Risk Pooling

The lease recently expired at our apartment, and we moved from a privately owned townhouse to a brand new managed apartment building. Interestingly, we did not have to put down a deposit, in contrast to with our old landlord, who had required the standard deposit equal to one month’s rent. In the new place, we only had to pay a one-time nonrefundable “insurance premium” of a couple hundred dollars. The big difference is that our landlord (as far as I could tell) only owned one property, so he was exposed to more variability risk than the management company, who ran hundreds of units. As a result, he needed more assurance that he would not incur a large loss, even though holding a deposit  might be costly (State law requires the money to be held in a separate account, and any interest accrues to the tenant etc.) The whole reason insurance exists at all is the “risk aversion” created by a non-linear function that maps outcomes into utility. That is, a big loss can be devastating, while the small cost of the premiums is not proportionally missed. Insurance for large losses is just a formalized way of taking advantage of the law of large numbers to average out risk, in a sense, taking from “alternate yous” that live in universes where things turn out OK. Thus, insurance is supposed to be boring (as opposed to Casinos), in the sense that it is designed to average out adverse events. This is why insurance commercials are made exciting in ways that have nothing to do with insurance.


Insurance is a hot topic with the roll-out of Obamacare. Any health insurance system needs many healthy people paying premiums in order to cover the costs incurred by people who get really sick. Under the previous system, insurance companies made sure that people didn’t just wait until they got sick to sign up by denying those with preexisting conditions. This created the incentive for everyone to join the pool, although some still couldn’t afford insurance and took their chances. Now, in order to get rid of the preexisting condition rules, Obamacare mandates that everyone have some form of insurance.


Author: lnemzer

Assistant Professor Nova Southeastern University

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