Friday, November 15, 2013

Insurance and Gambling

Earlier I wrote about how most people associate investing in the stock market with gambling and how that is not necessarily an accurate analogy.  Surprisingly, gambling has more in common with insurance, and insurance is something people rarely hesitate to buy.

Consider the lottery as representative of gambling in general.  People spend money on tickets.  The money goes into a pool.  Out of that pool comes money to support the program (administrative), money paid out (prizes) with some left over (used by the states for designated projects).  A lottery always pays out less than it collects.

Insurance is very similar.  People spend money on premiums.  The money goes into a pool.  Out of that pool comes money to support the company operation (administrative), money paid out (claims) with some left over (profits).  Insurance always pays out less than it collects.

Both cases involve a gamble.  If we play the lottery, we gamble about winning against incredibly poor odds.  If we forego insurance, we gamble that we will be safe and will never need to collect.  That’s why most money managers recommend against such things as extended warrantees on appliances and electronics or life insurance for children.  The risk you are insuring against is very low relative to the cost of premiums.

There are, of course, differences.  An insurance payout comes after a loss – a house is flooded, a car crashes, someone is sick or injured, an appliance malfunctions, or someone dies.  The insurance does not and cannot make things completely right in terms of suffering or inconvenience, but it does provide some compensation to soften the monetary loss.  Given the choice, most of us would rather not be in the position to collect on an insurance claim, but would love to win a lottery. 

The important similarity that many overlook is that in both cases the total paid in (by everyone) is more than is paid out.  The very lucky come out ahead playing the lottery.  The very unlucky (or dishonest or reckless) collect more from insurance than they ever pay in premiums.  For most the lottery is a losing proposition and most pay more over time for insurance than they collect.

That’s why the complaint that I paid for insurance all these years and deserve my money back often results in disappointment.  In most cases you are not investing in insurance; you are buying peace of mind against the risk of some mishap.  It’s a gamble you hope never to win.  So don’t expect to make a killing off an insurance company.  It’s not set up that way.

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