Friday, January 09, 2009

Why is Gerber Offering Life Insurance for Children?

Let me explain briefly how insurance works (because many people seem to wrongly think of insurance as a discount program or even a scam). Suppose the future has two possible states: One in which your house burns down, and one in which it does not. People who do not like risks (such as the risk of one's house burning down) would like to make that state of the world a bit better, and are willing to make the good state of the world (the one in which one's house does not burn down) a bit worse in order to do so.

Therefore such risk-averse people buy insurance. The agree to pay the insurance company a certain amount of money, in exchange for a promise that the insurance company will pay the insured if the bad state of the world should occur. The insurance company is, in a sense, taking a gamble that it will not have to anything (because the bad state of the world probably will not occur). In return the insured gets a reduction in risk--the bad state of the world is not as bad because it now involves being paid, and the good state of the world is not as good because the insured has to pay the insurer.

In another sense, however, the insurer is not really gambling, because it insures a large number of people. This makes the rate of payouts predictable. That is, if there is a 5% chance in a given year that a person's house will burn down, and the insurer sells insurance to 10,000 homeowners, then it should expect to pay claims to about 500 people.

Okay, that's insurance. What prompted this post was a reminder from Richard Phillips, one of my students, about a new program from Gerber Life, an insurance company. At least, I think it's new--they started advertising it on TV recently. They are selling insurance for children. That is, a parent can insure themselves against a child's death. When the child turns 18, they take over the policy, and can presumably decide who the beneficiary is.

This is puzzling. It doesn't really make sense for a parent to insure against a child's death. Why? Consider this: In which state of the world is money more valuable to a parent, the state in which the child is dead, or the state in which the child is alive? I would hope most parents would say the latter. Money is more useful, and more fun to spend, when one has children. Toward which state of the world does this policy redistribute income? Toward the later. This is backward. Money cannot make up for the loss of a child, and in fact money is less valuable after a child's death. It would make more sense to avoid paying the premium altogether (i.e. not purchase the insurance policy) in order to have more money in the state of the world in which the child is alive.

So why is Gerber Life offering this policy? I'm not sure. Here's a ridiculous and somewhat offensive explanation: Suppose some children are likely to die by, say, blowing themselves up in a crowded place. Doing so creates a lot of damage, and an insurance policy might be valuable to a parent in order to pay for some of this damage. This could create an adverse selection problem, however--only those parents whose children are likely to blow themselves up are likely to buy the policy. This makes it a bad bet for the insurer, and therefore the insurer is unlikely to offer the policy. On the other hand, if parents are unsure whether or not their children are likely to cause significant damage to others upon their deaths, the policy might still be offered profitably.

Another unlikely explanation might be that this policy appeals to evil parents who plan to murder their children. The adverse selection problem would still exist, though. And of course, the policy might appeal to people who haven't thought clearly about this and think insurance is always good (and who apparently have money to throw away).

What other explanations could there be? Will this insurance program last long, or will it disappear?

UPDATE #1: I anticipate one argument being that this allows the child to take over a substantial life insurance policy at age eighteen. I'm not sure if this argument makes sense. First, a healthy 18-year-old shouldn't find life insurance very expensive anyway. Second, a parent could probably do better buying a broad index of stocks, waiting eighteen years, and then selling the portfolio to buy generous life insurance. Finally, most 18-year-olds don't have any dependents who would need a life insurance anyway.

UPDATE #2: Matt Freeman commented on this on Facebook, and I'm pasting his comment here:
These types of policies have been around for a number of years. The cost is truly de minimis relative to insurance for adults (as you would expect) and the pitch is that it is for the child in the event that the child would develop a medical or other condition that would make them uninsurable (or would make the cost of insurance excessive). For this de minimis price, you can be certain they will have access to this insurance policy. There are some risk advserse people for whom this would have appeal. For me personally, I look at the exorbinant rates I get charged for insurance compared to LeAnn since I am type I diabetic (about 10x the price for term and even a higher % for permanent insurance) and there is some appeal to the notion that if my child develops type I diabetes or some other condition that they would have a policy that would not be based on those inflated rates. (Inflated because they lump lower life expectancy type II and normal life exp type I's together).

That answers most of my questions. This insurance is really insuring the child against the possibility that they have serious medical conditions, which might later make it difficult to afford life insurance. That makes sense, although again I wonder if it would make more sense to just invest the money. That way, when the child gets older, there would be money that could be used for a variety of things, one of which might be expensive life insurance. There could also be an adverse selection problem here, if parents have an inkling of whether or not it is likely for their children to develop such a health problem (which is probably not the case).

Matt raises another puzzle, though: Why would an insurance company lump policy holders with Type I and Type II diabetes together? Doing so means forgoing profits. If people with type I diabetes live much longer, then the insurer is giving up substantial profits. It could lower premiums, sell more policies, and not have to pay out much in claims. They have dedicated actuaries who do nothing but calculate this stuff all day--why are they leaving money on the table?

5 comments:

pkasting said...

Typo: At the very end of the first paragraph, the last "better" should be "worse".

Mike Hammock said...

Noted; thanks!

Mark said...

I actually saw this commercial as well and I was stunned. It's not a new practice though, so there are obviously people cajoled and misled into buying these policies. It's not illegal, so anything goes of course!

Insurance News

arizona carpet cleaners said...

insurance companies can accurately predict in most cases the number of people who die each year. that makes their business very predictible. life insurance companies are some of the most profitable.

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