When is insurance useful?

When does an insurance model make sense, when does an insurance model make less sense? After all, it clearly doesn’t make sense to do most of our transactions through an insurance model. We do not make our food choices with food insurance, nor do we buy movie or concert tickets with entertainment insurance.

A first answer one could give is that we should use insurance to cover very expensive transactions. But that’s not entirely true. Something expensive alone does not make insurance worthwhile. Because a lot of what is expensive is also reasonably predictable. An insurance agreement makes sense for events that are high in cost, low in probability, and unforeseeable at an individual level. Insurance, in short, makes sense for events that are individually a matter of if, not when, but at the population level, a matter of when, not if.

Consider home insurance as an example. There are many expenses associated with owning a home, but not all of them are typically covered by insurance. Depending on the building material, the roof of most houses has to be replaced about every fifteen to twenty years. Replacing a roof is very expensive, but most home insurance policies won’t cover this type of repair. That’s because your home’s roof needs replacing, not a matter of if, just a matter of when. These easily predictable expenses are best covered by savings rather than insurance. This is in contrast to, say, a house burning down. Whether your house burns down or not is not a question of when, it is a question of if. Statistically, your house probably won’t burn down. But from the perspective of the insurance company, which covers tens of thousands of homes or more, it’s not a matter of if, it’s just a matter of when that someone’s house will burn down. This difference in predictability, rather than overall cost, explains when it makes sense to have insurance or not. And that’s why a relatively small house fire that causes $5,000 in damage is covered by insurance, while a $20,000 roof replacement usually isn’t.

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When we think about it like this, we can see places where comprehensive homeowners insurance doesn’t make sense — places where major damage to the home isn’t a question of if, it’s a question of when. There are areas in the United States where certain types of natural disasters are almost guaranteed to occur frequently – hurricanes or major floods. If you live on the Atlantic coast of Florida, it’s not really a matter of if a hurricane will hit your home, it’s just a matter of when. In a free market we would expect relatively little insurance for this, and instead people who choose to buy homes in areas with such known and easily predictable risks would also be responsible for the repairs their homes need on a regular and predictable basis. Instead, insurance markets in high-risk areas are severely distorted by subsidies that make life in high-risk areas artificially cheap by forcing others to foot a significant chunk of the bill for the risks residents take. This creates a situation where the market sends a clear signal, “Hey, maybe don’t build a lot of expensive infrastructure here” and lawmakers respond by saying “counterpoint – maybe build a lot of expensive infrastructure there, and then if the inevitable.” and easily predictable results, you can simply pass most of the cost on to your fellow citizens!”

Even health insurance as it currently exists makes little sense from this point of view. In a free market, we would expect health insurance to cover treatment for illnesses that aren’t a question of when, but a question of if. It would be used for cases like car accidents, where you suddenly and unexpectedly have major injuries that need immediate attention, or for someone who is getting cancer or needs an organ transplant. But it would not (and does not) make sense to have an insurance model to provide ordinary, predictable health and routine care. Some people might think we need health insurance for this because even routine maintenance can be so expensive, but I would argue that the causality goes the other way — routine, everyday health maintenance is so expensive because so much of it is through an insurance model is covered.

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Imagine if, due to subsidies and government regulations, even routine car maintenance had to be covered by car insurance. Do you need an oil change or new winter tires for the winter? Imagine having to look around to see which dealership is in or outside your insurance company’s network, trying to determine what sets of tires your policy covers to what extent, and finding out what your deductible is for tire fitting will be, and never even bother asking the full price of the process because you never pay full price. And let’s say you’ve hit your annual car insurance limit! You would have every reason to take your car to the workshop as often as possible the rest of the year. That’s one of the reasons why healthcare reform, committed to even broader and more comprehensive health insurance, is sure to exacerbate the problems facing our healthcare system.

Insurance can be a great tool, but it is only a means to an end, not an end in itself. Making insurance broader and more comprehensive is not automatically a good thing – but it is very popular politically, and unfortunately that is often the determining factor.