Insurance refers to an arrangement whereby one party (the insured or buyer of insurance) contracts with another party (the insurer or seller of insurance) whereby the insurer agrees to bear part or all of the cost to the insured party arising from some adverse unanticipated event, if that event occurs within some timeframe.
A premium is an amount the insured party pays the insurer to acquire the insurance. The premium is the main source of revenue for the insured party.
A deductible is an initial part of the cost arising from an adverse event that the insured party has to pay.
A copayment or copay is a fraction of the cost from the adverse event that the insured party has to pay. For instance, an insurance contract may stipulate that the insured party needs to pay a fraction of 10% of the cost.
Advantages of insurance
Insurance is viewed as a means of risk diversification. For one party, having to pay a huge amount to cover the costs of an adverse event may lead to ruin, and the party may prefer to expose it self to this risk, even if it has low probability. An insurer who insures a large number of parties with small levels of risk may be able to make a profit. Insurance fundamentally arises from the fact that the utility cost to an individual arising from an adverse event is not proportional to the cost.
The collection of insured parties is sometimes referred to as the risk pool or insurance pool.
Potential problems with insurance
Further information: adverse selection in insurance
The general problem of adverse selection occurs when one party to a trade knows more about the quality of the good being traded than the other. In the case of insurance, this could arise when the insured party knows more about the probability and potential cost of the adverse event than the insurer. Since the insurer will try to charge a premium that reflects the average level of risk in the pool, the people who choose to buy insurance are likely to be more skewed toward those who are riskier than average. This drives up the average risk in the pool, causing the less risky people in the pool to drop out, driving up the cost still further.
Whether this problem occurs in practice depends on whether insurers have effective ways of determining risk levels. In some situations, insurers, who have more resources and technical knowledge about levels of risk, may actually be better informed about the probabilities and costs of adverse events than those seeking insurance, even if they do not know all specific details about those seeking insurance. In some cases, insurers may vary insurance premiums, deductibles, and copayments based on crude metrics such as demographic factors and personal histories. While this may not solve the problem of adverse selection completely, it may mitigate it to a level where an insurance market can function.
Further information: moral hazard
The general problem of moral hazard occurs when one party to a trade can take an unobservable action that imposes additional costs on the other party. In the case of insurance, the moral hazard problem arises if the insured party undertakes more reckless behavior than it would without being insured, because part of the cost is being borne by the insurer now.