An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk

by Allison Schrager

Often insurance is a good deal. Like magic, insurance can make some risk disappear. That’s because transferring risk to an insurance company is efficient. Suppose a model wants to insure against breaking her leg and losing months of income. If she self-insured, she’d need to put aside all that lost income, just in case something bad happens, because she bears all that risk on her own. But if she buys insurance, she only has to pay an insurance company a fraction of that lost income because it sells the same policy to hundreds of other models, and most of them won’t ever need their insurance since the odds of breaking a leg are pretty low. This is how insurance companies diversify risk: they pool all the premiums the models pay together and use this money to pay for that one unlucky model who will need to make a claim. The risk is reduced, though not eliminated. Say there is a freak accident at a fashion show and more than one model breaks her leg. The insurance company must bear the tail risk and compensate the injured models for their lost income.