You Don't Understand Insurance

May 13, 2015

It has become clear that most people, no matter how well-educated, do not understand insurance. Not just the complicated mess that is health insurance, but even renter’s insurance or traveler’s insurance or even things most people don’t think of as insurance, like extended warranties on small household appliances. People don’t understand the basics of insurance.

Insurance is an amazingly simple and powerful concept, but not one that’s taught very often outside of economics.

What Insurance Isn’t

Here’s one thing insurance isn’t: a way to get stuff “for free”. That’s no more true than the idea that repeatedly putting coins into a slot machine will eventually net you a lot of money.

People also tend to focus on the price of insurance, which for certain types of insurance is “so cheap” that it’s “obviously worth it”. That’s often not true either. Humans are very good at imagining terrible horrible worst-possible outcomes and what they will cost, ignoring the probability of those outcomes. In comparison, a premium will almost always seem cheap. In reality, the probability makes all the difference.

An Example: Defective Self-driving Cars

Let’s imagine a bizarre future where you and four friends all buy the same self-driving car for $10,000. But you know from the internet that exactly 20% of these cars are irreparably defective and will stop working after two weeks. The car manufacturer won’t issue refunds. (Yes, these cars are so good that people keep buying them despite this. Just go with it.)

What price would you pay to insure your car with your four friends?

To answer that question we need to do some simple math. There are five of you, and one in five cars will be defective, so it is likely that one will have to be replaced. You could each put $2,000 into a piggy bank, and then use that combined $10,000 to buy a replacement for the defective car.

This $2,000 is in a sense the “fair” price of insurance. It accurately reflects the underlying costs and probabilities, and guarantees that in the end you will definitely have a working car. It will cost you $12,000, but that’s perhaps better than a one-in-five chance that you’ll have to pay $20,000 to get a working car. And neither you nor any of your friends is actually making any extra profit on the deal.

However, $2000 is not the price that any insurance company will quote you and your friends for the same insurance. An insurance company has employees and office space to pay for. An insurance company has to pay transaction fees when you send in your $2000 premium. An insurance company has to pay someone to go out and track down your replacement car, and make sure it’s not defective also. And most importantly, an insurance company has to make a profit.

So an insurance company will always charge more than the fair price. It might charge something like $2200 to you and your friends, which would be enough to replace a defective car and have $1000 left over to cover expenses and take a bit of profit.

Would you pay $2200 instead of $2000 for the same insurance? What about $2400? What about $4000?

It’s one job of insurance companies to figure out how much you’re willing to pay for a given policy and charge you that. Seen in this light, most insurance is technically a “bad deal”.

Risk-aversion and self-insurance

Your willingness to pay more for the same insurance is a measure of your risk-aversion. In the example above, if you’re willing to pay $2400 to have a defective car replaced but I’m only willing to pay $2200 then you’re more risk-averse than me. There’s nothing wrong with that. It’s just a descriptive fact.

The problem with insurance is that people are naturally somewhat risk-averse, but we’re never presented with the opportunity to insure with friends at a “fair” price. Insurance company premiums are what they are, and we never see the actual underlying risk and payout model that they use to determine those premiums.

Also in real life it’s often difficult or imprudent to insure with friends, not least because estimating probabilities is hard and most people don’t actually have enough friends to spread risk effectively.

But you don’t need friends to self-insure. That’s essentially a fancy way of saying you can set aside enough money yourself so that if something bad happens you can cover the loss. Thus you’re not paying an insurance company and are always getting a “fair” price. But you are exposed to the risk that something bad might happen.

Often the decision to self-insure will depend on the cost of a negative outcome. If the example above were about insuring a $100 coffee maker for $22 when you know the fair price is $20, you might decide to self-insure instead. The most it will cost you to forego insurance is another $100.

The Rule

Once you understand that most insurance is technically a “bad deal” you can start to live by this rule:

If the cost of losing something would devastate your ability to live your life effectively, insure it. For everything else, you’re better off saving your money.

Here’s how this breaks down for me:

Things I don’t insure: shoes/clothes, coffee maker, computer, travel, bicycle, television, refrigerator, smartphone. If I lose or break one of these, I’ll either replace it or go without for a while.

Things I insure: my car and my health. And if I had a house I would insure it. These are expensive or irreplaceable, so insuring them makes a lot of sense (or is required by law).

What do you insure? Are there things you pay to insure now that you can afford to self-insure in the future? It’s usually a better deal.

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