Adam Smith on the paradox of insurance

Happy “1st of tha Month“! My previous post presented Adam Smith’s analysis of the psychology and emotional appeal of lotteries. In summary, we are motivated by the size of the prize, not the mathematical probability of winning: we buy lottery tickets out of the “vain hope” we might win a life-altering prize. But then why do most people also refuse to insure against large losses? How do we explain the fact that many of the same people who buy lottery tickets also refuse to pay for various forms of insurance? For Adam Smith, the so-called lottery-insurance paradox is a chimera. Instead, the paradox is why insurance markets exist at all! Left to our own devices, most people will avoid buying any insurance at all because of optimism bias: we undervalue the chance of loss. By way of example, how many of the insurance policies pictured below, would you have if you weren’t required by law or “nudged” by our employers to have them? By way of concrete example, how many houses in Smith’s day…