Is insurance irrational?

Insurance, says Matthew Parris, is “irrational.” Is he right?

Certainly, it’s a bad deal for the typical buyer, and would be even in a perfectly competitive market. This is because insurance companies must raise premia above what would be a fair price for risk to cover two problems.

One is adverse selection; the people most likely to buy insurance are those who believe they are more than averagely likely to need it.

The other is moral hazard. If you know you’re insured, you’re more likely to take risks.

This, though, doesn’t mean it’s irrational for the average person to buy insurance, for two reasons:

1. Loss aversion. For some people, a 1% chance of a loss of £10,000 is a nastier prospect than the 10% chance of a £1000 loss, even though the expected value is the same. This isn’t irrational – it’s just a taste. This is why the biggest insurance markets are for the tiny risk of big losses – such as fire – rather than the large chance of small losses, such as electrical appliances breaking down.

2. Liquidity constraints. Matthew is right that, on average, you’re better off paying insurance premia into a savings account, and using these proceeds to cover disasters.

But what if disaster strikes before you’ve saved enough? Then you might have to borrow at high interest rates. This loss could be bigger than the sum you lose by insurance premia being higher than the fair cost of the risk.

Does this mean all insurance is rational? No. There are two irrational sources of demand for it.

1. We over-estimate small probabilities, at least if the event can be easily imagined – as is the case of burglary and fire. This is why people do the lottery, and back outsiders more than favourites. And it’s part of the reason why opposition to genetically modified foods or nuclear power is so great; the odds of disaster are over-estimated.

2. People can be recklessly conservative. The desire to eliminate risks can swamp rational cost-benefit analysis. An extreme example of this is agoraphobia. Other examples are excessive health and safety legislation. A less extreme example is pension fund behaviour; their aversion to risk is so great that they have bought long-dated index-linked bonds at extremely low yields, thus sacrificing return.

But then, if everyone were completely rational, large chunks of the financial “services” business would cease to exist.

Comments

[Laurent GUERBY]

"Then you might have to borrow at high interest rates."

Hum, borrowing rate spreads are an insurance mechanism.

There is no escape :).

[Curious]

Morning Chris,

I'm not sure I agree with your point about "adverse selection". My reason is that, in a world where insurance isn't a legal requirement (as it is in some cases in this/our country), in a world where financial institutions (regulated - not that it makes a difference) missell insurance packages or play-up all manner of risks (which cannot possibly ever be eliminated or completely hedged), then and only then would we see only those that believe they need insurance (and probably the most likely to claim against it) going for it. Then and only then would we then agree that the risk premia mutliple that insurance companies charge is as a result of "adverse selections". But, insurance companies know how to whip up concerns about things that we've lived with for centuries and never had concern to insure against. They also know how to milk aspects of insurance that are a legal requirement, so that they rape consumers wallets just because they can. After all, that very behaviour is a rational move from a revenue maximising perspective.

The only thing I agree with is moral hazard, though the principle of self preservation would dictate that people would still make the effort even when they have insurance because - as we all know - insurance companies aren't what they are because they love to pay-up. On the contrary, even when the fault has been understood by all parties not to be yours, as their customer, you WILL get hassle. Moral hazard doesn't factor in the we as people would rather avoid that hassle like the plague.

Conclusion: I also agree that insurance is irrational. We can lead a far better quality of life with all the money we through into life's uncertainties and all the worry that we get from being constantly reminded by insurance sales agents that the world is risky.

But, it is rational to be irrational.

[Richard]

I'm not sure I agree -- insurance is a risk-reduction mechanism, pure and simple.

Of course, since insurance costs are composed of risks + administrative costs + profits, there will always be at least a slight discount to the expected value of the risk.

But the only time that insurance might be irrational is if the agent at hand can self-insure, i.e., has the resources to absorb an entire loss. Reserving such resources could be expensive indeed, and even if the agent can self-insure, there may be reason to reinsure over an acceptable risk. That's what deductibles are for: they permit an individual to reinsure at a rate appropriate to their own capacity to absorb monetary shocks.

So not so irrational after all . . . .

[dsquared]

[This is because insurance companies must raise premia above what would be a fair price for risk to cover two problems. ]

this isn't really true in the normal manner though; how many insurance companies run at an underwriting profit? The cost of insurance is the difference between what you would have earned if you'd invested it yourself and the investment earnings of the insurer. Which would mean that you probably couldn't cost-effectively replicate an insurance policy with a savings account.

[laika the space dog]

Insurance isn't something most people can escape. You have to have car insurance, otherwise you get prosecuted by the police and if you have a mortgage you have to have insurance on your house. The biggest insurance bills we pay are not free choices. It's not illogical to enforce driving insurance though, the type of driver who refuses to buy insurance is much more likely break the laws when driving and cause accidents too.

Electrical retailers tried to boost their margins on heavily discounted goods by selling expensive warrenties on their stuff. You'd be seduced into the store because of the cheap TV, then the guy would try to hit you with a hundred pound extended warrenty at the till once you were mentally committed to the sale. This was a complete con of course because modern electrical goods hardly ever go wrong and by the time they do you'll buy a whizz bang new model for the same amount of money it'd take to get the clapped out old one fixed. This type of insurance was irrational, and people see through it now i think.

A problem with insurance is that it encourages people to make false claims, because they think they've 'paid for it' and so it isn't really stealing. This increases the price for everyone. Insured business properties still have a strange tendency to go up in smoke every so often. Thus insurance distorts people's choices.

I still don't think that being insured makes responsible drivers drive stupidly though, the hassle of getting something fixed is the problem, more than its cost. Who leaves a good car in a high crime area safe in the knowledge that it's insured? We only abuse stuff we don't own - the company car, not our own. Who leaves their front door open because their belongings are insured? No-one. If you own a house you look after it, if you don't own it then you don't. It's not about insurance, it's about ownership.

[aaa visa gift card]

Space Exploration Benefits Our World, costs too much

[allnewaccs]

Fast food causes obesity

[ann]

I've just been letting everything pass me by , but so it goes. I just don't have much to say these days. Pfft. I can't be bothered with anything. More or less nothing seems worth doing. I haven't gotten much done recently, but oh well.

[unitrin]

More or less nothing seems important. So it goes. Oh well. It's not important. That's how it is.