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April 2017 Policy Study, Number 17-8


A Commentary on American Public Policy


Part 15



The subject of insurance may seem a rather eclectic interloper to be included in the same commentary as dealt with so far.  Please be patient with the author as he tries to make this topic pertinent to the theme.  He believes that the topic of insurance will provide an apt analogy for our current use of government.  And for pointing out that even though there are very good reasons for procuring insurance, over the long run and for most of those insured buying insurance coverage is a losing proposition.


The proof of the statement is this:  if all the covered liabilities borne by the insurance company are of a greater value than the premiums paid by the insured, they would quickly be driven out of business and insurance coverage would become unavailable.  You know for a fact that it is yet possible to procure insurance coverage.  Therefore, reason dictates that the liabilities are borne by some other entity.  That entity is the purchaser of the insurance coverage.  And just so, the cost of government is borne by you.


The base word of the subject at hand is “insure.”  A dictionary definition includes the following:  “to secure, to guarantee, to get as a certainty.”  It also states that insurance is “a contract whereby, in return for a fixed payment, the insurer guarantees the insured that a certain sum will be paid for a specified loss.”  (As we proceed through this portion of the commentary, please bear in mind the words “payment” and “loss.”)


If memory serves me correctly, the genesis of the insurance industry in this country was inaugurated by Benjamin Franklin.  He established a “mutual” insurance company.  Under this form of insurance, a group of subscribers voluntarily associate themselves together for the purpose of safeguarding their assets.  They make a payment into a fund based upon the amount of loss they wish to insure from which they will be reimbursed if they have an actual loss.


With mutual insurance, the purchaser’s liability is not limited to his original premium.  If the amount of the fund, which was based on the projected losses for the entire association, is not large enough to cover the combined losses of all the members, all subscribers are further compelled to contribute into the fund in the direct ratio of their coverage in relation to the entire coverage of the group (i.e. if the assets you wish to cover equal 10 percent of the total assets that the entire group desires to cover, then you would be liable for 10 percent of any further losses incurred by any member of the group.)


Risk of loss is transferred from the insured and is assumed by other members of the group in the same proportion that those others have transferred their own risk of loss to the group.  That seems fair enough, and it is, inasmuch as all subscribers enter into the agreement fully informed and voluntarily.  The reader is asked to keep the nature and operational behavior of this type of insurance (mutual) in mind as he reads on.


Insurance in today’s world has changed somewhat.  With the accrued history of insurance losses, and the refinement of both the statistical and actuarial sciences, the insurer is better able to predict the premium required to cover the inevitable losses.  Consequently, the insured’s liability can now be limited to the premium paid.  But in most other respects, authentic insurance remains a contract through which you transfer your risk of actual loss to others — for a price.  To wit:  you are responsible to pay a premium; if your premium payments are current, and if any of your insured property is damaged or destroyed (i.e. you incur an actual loss), then you will be reimbursed commensurately with your coverage.


Let’s take an extremely oversimplified look at how this all works.  Suppose an insurance company is insuring 100 clients, of which you are one.  Each client owns an automobile with a value of $10,000.  With 100 automobiles insured at $10,000 apiece, the company now has an insured liability of $1,000,000 for which they could be entirely liable.  That is the potential risk which they assume.  But experience has shown them that over the period of annual coverage, it is statistically likely that these 100 autos will sustain $100,000 worth of damage.  Clients incurring a loss will each receive a check for the amount of their personal loss, and the company will have incurred a $100,000 loss.


Since the company was reasonably certain of incurring this loss, they prepared for it.  Each client was sent an annual notice of premium due in the amount of $1,000, plus other charges.  They arrived at the figure of $1,000 by dividing the $100,000 loss by the number of clients (100,000/100=1,000).  Through this process, the company also incurs other expenses, such as rent, salaries, taxes, mailing costs, utilities, etc., which must be added to the original premium.  There will also be a charge for the outstanding potential risk they have assumed for which they have not charged directly, to cover their backside if you will.  And to this list must be added the company profit, without which no one would invest his money in the insurance company to make the insurance coverage available in the first place.  We’ll arbitrarily set a figure of $200 to these other charges, which will produce an annual premium of $1,200, or $100 per month.


At this point, you, as the insured, have transferred $1,000 of annual risk to the insurance company for an annual premium of $1,200.  It was stated in the first paragraph that buying insurance coverage was a losing proposition, and so it is.  In this example, it cost you an extra $200.  So why would anybody purchase insurance?  The answer is because it can make economic sense, and as an added benefit it provides peace of mind.  The insured makes a very rational decision.  If he remains uninsured, he bears the risk of a potential $10,000 loss that will be immediate.  That is, he will no longer have an automobile at his disposal unless he can come up with an additional $10,000 on the spot to replace his lost automobile.


Most of us are not in the position to do so.  The rational decision we make is that it is better to transfer the immediate nature and the unknown timing of the risk to others.  We deem it in our own self-interest to bear a known $100per month payment ($100 x 12 months = $1,200 yearly) over a long period of time rather than an unknown amount (up to $10,000) due at an unknown time.  And for this economic security and peace of mind, we are willing to pay an additional amount.  But unless we actually incur a loss, it is a losing economic proposition inasmuch as it costs us more than if we were willing to bear the unknown risk ourselves.  On the other hand, if you are willing to assume the risk, and assuming you do not incur a loss, and also assuming that you have the fiscal discipline to save that $100 per month, then if you invest that $100 per month at a 4% interest and allow the interest to compound, in seven years you will have accrued the $10,000 which you could use to purchase a new automobile.  But can you abide the risk of this alternative in the meanwhile?




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