So take 10,000 people, each with a 1% chance of incurring a $10,000 charge. You'll probably end up with about 100 people suffering the charge, or about 1 million dollars of pooled risk. If you charge $100 to each of the 10,000 people you can protect everyone from a devastating $10,000 charge with a relatively affordable premium. You might tack on about $5 a piece for your profits.
This is insurance. You knew that already, I know. The punchline is that each person effectively pays for his own risk. That is, if the risk wheel were spun over and over, the amount each person pays as a result of incurring the fees would about equal their premiums.
On the other hand, when you pool people with different levels of know risk and charge everyone similar premiums, you are no longer selling a true insurance product according to Dr. Orient's definition. Take 10,000 people. 5000 have a .5% chance of incurring the $10,000 charge. 5000 have a 2% chance of incurring the same charge. Overall, you have about a million dollars of risk in the group. But if you charge each a $100 premium, you're effectively overcharging those with lower risk and undercharging those with higher risk.
The question becomes: Is this fair?
- Makes insurance affordable for high-risk individuals
- Unfairly penalizes low-risk individuals. In fact, it effectively takes a valuable product off the market.