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Inside the Insurance Industry – Risk

One of the fundamental concepts of the insurance market is the concept of risk. A risk is any situation which involves exposure to a potentially negative consequence. We are all exposed to a wide variety of catastrophic risks such as house fires or severe automobile accidents. The probability that any one individual will experience one of these severe negative consequences is low; however, because of the large number of people exposed to these risks, the probability that at least one person will experience one of these severe negative consequences is high.

Risk Pooling

Individuals can implement numerous different risk management strategies to combat the issue of risk. Because people are generally risk averse (discussed below), one of the most common risk management strategies are risk pooling. Risk pooling is a strategy that allows a large group of people to all bear a small percentage of the cost of a negative consequence that happens to any member of the group. By agreeing to bear a portion of the cost, all participating members protect themselves from bearing the full cost in the event that the negative consequence happens to them.

This is the basic principle behind insurance. For example, consider the risk of a house fire and the risk pooling offered by home owners insurance. In 2012 there were approximately 365 thousand house fires resulting in $5.7 billion of damage. If each of the 365 thousand homeowners whose houses were involved in a house fire had to pay for his damages individually, the average coast would be just over $15 thousand per incidence. However, if all homeowners grouped together to bear the cost of damages, the impact for each homeowner would be much smaller. There are approximately 125 million homes in the U.S. The cost of $5.7 billion split evenly between all of these homeowners would be $45.60. This is the advantage of spreading risk over a large consumer base.

Risk Aversion

A key characteristic that helps risk pooling, and thus insurance markets, function is risk aversion. Risk aversion is a concept used in behavioral economics to describe people’s preference for certainty. In general, when people are faced with the choice between two outcomes—one with a high degree of certainty and low cost and the other a low degree of certainty but high cost—they place greater value on the certainty of the outcome than on the expected cost of their decision. People will often choose the outcome with a high certainty even if this outcome has higher expected costs. The greater the individual’s risk aversion, the more cost they are willing to take on in exchange for greater certainty.

Using the example mentioned above, homeowners are faced with the option of purchasing insurance or opting out. If they purchase insurance they have a 100 percent chance of paying $45.60. If they opt out of insurance they have a 0.3 percent chance (found by dividing the number of homes that were involved in a house fire by the total number of homes, 365,000/125,000,000) of paying $15 thousand. The expected costs are similar in either equation. (The expected cost is calculated by multiplying the probability of the outcome occurring by the cost of the outcome. $45.60 * 100% = $45.60. $15,000 * .3% = $45.00.) Given the choice between these two options, risk aversion leads people to purchase insurance because it is the more certain outcome. But the risk aversion principle suggests that people would be willing to pay even more than $45.60 in exchange for the certainty that insurance provides. How much more an individual would be willing to pay depends on how risk averse that individual is.

Insurance companies have overhead costs of administering policies. In order to pay for these overhead costs and still have enough money to pay for claims, insurance companies must charge premiums that are higher than the expected costs of claims. Because of risk aversion, insurance companies can charge these higher rates and people are still willing to purchase insurance.

When Risk Isn’t Enough

While risk is a sufficient motivating factor for many people to purchase insurance, some people still opt out of insurance markets for a variety of reasons. In some cases, non-participation in insurance markets isn’t an issue because the cost of not purchasing insurance falls primarily on the individual who opts out. But in other cases, such as vehicle and health insurance, society ultimately ends up bearing at least a portion, if not the majority, of the cost of non-insured. In these cases, legal structures can provide incentives for uninsured to purchase insurance. The individual responsibility payment under the Affordable Care Act is an example of this type of incentive restructuring.



National Association of Insurance Commissioners

National Fire Protection Association

Kaiser Health News

Psychological Science

United States Census Bureau

World Health Organization


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