When “It Probably Won’t Happen” Isn’t Enough: Why People Still Choose Insurance?

 

Every day, individuals make decisions under uncertainty. From buying travel insurance for a short holiday to purchasing health or car insurance, people routinely pay for protection against events that may never happen. This raises an important economic question: why do individuals choose to buy insurance even when the probability of needing it is relatively low?

Real-world behaviour strongly reflects this pattern. In the UK, car insurance is legally required for drivers, contributing to near-universal coverage. Beyond necessity, voluntary insurance is also widespread: millions of travellers purchase travel insurance each year despite relatively low claim rates. Globally, the insurance market was valued at over $6 trillion in 2023 (Swiss Re, 2024). In the UK alone, insurers paid out approximately £11 billion in general insurance claims in 2022, highlighting both the scale of risk and the demand for financial protection (Association of British Insurers, 2023).

Students frequently ensure laptops or phones, even though the probability of theft or damage is relatively small. Similarly, many individuals pay for extended warranties on electronics, despite evidence that such warranties often cost more than the expected repair value. These decisions suggest that individuals are motivated by more than just simple cost-benefit calculations.

Isn’t this violating economic intuition? At first glance, this behavior may appear irrational. Based on expected value alone, insurance premiums often exceed the expected monetary loss. Sometimes our loss even cannot be valued by the monetary compensation from insurance. However, as highlighted in microeconomic theory, individuals evaluate uncertain outcomes using expected utility rather than expected value. In particular, humans are born to be risk-hated, preferring a certain outcome over a risky one with a similar or even higher expected return.

This blog explores why individuals continue to purchase insurance despite low probabilities of loss. Drawing on concepts such as risk aversion and expected utility, this blog examines how decision-making under uncertainty often departs from standard profit-maximizing assumptions.

 

Expected Utility Theorem: The Microeconomic Logic Behind Insurance Demand

Insurance decision-making is influenced by Uncertainty and Risk Aversion (People’s dislike of risk). In daily life, there are many unexpected situations that like accidents, illness or injury. Although they occur rarely at once, the financial loss can be considerable. As a result, most people have been afraid to take risks, being content with just something safe and certain (Varian, 2014). What matters is not just how much money we may lose, but also how that loss would affect our life.

This is where microeconomics gives an important explanation through Expected Utility Theory. People evaluate outcomes not only by money itself but also by how beneficial or costly the result feels to them personally (Von Neumann and Morgenstern, 1944).

If a person’s wealth is , and there is a chance  of losing $, then without insurance the future situation they face is uncertainty. However, with insurance, they pay a fixed premium p and avoid the risk of a great loss in the future.

We can easily get:

Without insurance, the expected utility is:

 

With insurance, the expected utility is:

 

A risk-averse person will choose to buy insurance whenever:

 

In simple terms, uninsured individuals are exposed to wealth outcome uncertainty: they face a probability p of incurring economic losses, and a probability of 1-p to maintain their original wealth level. By purchasing insurance, individuals surrender a fixed sum of wealth, namely the insurance premium, to obtain fully predictable wealth status. For risk-averse economic agents, this wealth trade-off is highly favorable. The utility loss brought by massive wealth shrinkage is far more severe than the utility decline caused by paying a fixed, low premium.

The result depends on the assumption that the utility function is concave, which implies diminishing marginal utility of wealth. In other words, for a risk-averse person, the utility loss from a large fall in wealth is greater than the utility gain from an equally large increase. This is also emphasized in behavioural economics. Because of loss aversion, people are usually more sensative to a loss than to receive a benefit of the same amount (Kahneman and Tversky, 1979).

 

What Role Does Insurance Play In This?

Economically, insurance functions as a mechanism for Risk Pooling and Risk Transfer. In other words, insurance helps people transfer risks to the insurer in exchange for stable financial situation in the future. By paying a fixed, predictable amount, people avoid the possibility of a significant loss later.

This is especially important when the loss would generate a sharp fall in welfare. For many households, a sudden expense such as medical treatment, phone replacement, or travel disruption may create liquidity pressure even if the probability of that event is low. After all this, insurance provides not only financial protection but also peace of mind, which many people consider highly valuable.

Insurance markets are also shaped by information asymmetries. In particular, Adverse Selection arises when higher-risk individuals are more likely to purchase insurance, which may drive up premiums and reduce market efficiency (Akerlof, 1970). This means that insurance demand is not only about personal preferences toward risk, but also about the structure of the market itself.

 

New Insurance Appearing

There are also more and more new and flexible types of insurance appearing nowadays. Compared with traditional insurance, these are often more suitable for daily life. Parametric Insurance provides compensation according to an objective condition. For example, it may pay out depending on how long your flight is delayed. Usage-Based Insurance is a more flexible type of insurance that sets prices according to your previous behavior. The most common example is car insurance. In this case, the insurance company does not only evaluate your age or car type, but also considers your driving style and driving experience in order to see whether you drive safely.

 

Reference:

Varian, H.R. (2014) Intermediate Microeconomics: A Modern Approach. 9th edn. New York: W.W. Norton & Company.

Kahneman, D. and Tversky, A. (1979) ‘Prospect Theory: An Analysis of Decision under Risk’, Econometrica, 47(2), pp. 263–291.

Von Neumann, J. and Morgenstern, O. (1944) Theory of Games and Economic Behavior. Princeton: Princeton University Press.

Akerlof, G.A. (1970) ‘The Market for Lemons: Quality Uncertainty and the Market Mechanism’, The Quarterly Journal of Economics, 84(3), pp. 488–500.

Swiss Re (2024) World insurance: Strengthening global resilience. Sigma Report. Available at: https://www.swissre.com

Association of British Insurers (2023) General insurance claims statistics. Available at: https://www.abi.org.uk