By Donald D. Brown
October 25, 2011
When it comes to the concept of risk sharing, or what is sometimes also called spreading the risk, a word of caution is in order. Most people believe that insurance is based upon the principal of spreading risk. “Spreading” the risk is only half the principal. For insurance to work properly “risk must be spread among risks with similar risk characteristics.”
The financial goal of any insurance program should be to operate on an actuarially sound basis; that is, total premiums collected should more than offset total indemnities paid out. Spread of risk cannot compensate for under pricing of risk.
To illustrate: if you had four individuals wanting to purchase $100,000 of life insurance and one was 20 years old, one was 40 years old, one 60 years old and one 80. Should they all pay the same premium for the same coverage? Of course they should not. They each represent very different risks. The random risk that one of the four will die in the next five years (for instance) is very different. A slightly different principal would apply if I told you that the 20 year old and the 60 year old were smokers and the 40 year old was a skydiver. Now an element of human behavior must be taken into consideration.
A single price in the face of various risk attributes will cause adverse selection. As soon as one competitor begins to lower price for the best risks and/or not accept the poorer risks, any company that does not follow suit or take defensive action will find themselves adversely selected against with risks that have higher loss costs that their premium can cover.
Another way of illustrating the need to price different (non-homogeneous) risks differently is to consider the story of the origin of insurance.
Chinese and Babylonian traders practiced the first methods of transferring or distributing risk. Chinese merchants traveling treacherous river rapids would redistribute their wares across many vessels to limit the loss due to any single vessel’s capsizing. If a merchant received a loan to fund his shipment, he would pay the lender an additional sum in exchange for the lender’s guarantee to cancel the loan should the shipment be stolen. Now consider this: if the merchant was selecting the fleet of ship upon which his wares would be transported, would he want the most seaworthy vessels with the most experienced sailors or would he be more inclined to accept the most tattered vessels with the town drunk as the captain?
So, as you can see, spreading the risk is only half the story (particularly as it relates to price). If price is constant among a pool of non-homogeneous risks then some individuals in that pool will be subsidizing the 1) “random” risk characteristics, and the 2) human behavioral characteristics of others.
When this happens, whether by accident or intention, even when the differences are subtle, individuals begin to behave in ways that they might not otherwise consider in their own self-interest.
In conclusion, please forgive me but I always get a little nervous when I hear people talk about “spreading risk” because the “risk” they may want to spread to me may just be very different than mine.
About the Author: Don Brown is an insurance agent in DeFuniak Springs, FL, a Senior Fellow at The Heartland Institute, former member of the Florida House of Representative and Chairman of the House Insurance Committee.
