In an earlier post, we examined how insurance markets work and how companies and individuals both view risk. This post breaks down who actually ends up purchasing insurance and how this affects the entire market, and ultimately the cost of insurance.
Let’s consider the same scenario from the last post, where a homeowner was considering purchasing a fire insurance policy for their $500,000 apartment. The anticipated losses were $7,000 over a five year period but the insurance policy would cost them $10,000.
One key assumption in this simple model is that the probability of fire is known. In reality, the probability of fire varies from individual to individual.
Let’s make our model more realistic and say that the probabilities in the above example only represent the population averages for how likely each person is to have a fire. But the homeowner in question knows (or thinks) that their probability of having a fire is less, let’s say half as much. Should they still buy the insurance?
With the probability of fire cut in half, their expected loss would only be $3,500. But the insurer doesn’t take this into account so they would still charge the full $10,000 for the policy.
Some very risk-averse people might still purchase the policy, but many would not.
On the other side of the market, you have a reckless homeowner who has a much higher chance of fire, let’s say double. This person would then have an expected loss of $14,000, so the $10,000 policy would seem like a great deal. Of course some people still wouldn’t purchase it for a number of reasons including their ability to pay, risk-seeking behavior, etc.
Generally speaking, though, people who are more at risk and have higher expected losses are more likely to want insurance. This is true in almost all insurance markets (health, car, corporate).
So, what does this mean for the insurance company? Imagine that the market is made up equally of people like the first homeowner (low chance of fire) and people like the second homeowner (high chance of fire). The population averages for how likely each person is to have a fire remain the same, but we know that the people who are actually buying insurance will have a higher rate of fire.
Because of this, the actual payouts for the policies would probably average closer to $14,000 instead of the $7,000 payout used to calculate the policy cost and the company wouldn't be able to sustain their prices. Given the higher payouts, they would have to raise their total policy cost to $17,000 to cover their risk premium and administrative costs.
| Description | Amount |
|---|---|
| Expected Payout | $14,000 |
| Risk Premium | $500 |
| Administrative Costs | $2,500 |
| Total Cost | $17,000 |
