People like to be protected from losses large compared to their net worth, even if they have to pay enough more than the risk might naively cost that insurance companies are able to pay salesmen and administrators salaries to offer insurance. This market is developed in spite of other difficulties in addition to these costs.

There are two classical problems with insurance, one of which is really a problem with any commodity in which the buyers and sellers have different information (which is to say, almost all of them).

Moral Hazard

 "Moral hazard" is the problem that, when one has insured away a risk, one has no (or substantially less) incentive to take steps to mitigate that risk or the cost it imposes. If I insure my home against fire, I may then be less inclined to check the fireplace a second time to make sure the fire is out; when damage does take place, I may have it fixed (for free to me), even though fixing it to less than the original condition might be substantially cheaper and worth the difference.

In this example, as in others, I generally don't insure to the point where I don't care whether the adverse condition materializes; this is one of the ways that moral hazard is mitigated, is through the refusal of the insurance company to remove all risk, leaving you with a residual risk in the form of a deductible or perhaps making you still pay 10% of the cost of an event.

The insurance company can also create other incentives for you to reduce the risk that they are undertaking on your behalf; they can offer discounts for installing a sprinkler system, for example. Many large corporations that might not be any less able to bear the expense of a loss than is the insurance company to which this might be transfered still purchase insurance, primarily as a way of outsourcing their risk-mitigation; the insurance company will do inspections and install fire sprinklers on the company's behalf.

Adverse Selection

Suppose I want to sell hurricane insurance. I find that national losses to hurricanes are $100 per $100,000 of home value over a period of time, and offer everyone in the country hurricane insurance at this rate. How many people from Iowa will buy it? How many from South Carolina?

To the extent that sellers of something can better determine its quality than buyers can, the market will tend to be dominated by goods of low quality. This tendency is called adverse selection. This is actually a broader problem than just in the insurance industry, where the problem is that the insurance company may know less about your risks than you do. If the insurance company can't distinguish between the risks run by ten people, it will offer all ten the same rate; if five of those people buy the insurance and five do not, chances are good that the ones who bought it are higher risks than the ones who did not. (That is why they found it more attractive.)

Of course, the same principle is true of used cars; a used car with a well-hidden problem may be indistinguishable to the buyer from a used car in good condition. This has two (closely linked) effects:

  1. The costs for the party with less information will be higher than its best anticipated value; while the insurance company's "best guess" might be accurate if all ten consumers bought the insurance, it will probably cost more than that to provide the insurance to the customers who do buy it.
  2. The party with less information will be less willing to make the deal than he might otherwise be because he knows there is information he doesn't have. Thus the seller of insurance may have to demand a higher price of the ten potential customers than it thinks is the right price, while the buyer of a used car may be unwilling to buy at a price he would be unwilling to pay for a likely lemon, even if the car is good.
A similar situation can obtain if a pricing structure is, in some sense, "wrong"; a bank that charges no fees for certain activities will tend to attract customers who disproportionately engage in those activities, passing along the cost to those customers and others in other forms.