Sunday, March 08, 2009

Insurance (1) - Pooling Risk

Understanding and managing risk has become a bit of science. Risk has two parts.

  1. Liklihood
  2. Impact
Liklihood tells us the probablity of an event happening. Impact tells us how much harm the event will do. The two factors are combined for an assessment of risk. An event that is highly likely is not a problem, if it has no impact. A very high impact may not be a worry, if it only happens once in thousand years.

Insurance is a method of pooling risk to minimise the cost of rare events to any one person.

Insurance works well for situations where the risk has low likelihood, but high impact. For example, the likelihood of a person’s house burning down is quite low. However, the impact is enormous, if it does happen. House insurance is method for pooling the risk and the costs.

In a city with a thousand homes, only one homeowner might experience a catastrophic fire in their house in any year. If everyone who lives in the city pays into an insurance fund, each home owner will only have to pay one thousandth of the cost of rebuilding a home to give the insurance fund enough money to pay for the cost of replacing the one house that is burnt down. Homeowners have several good reasons for paying into an insurance fund.
  • No one knows in advance who will have a fire. It might be me.
  • The cost of a fire would be devastating for the family whose house burns.
  • The cost of the insurance is relatively cheap.
  • The probability of a house going on fire can be estimated by looking at the history of house fires.
Insurance deals effectively with risk like a house fire, because it is relatively rare. The insurance company is able to estimate the probability of fires occurring and calculate an appropriate level for premiums. Everyone benefits from sharing the costs of the fire, because they know that next time they could be the one facing a tragedy.

Insurance is very effective for risks with low likelihood and high impact, but it stops working if the risk changes from being low likelihood to extremely widespread. That is why insurance companies have exemptions for extreme events like war and acts of God. If the city is bombed during a war, nearly every house might be burned down. In that situation, sharing the cost does not help. Paying for a thousandth of the cost of rebuilding all the houses is no cheaper than the cost of rebuilding your own house. Pooling the risk of an event that will affect everyone the same makes no sense. Insurance cannot deal with a widespread risk, because there is no benefit in pooling the costs.

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