Everyone has a basic idea of what insurance is. Your parents might have taken out a life insurance policy, or perhaps a health insurance. They would pay the insurance company a small amount every month, in return for protection against accidents or illnesses. Sounds like a good deal, right?
But how could it be a good deal for the insurance company? In case of an unfortunate event, they’d have to pay you back a large amount that’s way more than the sum of your small monthly payments. And if your policy expires peacefully, they’d still have to pay you a maturity amount. Why, then, would they even run such a business where all they do is dole out their money?
The fundamental idea behind insurance is something called risk pooling. It’s been around for a long time, maybe because it’s so simple and elegant: what is a risk for one person is not really a risk for society at large. Mathematically stated, the Law of Large Numbers tells us we can fairly accurately predict the number of losses out of a large population. Thus the insurance company pools all its customers’ risks together so that it’s no longer a risk. (Interestingly, it’s also how casinos work!)
The earliest known insurance policies and risk pools date back to some 5,000 years ago, when merchants sought to protect themselves against the loss of their cargo at sea. To an individual merchant, the loss of a ship would be devastating. But by pooling their resources, a group of merchants could spread the risk among their numbers, so that each had to pay only a small amount to be able to receive full compensation for lost goods.
The modern insurance industry works much the same, with the addition of the process of risk evaluation. The company assesses how likely a particular customer is to claim the insurance payout, in order to calculate a suitable premium. For instance, an elderly man who smokes is more likely to fall seriously ill than a young woman, and hence he would be charged a higher premium. The combination of this risk evaluation with risk diversification (spreading risk by pooling) is the foundation of insurance.
Unfortunately, it’s not so easy to make this work in practice, largely because of moral hazard and selection bias. Moral hazard is when the security of being insured leads people to take more risks. For instance, if your house is insured against fire you might be careless with fire, pushing the risk higher. Or worse, you might decide the payout is worth more than the house and set fire to it yourself.
Selection bias, or adverse selection, is when an insurance policy naturally attracts people who are most likely to need it. For instance, health insurance tends to attract sick people or people who think they’re going to fall sick. If the risk pool is composed of a lot of sick people, then the premium will be high, which in turn further discourages healthy people from signing up. One possible solution is to make it mandatory for every citizen to take out health insurance.
Despite its fair share of problems, the insurance industry is built on a simple and strong foundation and has flourished for thousands of years, and will continue to do so.