accident, become ill, die, or have his home robbed in the next year. Imperfect information also applies to

estimating the risk that something will happen to any individual. It is difficult for an insurance company to

estimate the risk that, say, a particular 20-year-old male driver from New York City will have an accident,

because even within that group, some drivers will drive more safely than others. Thus, adverse events occur

out of a combination of people’s characteristics and choices that make the risks higher or lower and then the

good or bad luck of what actually happens.

How Insurance Works

A simplified example of automobile insurance might work this way. Suppose we divide a group of 100 drivers

into three groups. In a given year, 60 of those people have only a few door dings or chipped paint, which costs

$100 each. Another 30 of the drivers have medium-sized accidents that cost an average of $1,000 in damages,
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