Gambling and insurance are unfair bets. Hmm … so … why would anyone ever gamble or insure?
The answer lies in risk. Informally, risk is the variability in your future well-being. To illustrate, imagine two 50-50 bets. In Bet 1, you’re either up $1M or down $1M. In Bet 2, you’re either up $1 or down $1. Bet 1 is riskier than Bet 2. Because with Bet 1, there is greater variability in your future well-being.
The one fundamental difference between gambling and insurance is that gambling increases risk, while insurance decreases it.
Say that to enter a bet, you first pay the house $1. If the specified event occurs, your payout is $301, so that your net gain is $300. Suppose the event is: “roulette ball lands on 6”. Then this bet increases your risk and is gambling. Let’s see why.
The two possible outcomes are “ball lands on 6” and “it doesn’t”. If you bet, you’re either up $300 or down $1. Your well-being varies a lot across future outcomes. But if you don’t bet, you’re unaffected either way. Your well-being doesn’t vary across future outcomes.
By betting, you increase the variability in your future well-being. In other words, the bet increases your risk. It is therefore gambling.
Now, suppose instead the event is: “your phone is stolen”. Then this bet decreases your risk and is insurance. Let’s see why.
The two possible outcomes are “your phone is stolen” and “it isn’t”. If you don’t bet, then across those two outcomes, your well-being probably varies a lot. But if you do bet, then in the first outcome, you’re down a phone but up $300. In the second, you’re down $1 but still have your phone. And so your well-being is probably similar across those two outcomes.
By betting, you decrease the variability in your future well-being. In other words, the bet decreases your risk. It is therefore insurance.
So, again: Why would anyone ever gamble or insure? The quick answer is that some people like risk, while others dislike it. And so, even though both are unfair, some people like gambling, because it increases their risk. While others like insurance, because it decreases their risk.
But why do some people like risk while others dislike it? And is risk good? Or is it bad? In the next video, all will be revealed.