Insurance can’t solve everything
I’m a big fan of insurance. It solves a whole lot of social problems, restoring damaged property, securing mortgages, financing medical care.
But insurance doesn’t solve all problems. Insurance 101 lists characteristics that must be present in an exposure for insurance to apply. Five are listed to the right and expanded below.
The key principle that makes insurance work: Those who don’t have a loss pay for those who do. It is slightly more complicated than that but this spreading of risk is the key concept behind insurance.
Characteristics of insurable risks
Large number of similar units
Definite, measurable losses
Limited catastrophe exposure
Economically feasible to insure
Lots of Similar Units
Insurance spreads the cost of a few losses over all who are insured. There must be many insured units that do not have losses to provide funds to pay for those who do.
Insurance uses the law of large numbers (the law of averages) to project cost of losses within any class of insureds. The accuracy of these projections improves as there are more insured units in the class.
Insurance can only cover unexpected, unintended, “accidental” events. It cannot, for obvious reasons, cover intentionally caused damage. An expression we sometimes use is “fortuitous from the standpoint of the insured.” Meaning that prior to establishing the insurance contract, neither insured nor insurer can know a loss is certain. (It is here where the problem of pre-existing conditions causes problems.)
Definite Time and Place
Insurance covers damage resulting from “events” that happen at a specific time and place.
It cannot cover wear and tear over time. The term “inherent vice” is descriptive – things wear out. Insurance can’t cover rust, deterioration due to age, normal diminishing of function.
Low Catastrophe Risk
Examples – flood, earthquake, hurricanes, crop failure. Society has addressed these exposures, in other-than-insurance solutions. The problem here is having enough insured-units (homes, cars) that aren’t damaged to pay for those that are.
A second problem is “adverse selection” – only people in flood plains buy flood, or in coastal areas hurricane coverage – so there aren’t enough who don’t have losses to pay for the many that do.
Catastrophes destroy the balance between those who suffer losses and those who do not.
This could be a summary of the other conditions listed above. For insurance to work, the amounts customers pay in premium must be affordable to the customer and sufficient to pay the projected cost of all claim, plus operating expenses of the insurer, plus a reasonable profit (about 5%).
In theory, it may be possible to “insure” anything. If there is a 100% chance of loss, the cost of insuring would be 100% of the value of the object, plus a load for insurer expenses and profit. So the cost to insure would exceed the value of the property – it would not be economically feasible.