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In an ideal world, the function of insurance is to make policyholders’ losses equal to or less than the losses they would reasonably expect to suffer when assessing at a risk situation from the outset. Policyholders pay premiums equivalent to the likelihood of loss times the payout they will receive in the event of that loss, plus anything they are willing to pay as profit in exchange for the certainty of knowing what their losses will be and the ability to plan accordingly—the “peace of mind” touted by insurance advertisers. When possible, insurers increase returns on premiums—for instance, by investing them—and reduce their own risk—through diversification of the types of risks they assume—in order to make a profit while charging premiums of an amount lower than the losses policyholders could expect to suffer without insurance.
Ours is not an ideal world, however, and the distortions from which it suffers include coverage mandates and laws requiring insurers to participate in residual markets. Though promoted as a way to make sure that people at high risk can buy insurance, coverage mandates also force consumers to buy insurance, often at above-market rates or for risks they do not face. When states make insurers participate in residual markets, insurers must usually cover high-risk policyholders at insufficient rates and pass on the resulting losses to other policyholders.
Fortunately, there is a feasible solution to the market distortions and high costs that these requirements impose on both insurers and consumers: Interstate insurance choice.