Fundamentals of Insurance (Part 1): The Good

These days, private insurance executives must feel pretty lonely. They are the villains in the official White House storyline. Most of the public has at least a few complaints about some experience they had with insurance claims. And in congress, even those in opposition to the current reform don't want to be on the record in praise of insurers.

Don't look here for a love-fest either. There are significant problems in the health insurance market that make it less than ideal. But before we shackle, dismantle, or dismember these villains, we would be wise to carefully examine what insurance is supposed to do. Frankly, some of the things people expect of insurance are really the job of welfare or maybe the tooth fairy. So let's look at the purpose of insurance (how it functions at its best) and why it is ill-suited to play other roles.

Mommy, where does insurance come from?

Insurance has a role in our world because of two basic truths: (1) Big, expensive things randomly happen to people. (2) But not to everyone at the same time.

The first truth establishes a need (i.e. demand) for insurance. Those big events (like heart surgery) are scary enough without contemplating how to pay for it. Thus, we are willing to pay a much smaller amount every year (even when we are perfectly healthy!) so that, if it should occur, we won't be the one paying the bill.

An extreme case of this is life insurance. If I pass away in the next 15 years, not only would wife and children mourn my loss, but they would be in a much worse financial situation without my income. Thus, I am willing to pay a small amount each year for a life insurance policy that would cushion the financial blow. Now, I'm a healthy guy, so it's quite likely that at the end of 15 years, I will be alive and kicking — meaning I wasted several thousand dollars in life insurance premiums, right? No. Even then, they provided me a service those 15 years: peace of mind. And at the price I was quoted, it was worth it to me.

The second truth is what makes it possible for someone to offer (i.e. supply) insurance. DMBA isn't insuring me out of a concern for my well being, or a desire to bless the human race. This is how they earn their living, so they need what I pay in premiums (their income) to be more than what they pay on my claims (their costs). The difference is their paycheck.

In actuality, my premiums don't have to cover my costs every year — surely some years I will get sick more often or have an accident, and others I won't. But they have to balance out on average. And in fact, the insurance company can average these premiums and costs over alltheir many clients. Thus, their income and expenses stay rather steady, despite all the randomness among the clients they insure.

There are two major complications that can arise in insurance, described in the next posts.