Insurance – Part 2

In Part One of this article we explained, very basically, what insurance is. Insurance, in the most fundamental explanation possible, is paying someone else to assume your financial risk.

For example, if you own and drive a car, you have a risk of being in an accident. The details of the accident are immaterial to our discussion; it’s only necessary to accept that fact that you may have an accident, no matter where you drive, no matter how carefully you drive, and no matter the value of your vehicle. If you have an accident there will be financial costs. These are costs associated with damage to your and other vehicles, non-vehicle property, and the cost of medical care for people involved. Those costs can easily accumulate to a sum impossible to pay for most people. Knowing that accidents happen no matter how carefully one drives, insurance is, for most people, a moral if not legal necessity; part of the cost of owning and driving a vehicle is making sure you have the ability to pay for damage and medical expenses if you are in an accident.

Many centuries ago people realized that some risks in life were too great to accept on their own. You could load a ship with the entire product of your farm to transport the crop to another location for sale. But if the ship was lost at sea, you might very well be financially ruined. What to do?

For sake of example, let's paint a picture: If the ship arrived safely in the next harbor and you were able to sell your goods you might earn $100,000. If the ship were lost at sea, you would earn $0. Let’s say in this example that one in twenty ships are typically lost at sea. You could pay another person, or a number of persons who pooled their money to provide reimbursement in the event of disaster, in effect, forming an insurance company, 1/20 of the value of your cargo with an agreement that they would pay you $100,000 should the ship be lost. If the ship arrives safely in port and you sell your goods, you earn $100,000, out of which you must pay 1/20, or $5,000 to the insurance company. You have only $95,000 remaining even though nothing bad happened. But should the ship be lost, you will still be paid $100,000 by the insurance company. You have paid them $5,000 for accepting this risk, so you know either way, your earnings are guaranteed.
The above example, even in its most simple form, is not entirely accurate. The insurance company does not operate without making a profit. No one works for free. You’re going to have to pay more than the pure risk of loss percentage; your payment will include an extra amount for operating expenses and a reasonable profit for the insurance company. Insurance companies in a free market all have to deal with the same risk of loss. The way they compete is by accepting the smallest profit possible while still making the business desirable by investors, lowering their operating expenses, and estimating the risk of losses more accurately than their competitors.

Actuarial science is the discipline that applies mathematical and statistical methods to assess risk in insurance, finance, and other industries and professions. This has been a discipline in mathematics since the late 1600’s. Part of this discipline involves discrimination—that dreaded, politically incorrect word.

As in our first article, we need to define our terms. To discriminate is neither good nor bad. It only means to mark or perceive the distinguishing or peculiar features of, to distinguish by discerning or exposing differences; to recognize or identify as separate and distinct. In relation to our subject, insurance, providers have to discriminate in order to charge the least amount possible to a group of insured clients, what they term a risk pool. The word group is important. An insurance company cannot exist, cannot stay in business by insuring one person. Actuarial science and statistics predicts the risk of loss based on a large number of individuals having similar characteristics. In any year no one can predict the risk of loss for any one driver, even though it is known that he is 18 years of age, white, male, employed part time, with a 4.0 GPA, drives a 10-year-old Nissan Sentra, has never had an accident, and lives in a remote town in Nebraska of 50,000 population. However, the insurance company can fairly accurately predict the losses over several years given a large number of people who fall into that same description. They can then charge insurance premiums that will allow them to pay losses while still retaining enough money to pay business expenses and provide a reasonable profit for the business owners.

That’s a long, round-about way of getting to our thesis: At what point are you subsidizing the insurance of others and should you have to?

There is admittedly much we do not know about our example driver. Is he a risk taker or risk averse? Is he susceptible to fits of rage? Did he buy the car with his own money or did a wealthy parent buy it for him? There are a plethora of unknowns that may affect the risk profile of our young driver, but some things are unknowable and have to remain so. The balance of known and unknown risk profile characteristics affect the amount of risk the insurance company takes and has to be calculated into the insurance premium to ensure the insurance company has enough revenue to pay contracted liabilities.

Let’s say the legislature passes a law saying it is illegal to discriminate based on sex. Now our teenage driver is 18 years of age, white, employed part time, with a 4.0 GPA, drives a 10-year-old Nissan Sentra, has never had an accident, and lives in a remote town in Nebraska of 50,000 population. We now no longer know whether this driver is male or female. We’ve introduced another unknown so the risk to the insurance company is increased, causing a necessary increase in the premium. If we do not know the sex of the driver, yet actuarial tables and millions of person-years of driving history indicate male drivers cost the insurance company more in insurance payouts, the company has no choice but to equalize premiums throughout the risk pool, regardless of sex of the insured. Males will pay a little less, females a little more, but the revenue from premiums will increase overall because loss of the ability to discriminate on this information increases the general risk for the insurance company. Female drivers now have to  subsidize the cost of insurance for male drivers.

Let’s say the legislature passes a law saying discrimination based on age is no longer allowed. Now our driver is white, employed part time, with a 4.0 GPA, drives a 10-year-old Nissan Sentra, has never had an accident, and lives in a remote town in Nebraska of 50,000 population. If the millions of person-years of driving history tells the insurance company that 18-year-old drivers have higher accident rates than 40-year-olds, they still must charge a higher premium to everyone because they cannot take into account the lower costs of insuring 40-year-old drivers. The older drivers are now subsidizing the younger.

Without belaboring the issue, it’s easy to see that the less we allow insurance companies to discriminate on readily available, unchangeable information concerning the insured (hair color would not be used to determine a risk profile because it is easy to change), the higher the risk exposure to the company and the higher the premiums will be for those who would otherwise fall into a lower-risk category.

Why is this of any importance to you? By disallowing the ability of an insurance company to discriminate on available data concerning its pool of insured, we create inefficiencies and promote higher risk-taking within the insurance industry. This results in higher costs for everyone. It also creates a business atmosphere where some companies will take higher risks in an effort to lower premiums in order to attract more customers. Higher risk-taking will inevitably result in failure of more companies. Those who were insured by those companies will be the ones who suffer when a claim cannot be paid for lack of funds or the company goes bankrupt and the insured must find other insurance, sometimes after their life circumstances have changed radically, causing them to have to pay higher premium to the new company.

Further, forcing someone else to pay for something that benefits you is a form of theft. You may choose, of your own free will, to pay into an account that subsidizes high-risk individuals who could not otherwise afford insurance, but forcing that payment by government fiat, even under a democratic system, is still theft.

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