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The Economics of Insurance

posted Apr 21, 2012, 11:53 AM by Simon Nguyen   [ updated Apr 21, 2012, 11:54 AM ]
Why buy insurance? This is one economic question that has been asked repeatedly. It is very difficult for some people to grasp the idea that we should pay in advance for something that has not yet happened, and only has a slight chance of ever happening.

Many people don't realize how much we rely on insurance in our everyday lives. Let say you have a big job interview at 10 AM tomorrow. It takes you approximately 15 minutes to get from your house to the interview site. But instead of leaving your house 15-20 minutes before the interview time, you decide to leave 30 minutes early. In effect, you have just insured yourself against unexpected events such as traffic jams or parking problems with 15 extra minutes of your time. I bet many of you have never considered things like this as insurance, but they are.

The most popular complaint with regards to conventional insurance is that it is too expensive. People don’t mind paying for insurance as long as the cost is at a fair value. It just does not make sense for a healthy individual to be charged the same amount for health coverage as someone who is overweight and is heavy smoker. The healthy individual is unlikely to demand as much resources as the unhealthy person. It is more efficient to charge the healthy person less and the less healthy person more.

Unfortunately, this can never come to fruition as long as government regulations and adverse selection exist. In most countries, the role of government is to have empathy for its people. It is sometimes illegal for companies to ask people about their health status or to obtain their health information. Additionally, people often lie about their health status; health records are often incomplete. Most importantly, insurance companies typically can’t charge people different rates for the same coverage.

Insurance companies do, however, have the right to deny certain applications for insurance coverage. This leads to insurance companies resorting to excluding people with preexisting medical conditions or who are older. (Note that this maneuver would be banned under President Obama's health care legislation.) 

I would love to explain further how insurance works, but that would make this article longer and render it a dull read. I do want to address the important question of whether or not life insurance is a good long term investment.

Life insurance (with fixed payoff) is never a good investment. Money loses value over time and the rate of depreciation is quite significant. For example, $100,000 in current value probably only worth about $50,000 (in equivalent value) 20 years from now. Unless you know you will die very soon (I doubt you will be able to get life insurance), you are much better off keeping what you have and investing it in something that yields a better return.

Simon Nguyen, M.A. Economics