Financial planning is about making sure you will always have an adequate income to support your life style. The fun part of planning is investing, accumulating enough wealth to produce the income you need so that you will no longer need to sell your body, I mean labour. That independence is the destination your financial plan is working towards.

Now go back to my last column in April, about what can screw you up on your road to freedom. That is less fun. But we can plan for life’s risks as well. Before getting to the fun part, you need to deal with setting up a risk management plan using insurance. But before you look at buying insurance, you need to understand insurance. That is our mission for this month’s lesson.

The economics of the insurance business is about pooling risk. Say for a pool of a thousand homes, there is a risk, determined by actuaries from statistical data, of one house burning down each year with a total loss of $250,000. Each of a 1000 home owners puts $250 a year into the pool. Whomever’s house burns down is compensated for their loss with the $250,000 in that year’s pool. An insurance company adds a margin for administrative costs, and profit, and the risk of higher than expected losses, a risk they may insure with other companies called re-insurers to further spread the risk in larger pools. The result may be a premium of $500 to insure your home. If that was all there was to it, then every insurance broker would have the same price and it would not matter where you bought yours.

But you should also appreciate the behavioural economics of insurance; the psychology of economics is every bit as important as the mathematics. Human behaviour is the foundation of the supply and demand curves: self-interested consumers buy more when the price goes down or sellers put it on sale to move extra supply. Or self-interested sellers may hold back supply to keep the price up. Competition might then attract a new supplier who thinks they can make a buck offering a lower price. That’s how it is supposed to work. But then the waters get muddied by marketers using techniques such as branding. A distinctive brand on a generic product tries to convince a consumer that their branded product is worth more; think Apirin versus ASA. Marketers, be they selling cars or groceries, will have special names to make their generic products sound different, or insert “features” to give an impression of more value. Marketers say that “packaging is 90% of the product”; an attractively presented product is more saleable, at a higher price. Insurance companies are no different.

The particular behaviour affecting insurance freakonomics is “risk aversion”. This is the human tendency to buy more insurance as the risk of a loss gets greater and/or the loss has a greater impact.

Risk aversion behaviour creates a gap between the risk neutral pooled risk cost curve and what people are willing to pay for protection from the risk. This gap in the risk neutral versus the risk-averse curve is where insurance companies make their money. Your job is to realize that companies will try to capitalize on your fears to sell you more. You need to understand they are using your fear to move more product. But you can now buy your insurance objectively, because you understand the marketing.

The Cost of Risk Aversion

The third principle behind the insurance business is insurability. Now hear this: insurance companies are not charities. When you are betting that your premium is a fair price for the odds of you collecting, they are betting they will not have to pay. The result is that they will only offer insurance if you are a good risk. One of the most important things you can insure is your insurability. Even though a child may not have an income to insure, starting them off with a policy that provides some savings while also giving them guaranteed insurability options in the future can be worthwhile. For a young person just establishing their income, insurance is so cheap at 25 or 30 that it can be a good investment just for protecting insurability for future needs. If you wait till you appreciate the need and importance of insurance, say at 40, you may have developed blood pressure, early diabetes or a myriad of other health concerns, or taken up a hazardous hobby, that will get you declined, or at best rated, by insurance companies.

Before you set out to buy insurance, understand the rational economics of the pooling of risks, as well as the irrational marketing of insurance based on risk aversion, and the risk of being able to plan for life’s risks with insurance if you yourself are at risk of becoming not a good risk.

Come June, we can turn to how to buy insurance to get the best value for our money.

Fredrick Petrie, author of “THE END OF WORK: financial planning for people with better things to do”, practices financial planning at Mortgage Logic, 1793 Portage Ave., Winnipeg, MB.  (204) 298-2900

Addendum

Risk-seeking freakonomics
The risk aversion curve of behavioural freakonomics also explains the lottery business. We all know that the chances of winning are remote, even stacked against us. Nevertheless, if the reward is large enough, even though the possibility of winning is miniscule, we are induced to risk-seeking behaviour and buy a ticket. My freakonomics rationale is that I know I will only win the lottery if “God” wants me to. If God wants me to, all I need to do is buy one ticket. “I’ve done my part God, now make me rich!” Guess God wants me poor, but just in case He changes his mind, excuse me while I run next door to the 7-Eleven to get my 6-49 ticket!