Understanding The Basics Of Insurance

Warning: Plenty of economics lingo in this post.

It’s quite surprising to find that I haven’t really mentioned much about insurance since the birth of this blog. Afterall, besides having a strong interest in the subject (motivated by previous negative experiences), I was also an Economics major who even took a module on Health Economics. So short of claiming to be an expert in this area, I shall share my take on the concept of insurance.

First of all, I would like to highlight that the main purpose of purchasing insurances is to hedge/transfer our risk, and at a small cost. In this natural form, insurance is a beneficial tool for most people. This is because human beings suffer from risk-aversion and having insurance to protect them from catastrophic losses would increase the average utility of the person and population.

If you struggle to understand the previous sentence, let me illustrate with an example.

Imagine this place named Almost A Utopia (AAU). There’s 1,000 people staying in AAU and each of them live off the dividends of a $1 million inheritance. Once a year, a heavy lightning would strike at only one of the 1,000 houses that everyone stays in and repairing the house would cost exactly $1 million, wiping out the unlucky person’s inheritance.

Being a smart community (they are able to generate 5% dividends and happy to live off that), they decided to pool $1,000 each every year to accumulate the sum of $1 million which will be dedicated to that unlucky person whose home is struck by lightning. With this measure, they eliminated the negative financial outcome if lightning really hits them. The trade-off is that instead of being able to spend $50,000 freely a year, the amount is now reduced to $49,000.

With $$50,000 to spend, the average AAU citizen would have achieved a utility or happiness index of 100 (utopia). However, if lightning strikes their homes, this happiness index would become -100 since they would lose everything and have to start working 40 hour work weeks for their fellow citizens. Calculating based on simple probability, the expected utility for each of them is 99.8 (99 x 100 + 1 x -100, divided by 100). However, if they bought the insurance every year and have $49,000 left, their utility would be a certain 99.9 which is also comparatively higher than 99.8 (a small drop from 100 due to diminishing marginal increase in utility once income is >$40,000). So as you can see, everyone in AAU is better off.

“Wow, all of us should really go buy insurances now! Maybe those pretty ladies touting insurances at MRT stations are really angels sent from the heavens!”

If only things were really so simple in AAU. The limitations of the insurance tool are highlighted below.

Adverse Selection

The fact is that some houses in AAU are taller than others and these houses are more prone to lightning. The citizens residing in shorter houses realise this and knowing that their chances of being embroiled into this unfortunate circumstance are now close to 0, decide not to participate in this insurance. As a result, the remaining participants have to cough up higher premiums due to a higher risk. This begins a vicious cycle as after performing some cost-benefit analysis, residents of relatively shorter houses decide that it is not worth paying so much to transfer their smaller risk away and decide to drop out too.

A long running joke is that to avoid the prospect of insuring only the segment of population with much higher risks, the application offices of health insurers should be on the 50th floor of a building whose lifts are always spoiled. =p The threat of adverse selection also helps explain why CPF LIFE was made compulsory for everyone (otherwise only the very healthy would opt in) and the upcoming Medishield Life would also be made mandatory for all Singaporeans. Not so democratic since risk-loving people who wouldn’t buy insurance are made to do so. An alternative for private insurers to counter this risk would be to charge much higher premiums.

Moral Hazard

The lightning rod was invented and all the AAU citizens started purchasing them to reduce the chances of disaster by half. Lightning rods also became a pre-requisite for participation in the insurance. The payouts remain the same even though contributions are halved. Unfortunately, lightning rods decay and become faulty over time. But the citizens have little incentives to replace their faulty lightning rods and keep their risk low. It’s now okay to get struck by lightning since in all likelihood, the $1 million payout would provide for a nice renovation too. As a result, gradually, the insurance premiums start to become unsustainable since the incidences are higher than expected.

Moral hazard is also known as the buffet syndrome. This is a big concern for health insurers again. Since everything is already paid for by insurance, why not just visit the doctor/specialist whenever my muscles are aching, eh? And what’s the point of exercising when I can go for medical treatments, eh? For some who really hate their work, hospitalisation is being treated as paid leave too.

This is also the reason why many Welfare states are becoming unsustainable. The taxes (akin to insurance premiums) have to be raised if the services are being abused and used much more often than expected. Therefore, in the real world, premiums for health insurance are much lower if one is prepared for higher co-payments or deductibles     because this would be a signal to the insurers that you are unlikely to exhibit moral hazard behaviour.

This is just the 1st of a 3-part series on the topic of insurance. Instead of droning on and on about the theoretical stuff, I shall be sharing some practical aspects where you could take action on in the next couple of posts. (Update: How we keep our insurance expenses low)