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Q&A: Risky business? The economics of car insurance explained.

If you drive, insurance is unavoidable. But why are we going to all the trouble of regulating car insurance companies and spending our hard-earned money on policies? In short, why should we bother with insurance?

We asked Dr. Leonard Arvi, Assistant Professor of Finance at Salisbury University in Maryland, to give us a better understanding of exactly why insurance is beneficial.

Q: If tomorrow there were no car insurance, how would our world change?

Leornard Arvi, Ph.D.A: Without car insurance, the individual’s liability will skyrocket if they have a car accident and they are liable. Not only will the individual responsible for the accident have to pay the medical bills of the injured, but they’ll also have to pay for the property damage [such as the cost of fixing the wrecked car or having to replace the damaged car].

Insurance is a great innovation that reduces risk and incentivizes good driving behavior, and that makes our world much safer and more affordable.

Imagine if there are no road rules. It would be completely chaotic on the roads and a very unsafe place for everyone who drives, walks or uses the roadways. Hit and run accidents might become commonplace as people who are involved in accidents try to get away as soon as possible to avoid the costs as well as fear of prosecution. The damages caused by accidents might force many to declare bankruptcy. A world without car insurance would be catastrophic to the general public in all aspects.

Q: Does risk-based pricing -- based on health, age or geography -- defeat the purpose of insurance (and pooling risk) in the first place?

A: Insurance companies are also for-profit corporations. They would like to minimize their risk and maximize their profits. From the insurance company’s perspective, it makes perfect sense to identify riskier factors that might be too expensive to insure, and charge them abnormally high premiums to the point of unaffordability.

By pooling all types of insurable assets -- low risk, moderate risk to extremely high risk -- and by building actuarial models that quantify losses, insurance firms might be able to diversify/reduce their risk yet make a decent profit.

I am not an expert on the laws governing the insurance industry or how/where insurance carriers can or cannot underwrite policies. Insurance carriers evaluate the risks of underwriting policies, whether car insurance or homeowners insurance, based on several factors. If they conclude that the risks outweigh the benefits, they might pull out of such markets. A good example would be Florida, where there is lack of private insurance market competition due to hurricanes.

Insurance carriers pool their nationwide underwritten assets such that they can mitigate the losses in any particular geographic area. But nature and other catastrophic events are unpredictable even with the best computer-simulated models.

Also, historically the damages caused by adverse weather events and the losses suffered by the insurance industry make it less viable for insurance companies to continue providing coverage. So, risk-based pricing is a survival issue for insurance companies and it is a perfectly legitimate way for them to continue to stay in business and provide insurance in those markets that they feel they can serve. 

Q: How do you think the unprecedented aging population, or so-called "silver tsunami," will impact the insurance industry?

A: The fact is the entire global population is aging, more so in advanced economies of West, Japan and China. The aging phenomenon is a formidable challenge to the insurance industry but not insurmountable.

There are parts of the world in the developing or less developed economies which are woefully underinsured. Insurance companies need to expand their underwriting operations globally, serve the less insured populations in China, India, Middle East, and fast-growing economies in Africa and South America. By covering a much larger and younger population in these economies, insurers might be able to mitigate the loss of business in their existing advanced economic markets.

The developing and less developed economies will benefit from having insurance products for their populations. It will be win-win for both consumers in such underinsured countries as well as for the insurers that need to diversify their revenue streams.

History has shown the capitalism has the uncanny ability to innovate itself, out of necessity. I have no doubt that the insurance business will thrive by opening new markets and creating innovative products that are currently nonexistent.

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