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| An Introduction to Insurance |
| Written by Michael Bar, PhD. Economics |
| Thursday, 16 October 2008 18:58 |
 When I looked at my paycheck, I noticed that the entire benefit package, about 30% of the gross pay, consist of various types of insurance. The main benefits are health insurance, retirement, social security, life insurance and other. In addition to the benefits that we receive from our employer, we typically spend some part of our paycheck on additional insurance such as car insurance, savings (which is also a type of insurance), property insurance, etc. Why do people spend so much of their income on insurance? In this short piece I will try to explain what insurance is and why do people spend so much resource on it. Insurance exists because many animals in general and humans in particular, prefer average over extremes. Birds migrate because they don’t like extreme whether conditions and prefer mild (average) temperatures. In lab experiments*, when a rat is given one maze with average amount of cheese all the time and another maze with twice the food but only half of the time, the rat will choose the first maze (after learning both). The reason is that the rat prefers eating average amounts of food on a regular basis, rather than stuffing himself half of the time and staying hungry half of the times.Humans are not an exception from the animal kingdom, in that we prefer average over extremes. We would not be happy with freezing cold one day and extraordinary heat the next day. We would not like to eat large amounts only once in several days, and starve in between gigantic meals. There is one big difference between us and other animals – intelligence. Humans figured out that they can get closer to the average and away from extremes by getting insurance. The purpose of insurance is therefore averaging. The onset of human civilization is dated about 15,000 years ago when humans started to domesticate animals and began agriculture. What was the purpose of domesticating animals? When humans hunt, they are exposed to risk that one year will be successful due to abundance of animals, and the next season there are only few animals because of climate change or other reasons. By domesticating animals, humans keep certain number of them and eat regularly. Agriculture works the same way. Instead of gathering fruits in the forest, humans grow certain plants that provide regular supply of food. Other animals, though may not be as intelligent as humans, also enjoy insurance as provided by evolution. For example, the evolution provided the crocodile with low metabolism so that he can eat a gigantic meal once in six moths to a year. Modern insurance works in the same way – it enables us to get closer to the average and away from extremes. Let’s look at car insurance for instance. There are several states of nature (possibilities). In one state of nature, let’s call it GOOD, nothing happens to our car and we are very happy. In another state of nature, lets call it BAD, the car is totaled or stolen and we very sad. Car insurance does not eliminate the risk of a bad state, but it gives us an average between very good and very bad. In the good state we pay premium, so we loose some if nothing happens to the car. But in the bad state, we get compensation from the insurance company, so we gain a lot in the bad state. Old age insurance works in the same way – it allows us to average consumption when we work and after retirement. Health insurance allows us to average our wealth in the good state when we are healthy, and the bad state when we are sick. To summarize this discussion, insurance is averaging. It is not a way to eliminate risk, because the risk is still there whether you buy insurance or not. However, with insurance we can get closer to the average and away from extremes. So why do we spend so much on insurance? Because we (humans) and other animals prefer the average over extremes. And why do humans and other animals prefer average over extremes? This is something that economists can’t answer and you’d have to refer this question to our creator. *http://psycnet.apa.org/index.cfm?fa=main.doiLanding&uid=1986-26398-001 |
