| > why should it matter what others are willing to pay for it? Because the actual value of the item determines your incentive to commit fraud. If you insure a $10 pillow for $10, when you damage your pillow, you personally will definitely be out $10's value in goods in the hope you'll recover that $10 later. Since your only outcome is mildly negative, you don't have any incentive to file a false claim. If you insure your $10 pillow for $1 million, as soon as the insurance is in hand, will have a strong incentive to destroy the pillow and try to collect a million dollars, since $1 million - $10 = $999,990. This incentive exists regardless of what premium you had paid for the insurance (since it was a prior cost), and can't really be perfectly mitigated. Yes, you can criminalize fraud, ask for evidence, etc. but courts aren't perfect and it's always possible to be clever and fool people. Also, some people are honest, and others are dishonest. An insurance company can't perfectly tell ahead of time who is who. Let's say I quote you $500k premium to insure your pillow for $1mm. A fraudster will see this as an opportunity to profit by $500k - $10. An honest person would see this as a terrible deal. Therefore only fraudsters would take this deal. If you continue to work backwards, as an insurance company you know there's no premium that you could quote that would end up in honest people taking this deal—there's no stable equilibrium where the premium charged ends up outweighing the (potentially fraudulent) claims. Btw, this situation is famously described in George Akerlof's paper The Market for Lemons (he called it "market collapse"): https://en.wikipedia.org/wiki/The_Market_for_Lemons#Conditio... Another way to see this: rationally as an insurance company, if you ask me for a policy for $1mm on a pillow, due to the risk of fraud I will likely be quoting you close to $1mm as the premium. You (as an honest person) rationally would never take this policy. Therefore, I shouldn't even bother offering it, to save everyone involved time and energy. |