How Much Risk are You Willing to Take?

Nobody can avoid risks during a lifetime. In fact, everything we do day to day involves risk. When we go for a walk or running, we are at risk of twisting our ankle for example. When we invest our money, we accept a risk that a value of an asset can drop, and we might not profit from it. Ironically, even doing nothing is risky because if you just sit or lay still and not move at all, you put your health in grave danger. However, some risks are worth taking and we just must “risk it for the biscuit”. In my opinion, getting a mortgage (with a plan how to pay it off of course) to buy an adequate home offering appropriate living conditions for your family is a good idea, although a bit risky. Or, if you are dreaming of opening your own business and it would make you really happy and fulfilled, you should, having a solid plan, risk it and borrow money to launch it. In some cases, we have more influence on heightening or lowering a risk, while at other times it is not really in our hands. Although we can never for sure prevent it, we can alleviate the consequences in case if our move does not pay off. How? By paying for an insurance policy.

An insurance protects its policyholders from certain risks which are clearly defined in a contract concluded with an insurance company. If not eligible for a subsidized insurance, policyholders must pay a premium (a regular payment) to the company for its standing ready to cover costs of damage if a policyholder is affected by a risk. The most common insurances include home, health and car insurance, but actually, you can insure anything you want – from your crops, if you are a farmer, to some celebrities insuring parts of their body.

But why would anyone want to pay for safety from something that will probably not even occur, when you could just save this amount of money and put in in the bank instead? Well, the point of insurance is to transfer risk managing from a policy holder to an insurance company who must then also deal with a cost of consequences. Based on this, in general, insurance is a good idea. It can, in a case of a horrible event, like an unpredictable natural disaster which destroys everything we possess, save us from drowning in debt.

A theory behind how insurance companies set a value of their premiums, is called risk pooling. They know that some clients will be entitled to compensation because accidents of course happen, and they know that it might cost them a lot of money. However, companies expect that not every single policy holder will need damage coverage. Based on this, insurance business is not as risky for them as it seems. Statistics professionals do not calculate only how risky a collaboration with every independent client would be, but also pool together all the policies and check how risky their business is overall. According to the law of large numbers, a statistical theorem, the higher a number of clients paying a premium or the higher a number of issued policies, which are independent, the lower a risk for a company to lose money.

Apart from mathematical theorems, insurance is way beyond just numbers. One of the biggest problems insurance companies have is not figuring out at what price to sell their service, but how to deal with moral hazard. When an insured house burns down or a car gets damaged, investigators need to confirm that it really was an accident or that it was caused by a greater force. It is important for them to exclude a possibility of a fraud, intentionally executed by money-driven con artists. In his Financial Markets course, Professor Shiller also told us about farmers, who had sold their crop and then pretended as they would not get much of a yield this year to receive help from an insurance company. The World Bank came to an interesting solution to this problem, suggesting a weather-based insurance instead. Information regarding the weather are easily accessible, making it easy to know whether it really was the factor that destroyed the crops or not. Thus, farmers would not be able to fake proofs to claim a financial coverage.

Policy buyers can be disadvantaged as well because of selection bias, which had been especially well known in the USA up until 2010. When an individual wanted to open for example a health insurance policy there, an insurance company could demand for the person to undergo a medical examination first. Then, based on their health state, they would make an offer for them, which was a huge problem. Ill or disabled people, who already had to spend lots of money on medication and treatment, and needed insurance the most, were considered as costumers it was most risky to have a deal with, and were therefore offered a policy with the highest premiums. Based on this, it was very dangerous to have health problems while being uninsured in the USA, because without an insurance policy, you did not have access to free medication and treatment, meaning that in some cases, you would not be able to recover or get better. You would suddenly find yourself in a vicious circle of your health state becoming worse and worse. Consequently, you could come to a point where you would lose your job because you would not be able to do it anymore, resulting in being left without an income and ending on the street.

In 2010, the Patient Protection and Affordable Care Act, also known as Obamacare, went into effect. Its goal has been to make healthcare more affordable especially to those, who have needed it the most. According to Fortune, 20 million more Americans were able to afford health insurance because of it. The Act has made an end to selection bias, meaning that insurance companies have no longer been allowed to decline a client or rise their premium based on their pre-existing medical conditions. At for most Americans way lower price, health insurance became mandatory for all US residents, and offenders were punished with a penalty. Although Obamacare was made during Obama’s presidency, it has stayed in force even after his mandate expired and is still valid today. The only major change happened in 2017, when the Congress decided to abolish the penalty from 2019 on. As some Republican-led US states, supported by Trump administration, argued that the whole Affordable Care Act should not be valid anymore because the reduction of the penalty made a requirement to obtain health insurance no longer workable, the rest of decisions regarding Obamacare’s future is now in hands of American Supreme Court.

Obamacare has brought American insurance system closer to European standards. Most of European Union member states have universal healthcare system, meaning that everyone has access to health services. Although countries’ systems slightly differ from one another, it is common to all of them that all adult residents pay a contribution for compulsory health insurance. Residents and their families, who cannot afford to pay it, get at least the basic health insurance expenses covered by their home country. In addition, European insurance companies never set a value of premiums based on selection bias. Even more, insurers, who sell insurance policies, should always check if their client has enough knowledge about insurance and finances before making a deal with them, according to Solvency II, a EU directive on the taking-up and pursuit of the business of Insurance and Reinsurance.

I believe that also a country’s culture is reflected in its insurance industry. For the USA, it has been clear that laws and regulations are made for benefits of insurance companies and their profit. Although they tried to change that with Obamacare in 2010, Americans are still so unsure about it that now the Supreme Court has to make a decision whether to let it in force or not. On the other hand, Europeans put policyholders first, and they make that clear by setting adequate rules and directives.

Which side of the coin will prevail – corporate profit or solidarity?