Insurance is a method of pooling risk to minimise the cost of rare events to any one person.
Insurance works well for situations where the risk has low likelihood, but high impact. For example, the likelihood of a person's house burning down is quite low. However, the impact on the inhabitants is enormous, if it does happen. House insurance is method for pooling the risk and spreading the costs of fires across all homeowners.
In a city with a thousand homes, only one homeowner might experience a catastrophic fire in their house in any year. If everyone who lives in the city pays into an insurance fund, each home owner will only have to pay one thousandth of the cost of rebuilding a home to give the insurance fund enough money to pay for the cost of replacing the one house that is burnt down.
Homeowners have several good reasons for paying into an insurance fund.
No one knows in advance who will have a fire. It might be me.
The cost of a fire would be devastating for the family whose house burns.
The cost of the insurance is relatively cheap.
The probability of a house going on fire can be estimated by investigating at the history of house fires.
Insurance deals effectively with risk like a house fire, because it is relatively rare. The insurance company is able to estimate the probability of fires occurring and calculate an appropriate level for premiums. Everyone benefits from sharing the costs of the fire, because they know that next time they could be the one facing a tragedy.
Insurance is very effective for risks with low likelihood and high impact, but it stops working if the risk changes from being low likelihood to extremely widespread. That is why insurance companies have exemptions for extreme events like war and "acts of God". If the city is bombed during a war, nearly every house might be burned down. In that situation, sharing the cost does not help. Paying for a thousandth of the cost of rebuilding all the houses is no cheaper than the cost of rebuilding your own house. Pooling the risk of an event that will affect everyone the same makes no sense. Insurance cannot deal with a widespread risk, because there is no benefit in pooling the costs.
Risk Always Remains
Insurance pools risk, it does not eliminate it. When all the people in a city take fire insurance, the risk is transformed, but it is now concentrated in the insurance company. If dishonest people gain control of the insurance company, and embezzle the premiums and reserved held in trust, the company might default on its promise to rebuild houses that are burnt down. The risk of the insurance company defaulting is even lower likelihood than the risk of a fire, but the impact is even greater. The people of the city can spread this risk by dealing with several insurance companies, but the risk can never be totally eliminated.
The huge AIG insurance conglomerate has been bailed out by the US Government. The principles outlined above explain why they got into trouble. AIG was insuring various kinds of debt instruments (CDOs) against the risk of default. Most of the CDOs were based on residential mortgages in the United States. Insurance made sense while the risk of mortgage default was low likelihood and high impact. In normal times, the risk of a homeowner defaulting on their mortgage is quite low, even though the loss could be quite large, on the rare situations when they did default. Pooling the risk of mortgage default due to the vagaries of life was sensible.
Everything changes in a housing boom. When credit is flowing freely and every man and his dog is flipping houses, the nature of the risk changes. The boom eventually collapses and house prices fall. The risk of default ceases to be low likelihood, as default becomes widespread. The insurance companies set their fees as, if the risk was low, but now the risk is widespread and high impact, they are unable to compensate all those who face looses.
Banks and Risk
The banks and other financial institutions that bought CDOs also misunderstood the nature of risk. They assumed that insurance against default had eliminated the risk, so they purchased these financial instruments as if they were risk free. The reality was that they had swapped one form of risk for another. The risk of many homeowners defaulting had been replaced with the risk of a large monoline insurance company failing and defaulting on its obligation.
The risk of AIG defaulting could not be estimated on the basis of previous history, because this type of event does not happen very often. The default risk for AIG was probably very, very small, but the impact would be absolutely huge. The banks and institutions who trusted in AIG did not take this risk into account. Once the risk of mortgage default became widespread, the risk of AIG defaulting changed quite dramatically, but by then it was too late for any changes to mitigate the risk.
The government came to the rescue of AIG, but that did not eliminate the risk. The risk was just transferred to all the taxpayers of the United States. This is not pooling of the risk, but pooling of the costs of default.