Tuesday, November 27, 2007

How Can Insurance be Good for Both Sides?

In my last post, I discussed how insurance is a financial matter and doesn’t do anything to prevent accidents. So, if insurance is just about trading money back and forth, how can it be a good deal for both the insurance company and the person buying the insurance?

When it comes to buying goods like food, it is easy to see why an apple is more valuable to a person buying one than it is to the farmer who owns an orchard full of apples. I’m quite happy to part with 50 cents for an apple when I’m hungry, and farmers are willing to take less than 50 cents for each of their apples. So, in this case, it is possible for both sides to win. When it comes to insurance, it isn’t as obvious that both sides can benefit.

To keep things simple, imagine that a car insurance company has worked out that they will have to pay out an average of $600 per driver in claims for car accidents next year. If they charge each driver $1000 for the insurance, then they will make a $400 profit on each driver minus administrative costs. But, doesn’t this mean that each driver is making a bad deal and is wasting $400? Not exactly.

If we knew that each driver would claim exactly $600 for accidents during the year, then it would be a bad deal for the drivers. But, the majority of drivers will make no claims, and a small number will make large claims. If two cars are totalled, the claim could be $50,000 or more, and if people are injured, the claim could be $1,000,000 or more. Losses like this for the average person can be devastating financially. It is worth paying a little extra to avoid a small chance of losing everything you have.

This type of reasoning takes the “utility of money” into account, which we’ll discuss further in the next post.


  1. The Big Cajun Man asked about car insurance riders that guarantee your rates won't go up after one at-fault accident.

    If the insurance company has done its job properly, all insurance is priced to benefit the insurance company. You have to decide if you want to pay extra to reduce risk. If the risk of higher car insurance premiums is keeping you up at night, then pay for this rider. If you could handle higher premiums without much difficulty, then this rider probably isn't a good deal for you.

    1. This comment is in reply to Big Cajun Man's comment:

      To complicate the model you have variable rates for the "quality" of the driver (i.e. Larry the Lead foot who drives a Lexus like a Lunatic pays more than, Law Abiding Al his counterpart). The real question is, is it worthwhile to subscribe to the new service of "one free accident" where if you have an accident which wasn't alcohol related and you weren't robbing a bank at the time, it will not count against your driver rating?