We spend over $4.5 trillion U.S. a year on insurance premiums, which works out to over 6% of worldwide GDP, so the insurance business is a huge one indeed. With all this money spent though, people do give insurance quite a bit of thought, but perhaps not as much as they should.
It certainly can be helpful to have at least a good idea of the basics of insurance, beyond just thinking about looking to protect oneself from future risks. That’s certainly the main goal of it, but we really need to understand the value here in certain cases anyway to decide whether we should insure, and if so, how much insurance we should buy.
Insurance companies will sell you insurance for just about anything, save for some pretty bizarre requests such as Stanley Kubrik looking for insurance against space aliens being discovered before the release of his film 2001: A Space Odyssey, which he was unable to get.
The problem with this request is that it was impossible to ascertain what the risk really was that they would be taking, but generally even some off the wall requests such as insuring the legs of celebrities are successfully appraised and underwritten.
So that’s what insurance companies do, they calculate the risk that they are taking and they price the premiums such that it becomes probable that they make a profit from the deal. So people who do business with them are paying a premium for this coverage, and premium means more than just the cost of the policy, it means a premium over the actual expected value, much like taking out a loan involves a premium over the cost of what is bought from the proceeds of the loan.
Insurance Is Actually A Lot Like A Loan
If you’re going to pay a premium, you should make sure that paying this premium is worth it, whether that be economically, psychologically, or generally a combination of both benefits.
This is the case with loans as well, as you pay more to get it now than to just save up your money and get it later, and in many cases people don’t give this enough thought actually, and act too capriciously.
With some purchases, there is enough utility involved in getting it now to make the extra expense well worthwhile in many cases, for instance with borrowing to buy a home. You get to live in the home all this extra time, and you also get to build wealth as it increases in value. You also may not even be able to ever save up for it otherwise as you’d generally have to pay rent, which is the money that you’d need to save up for the house, so you’d very often never get there.
With insurance, there are certain times that you are required to hold it, if you’re buying something like a house or a car and the lender requires it for instance or you don’t get the loan. So in the case of the mortgage that it may make sense to get, no one is going to give you one unless you insure the place, as they don’t want to be holding the bag in case it is destroyed by fire or some other event.
People may also want to buy mortgage insurance in case one of the joint mortgage holders passes away, where the survivor may be unable to make the payments, or if one of them becomes disabled or has another event which may reduce their ability to service the mortgage.
Just like not being able to save up to buy the place, one is not really able to save up enough to cover losses to it should it become destroyed or significantly damaged, so a premium is paid to an insurance company to cover them for what they cannot afford at the present time.
So in both cases, the interest on borrowing, and the insurance premiums for coverage, serve to make up for a present lack of liquidity, and if one had sufficient funds, they could both buy the place and cover potential losses it with their own money, although they still may not want to for another reason.
The Psychological Benefits of Insurance Coverage
Insurance companies focus a lot on what they call the peace of mind that their insurance coverage provides, and this is certainly something that appeals to a lot of people to some degree, some more than others.
If you’re faced with the possibility of an outcome that would place you under hardship, and the probability of that event is one that is likely enough so that you take it seriously, then not having to worry about that certainly would be something desirable in itself, apart from the monetary considerations involved.
People don’t generally worry about things like being kidnapped by aliens, even if they believe this might happen to some people, so getting insurance against this is not really going to make sense, even if you could buy it. However, some people are exposed to kidnapping risk and they or the companies they work for do purchase kidnapping insurance, and this does give them more peace of mind at least, and may also benefit them should this ever happen.
Stress plays a big enough role in people’s lives, there’s enough to worry about anyway generally, without having to worry about certain events that can be protected against by buying an insurance policy. This also includes things like one’s own death, and a lot of people feel more secure in their lives in knowing that their family will receive financial benefits when they pass, which generally allows them to enjoy their lives more.
Insurance is also a convenient way to manage things, where for a sum of money some defined benefits can be realized, instead of relying on more uncertain and variable factors such as one’s investing successfully enough to achieve the same goal, for instance providing for their loved ones when they are gone.
There’s also the possibility of avoiding the pain of regret should you not insure and the event occurs, and even if the decision may have been a sound one at the time, like for instance not taking advantage of some extra warranty on a purchase, which generally aren’t that great of a deal, when these things happen, people naturally kick themselves. So people may want to avoid that and this would be another potential psychological benefit of insurance.
The Economics of Insurance Coverage
Insurance policies always involve a negative expected value, even though this may be desirable, for various reasons. If this weren’t the case, insurance companies wouldn’t offer the coverage, as their goal is to make a profit of course.
This is similar to casinos offering games which have a positive expected return for them, which means a negative expected return for the player, but people spend billions a year at casinos for the entertainment value and the chance to make a profit, even though the odds are against it.
With insurance, people do buy it for the chance to profit from it, although in this case it’s a profit that they are hoping not to have to collect, generally speaking anyway. Some people do benefit economically from insurance coverage the same way as some do profit from casino gambling, from bad luck in the case of insurance as opposed to good luck with gambling.
The economic principle that stands out the most with insurance though is the one that tells us that the less money you have, the more it is worth dollar for dollar. This is the concept of diminishing marginal utility, and for instance there’s a certain amount of money you need to just stay alive, and that’s much more critical than if you have a lot of money and you’re just looking to blow some of it for kicks.
So the $50 or whatever that you spend to take your family to the movies rather than just watching one at home isn’t going to be as valuable as the $50 you spend buying food to keep your family from starving. The money you spend to go on a vacation isn’t going to be anywhere near as important as the money spent keeping a roof over your heads and not having to live in your car or the homeless shelter or on the street.
So this is the biggest thing that makes buying insurance economically wise, because this may and often will mean that for every dollar that you spend on coverage now has the potential for greater and perhaps much greater marginal utility in the future.
So if we take this into account in our calculation, we can see that both the insurer and the insured can win in this game, with the insurer reaping the profit from the pure economic calculation of expected value, and the insurer also getting higher expected value out of the proposition, in this case involving greater marginal expected value.
This is often the case, but not always, and it really comes down to just how needed the payout is should a claim be made. Perhaps you won’t be too put out by your toaster dying a little after the normal warranty expires for instance, so that might not be worth it to you, not affecting your life in any meaningful way, but there are going to be some other things of greater or much greater significance that you may not want to have to deal with without protection.
So insurance allows people to have things like stability and security in their lives, usually at a modest cost which provides both potential economic and psychological benefits. Sometimes it’s just your good credit that you’re protecting, but people do value that and are willing to pay a premium to protect this and things much more important as well.
Insurance is often a good deal, and it’s important to both understand the types of coverages you can get, whether you need a certain type or not, and all of the options available if you are going to navigate the world of insurance and successfully protect yourself.