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Insurance is inherently a group collectively paying for loss
Posted on: July 22, 2016 at 12:35:59 CT
JeffB MU
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es of individuals.
The first recorded instances of an insurance type sharing of risks was of people who took small canoes/boats down the Yangtzee River. They would take the food/products they had produced for the year down the river to sell. There were some very dangerous rapids and about 10% of the boats would capsize. If an individual lost everything it could wipe them out... it would be a complete catastrophe.
So they would stop and congregate above the rapids and when they would get about 10 guys together they would each place about 10% of their own product on each of the other boats and then they would proceed through the rapids. They would still average one of the 10 boats capsizing and losing its load, but no one person or family was wiped out. They would average losing 10% of their produce but that was just a cost of doing business now.
In similar fashion in the early days of our country if someone had a fire that burned down their home or barn the neighbors would all get together and help rebuild it for them. They were each inconvenienced whenever this happened and it probably seemed that they were always working on building someone else's buildings, but it wasn't catastrophic for any one family when these catastrophes did happen.
Insurance works in much the same way. Of all the people with homeowners insurance maybe 1 out of 1,000 (I'm making up numbers for illustrative purposes) will get hit by a tornado & 1 out of 500 will have a big fire. Any one of those events might be catastrophic for a family that suffers such a loss, but if all of the people with homeowners insurance paid premiums that went into a big pool and then claims were paid out of that big pool the loss would be spread out over all of the individuals participating in that pool.
Like the folks upriver on the Yangtzee or the early settlers, the insurance did not reduce the number of these catastrophes but spread out the costs among all of those in the community who wanted to participate in such cost sharing. It became a more standardized fixed cost rather than gambling on whether one would have no loss or have a catastrophic loss.
There are administrative costs for the insurance, so the expected values of the loss for all of those purchasing policies (eg in the pool) will be a little higher than the expected values of just throwing the dice and absorbing the loss in full should it come, but it still makes financial sense. That is because of the concept of the marginal utility of money.
The marginal utility of money hypothesizes that the first dollars someone earns are worth more to a person than the last dollars they have earned. One hundred dollars is going to mean a lot more to a starving homeless man than it would be to a billionaire.
The premiums for homeowners insurance are like the last dollars earned, whereas the dollars received after someone's home burns down are more like some of the earliest dollars earned, and hence have more real value or utility to the family in question.
If a thousand families didn't buy homeowners insurance they might be able to take a nicer vacation or maybe buy a little nicer car or go out to eat more times. But the family that lost a home and had no money to buy another one, or perhaps even to rent another one would be suffering more than the extra perks enjoyed by the other 999 families. Some might still be saddled with house payments for another 20 years or so for a pile of burned rubble that they need to clean up & haul away.
They also probably lost many/most/all of their personal belongings as well.
But insurance is voluntary.
If you think it is all baloney don't buy it. Unless you are borrowing money no one will require that you have homeowners insurance. If you either want to self-insure, or you would like to come up with some alternative, such as perhaps your friends or your commune or whatever all decide to just help each other out like the early settlers did you can make your statement and put your money where your mouth is, so to speak.
The first recorded instances of an insurance type sharing of risks was of people who took small canoes/boats down the Yangtzee River. They would take the food/products they had produced for the year down the river to sell. There were some very dangerous rapids and about 10% of the boats would capsize. If an individual lost everything it could wipe them out... it would be a complete catastrophe.
So they would stop and congregate above the rapids and when they would get about 10 guys together they would each place about 10% of their own product on each of the other boats and then they would proceed through the rapids. They would still average one of the 10 boats capsizing and losing its load, but no one person or family was wiped out. They would average losing 10% of their produce but that was just a cost of doing business now.
In similar fashion in the early days of our country if someone had a fire that burned down their home or barn the neighbors would all get together and help rebuild it for them. They were each inconvenienced whenever this happened and it probably seemed that they were always working on building someone else's buildings, but it wasn't catastrophic for any one family when these catastrophes did happen.
Insurance works in much the same way. Of all the people with homeowners insurance maybe 1 out of 1,000 (I'm making up numbers for illustrative purposes) will get hit by a tornado & 1 out of 500 will have a big fire. Any one of those events might be catastrophic for a family that suffers such a loss, but if all of the people with homeowners insurance paid premiums that went into a big pool and then claims were paid out of that big pool the loss would be spread out over all of the individuals participating in that pool.
Like the folks upriver on the Yangtzee or the early settlers, the insurance did not reduce the number of these catastrophes but spread out the costs among all of those in the community who wanted to participate in such cost sharing. It became a more standardized fixed cost rather than gambling on whether one would have no loss or have a catastrophic loss.
There are administrative costs for the insurance, so the expected values of the loss for all of those purchasing policies (eg in the pool) will be a little higher than the expected values of just throwing the dice and absorbing the loss in full should it come, but it still makes financial sense. That is because of the concept of the marginal utility of money.
The marginal utility of money hypothesizes that the first dollars someone earns are worth more to a person than the last dollars they have earned. One hundred dollars is going to mean a lot more to a starving homeless man than it would be to a billionaire.
The premiums for homeowners insurance are like the last dollars earned, whereas the dollars received after someone's home burns down are more like some of the earliest dollars earned, and hence have more real value or utility to the family in question.
If a thousand families didn't buy homeowners insurance they might be able to take a nicer vacation or maybe buy a little nicer car or go out to eat more times. But the family that lost a home and had no money to buy another one, or perhaps even to rent another one would be suffering more than the extra perks enjoyed by the other 999 families. Some might still be saddled with house payments for another 20 years or so for a pile of burned rubble that they need to clean up & haul away.
They also probably lost many/most/all of their personal belongings as well.
But insurance is voluntary.
If you think it is all baloney don't buy it. Unless you are borrowing money no one will require that you have homeowners insurance. If you either want to self-insure, or you would like to come up with some alternative, such as perhaps your friends or your commune or whatever all decide to just help each other out like the early settlers did you can make your statement and put your money where your mouth is, so to speak.
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Insurance is inherently a group collectively paying for loss - JeffB MU - 7/22 12:35:59