What is the Theory Behind the Practice of Insurance?
There is a fairly common misconception among insurance policy holders that, when they take up any insurance product, they are entering into an individual arrangement with their insurance company. This misconception is not surprising. This is how the law itself views the relationship.
But the whole concept of Insurance a little bit more complicated than that.
In fact, the insurance concept operates in a somewhat different manner. Insurance companies are actually financial intermediaries.
The Insurance Practice is defined by the following major concepts:
- Risk Transfer
- Common Pool
- Equitable premium
Let us delve into each of these concepts further
Risk Transfer - insurance
What is risk transfer in insurance theory?
Here is the theory behind what is referred to as risk transfer in regard to insurance. We start by making an assumption – after all, that is what theories are about.
We assume that a situation exists whereby a reasonably large number of individuals all face a similar economic risk. And this risk also has a reasonably low probability of occurrence.
The risk is of a magnitude that it would at least seriously damage the wealth of the unfortunate few who suffer loss.
So, even if the probability of loss is low, the consequences are sufficiently severe enough, to lead the concerned individuals to think of avoiding the risk. This then creates a desire to avoid the risk.
However, if the benefits gained are perceived to be so valuable that they cannot be foregone, then the individuals accept the risk.
For example, think about home ownership. If you own a home, you have no alternative but to accept the risk that it may be damaged – by fire, by trees falling, by any type of unforeseen event.
If you drive a car, you must accept that the risk that you may be involved in a motor accident. This may cause injuries to you or damage to your car.
These risks are of personal nature and they cannot be transferred.
However, the financial consequences coming from these risks can be transferred. It is this transfer of financial consequences that form the first stage of the insurance concept.
Insurance Common Pool
Now that we know that it is the transfer to financial consequences that kicks off the process of insurance, the next point is to talk about where the financial risks are transferred to.
Many would imagine, or even argue that the risks are transferred to the insurance company or the insurer.
The problem with this reasoning or argument is that recognizable insurance transactions were taking place thousands of years before the first insurance company appeared. So the risk is not transferred to the insurance company.
But where is the risk transferred to?
The fact of the matter is that the risk is being transferred from a number of individuals to a collective pool. This collective pool contains the collective risk of all its members, together with the collective resources that these members have set aside to meet the occurrence of such risk.
Each member of the collective pool agrees to surrender a small sum of money to the common pool with the intention that this be used to meet the collective loss, regardless of where the loss actually falls.
In essence, what any policy holder, or any person who takes up any kind of insurance is agreeing to, is to be pay for the mistakes of others – within the pool. As insurance policy holders, we do this in the hope that those other member of the common pool will also pay for our mistake or misfortune, if or when we make a mistake or if a misfortune comes our way.
The reason that we, as insurance policy holders are happy to do so is because we cannot know whether we will be the one who makes the mistake or is meet by a misfortune, and need to draw on the pooled resource to meet the cost.
Faced with the possibility of severe financial loss, it makes a great deal of sense to elect to take a small, certain loss instead – it is called premium.
As human beings, we like comfort. That means every risk holder would like to be a member of a common pool the cushions us against hefty financial consequences, in the event of a loss or damage.
However, the same human nature also dictates that we would all be very happy to contribute as small amount as possible to the common pool.
That means if the decision regarding how much each one of us should contribute is left to the members themselves, there is a danger that we might not collect enough within the pool.
The understandable reluctance to payment – or to payment of enough money – means that collective contributions might insufficient to meet the collective losses.
In order to meet the potential losses, there are 2 approaches that can be taken.
Insurance Premiums - Flat Rate or Equitable?
Flat Rate – The simplest method would be to charge every pool member the average cost of the anticipated loss for the average member (plus the cost of administering the pool).
This looks and sounds like a straight forward way of doing this. But it is not only deceptive, but also fatally flawed.
The risks in the pool may be similar, but they are certainly not identical.
If a flat rate premium based upon average costs is charged, those members who represent a better than average risk will be subsiding those members who are below average risks. This may arise either because the hazard factor is lower (it is less probable that the loss will occur) or because the greater wealth of certain policy holders means that their losses will be large on average.
Premiums will look expensive to “good” risks while seeming cheap to ‘poor’ risks. The likely result in this scenario will be that below average risks are disproportionately represented in the pool as good risks are deterred and poor risks attracted. This would in turn raise the average cost of loss per policy holder and leading to a shortfall in pool funding. The risk that only those more likely to claim will take out insurance is known as ‘selection’ by insurers and is fread due to its distorting effect on loss estimates.
Flat Rate Premiums are only workable where the size of the premium is so small that any differential will be so small that distorting effect on the pool will be insignificant.
Equitable Premiums – The alternative to flat rate method, is to charge each member of the pool a sum of money that represents the financial equivalent of the degree of risk that they have transferred into the pool. That is what is referred to equitable premium.
This requires that a hazard analysis is undertaken to determine the probable frequency and severity of loss for each applicant. The expected cost of loss is its probable frequency multiplied by its probable severity.
A sum equivalent to this expected cost can then be charged, known as the pure risk premium. This pure risk premium is the part of premium that is going into the pool to cover the risk, as opposed to the part of the premium that is going to cover administrative cost.
Using equitable premium method, a fair premium will be paid by all based upon their risk, cross-subsidization can be avoided – at least in theory. And therefore, membership should be equally attractive to al, avoiding selection.
Concluding on the Concept of Insurance
Many insurance theory experts argue that any pool that is not based upon equitable premium principles is unlikely to succeed.
Only if there is a very high degree of homogeneity between the risks can flat rating work. In such a case equitable premiums would be more or less equal and it could be argued that that the saving in administrative costs would outweigh any benefit to be gained from the strict application of equitable premium.
This scenario is a very rare one in the real world and when insurers do flat rate premiums, it is generally because the premiums are so low that differentiation is not cost effective rather than because they are truly highly homogeneous.
That said, even this is becoming unusual as the use of computerized quotation systems and the internet allow insurers to distinguish between risks at minimal cost.