The Purpose and Results of Insurance

Why does insurance exist? Insurance exists because risk is inherent in living life. Think about the various forms insurance takes: automobile insurance, property insurance, life insurance, health insurance, disability income insurance, flood insurance, etc. You cannot predict when another driver will hit your car, when your home will catch fire, when you’ll get a serious illness or injury or when you’ll die, but insurance companies can look at the statistics of those who possess similar characteristics as yours and figure out when you’re likely to die, which diseases you’re likely to get and when, the likelihood of getting into an accident in your community or city, or the likelihood of flooding in your neighborhood. Being able to shift the burden of risk to a big company is the reason insurance is attractive to consumers – shifting the burden from those with less knowledge to those with more. This is the purpose of insurance: to efficiently manage and distribute risk, from those least able to handle the costs to those most able to do so.

The competitive pressures of a free marketplace will cause premiums to be just high enough to earn profits and attract investment for efficiently managed companies and just low enough to be attractive to consumers.

In effective markets, the beneficial results of insurance are two-fold. First, insurance premiums create an incentive to minimize risky behavior. Second, insurance premiums create an incentive to maximize ‘good’ (as in, economically efficient) decision-making. This is why your health insurance premiums will be higher if you smoke, your life insurance premiums will be higher if you skydive or disarm bombs for a living, your property insurance will be higher if you live in a floodplain, and your automobile insurance will be higher if you live in a big city versus a rural community.

What happens when economic principles controlling insurance conflict with political principles controlling government? Inefficiency happens, and sometimes it is disastrous. For example, let’s take a look at FEMA, the Federal Emergency Management Agency. Federal disaster relief is sometimes called insurance, but it is not. The reason is simple to see and simple to understand. Insurance, as noted above, creates incentives to minimize risky behavior and maximize efficient behavior. Federal disaster relief subsidizes inefficient decision-making and risky behavior. The results are drastic and highly regrettable.

Would Hurricane Katrina have been as dramatically destructive without FEMA? No. Why not? Because if you wanted your property protected and you chose to own that property where hurricanes were able to destroy it, regularly, you would have to pay for taking that risk in the form of high insurance premiums, if, indeed, any insurance companies were willing to insure the property at all. The only ones who could have afforded those premiums, or taken the risk entirely upon their own shoulders, are wealthy people. If property losses will be covered by government-directed funds, this mitigates the costs of locating in risky areas. Suddenly, it is not as unattractive for poorer people to live in flood plains and coastal areas hit regularly by hurricanes. Property developers build because the demand is there and the demand is there because the risk has been shifted from the property owners to the taxpayers in general. Without federal disaster relief, it is likely that New Orleans would not have suffered so much structural damage because the development of the city would have taken an entirely different form. Note, for instance, the condition of the old city after the hurricane hit versus the most recently constructed portions.

The same is true up and down the Mississippi River. The river floods regularly. Every time the river does flood, we see images of people stranded on their roofs, many stubbornly maintaining they’ll never move. Of course they’ll never move. The government funds the reconstruction, only to have to reconstruct yet again the next time the river floods, as it will inevitably do.

It is all needlessly destructive, needlessly wasteful, perfectly ridiculous economically and perfectly understandable politically. No politician is going to sit idly by and watch suffering constituents without ‘taking action.’

If more truly understood basic economic principles, perhaps the situation would be such that ‘taking action’ wasn’t politically necessary, because the constituents interacted within a functioning insurance market, understanding the risks and the costs associated with those risks.