Thus increasing the percentage of high-risk drivers.  Which forces the insurance companies to raise their premiums again to cover these higher losses.  We call this problem adverse selection.  Where pricing plans to manage risk ends up increasing risk.  One way around this is by group coverage.  Like in health insurance.  Where everyone at a company buys insurance in exchange for a lower group rate.  Including the high-risk people.  And the low-risk people.  Thus avoiding adverse selection.

Economic Growth is the Creation of Wealth and our Insurance Protects that Wealth

When is insurance not insurance?  When it is health insurance.  At least as it is today.  It still acts like insurance for the unexpected and catastrophic accident or illness.  But it is anything but insurance for most everything else.  The latest example in the media these days being birth control.  Which is neither an unexpected nor a catastrophic expense.  For there are few expenses that are more expected and more affordable than birth control.  Unlike, say, chemotherapy.  Or trauma care in the emergency room.  Both of which are unexpected.  And very, very expensive.

When insurance pays for everything for everybody it is no longer managing risk.  Insurance companies are no longer collecting a small fee from all policy holders to pay for the large losses of a few.  Instead they’re collecting a large fee from everyone to pay for the costs of everyone.  Or more precisely, they’re collecting a large fee from the employers who provide health insurance to their employees.  So the recipients of all those free health care goodies don’t see their costs.  Which is how they’ve been able to include everything but the kitchen sink in today’s health care insurance policies.  Causing the price of health insurance to soar.  Hurting families.  Businesses.  And the economy as a whole.

A healthy economy allocates scarce resources to where we use them most efficiently.  When we do we create the most goods possible from these scarce resources.  Making society as a whole better off.  By improving the standard of living for society as a whole.  But by turning health insurance into a welfare program it increases the cost of doing business.  Which puts downward pressures on wages.  Preventing real wages from keeping pace with the rise in consumer prices.  Leaving workers with less disposable income.  Which translates into weak economic growth.  And a stagnant or declining standard of living.

Economic growth is the creation of wealth.  And our insurance protects that wealth.  When we convert that insurance into welfare, though, we put our wealth at risk.  By putting greater pressures on that stream of payments to sustain our wealth.  Our future plans.  And our families.

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