Why is auto insurance required?

Of all of the personal lines of insurance, only auto insurance is mandatory. (To be more specific, it’s required if you drive a car on public roads. Those who ride the train or drive only on private roads aren’t obligated to get coverage.)

So why does the government require insurance?

In answering this question, it helps to understand the economic concept of externalities. (You don’t need a Ph.D. to understand the definition, so don’t click away just yet!)

An externality is a result of a particular economic activity, an activity either conducted by a person, business, or government. Shortened, an externality is a side effect.

Externalities can be both positive and negative, but the ones you hear about in the news are usually negative.

Take the example of a nuclear power plant, which is dumping the water it uses to cool its reactors into the nearby stream. The hot water alters the river’s ecosystem and all of the fish subsequently die off.

Meanwhile, down river, Bob, who operates a fly-fishing outfit, is suddenly faced with a fishless river. He is the victim of a negative externality. He had no economic stake in the nuclear plant’s activities, but he is paying a price nonetheless.

OK. Now that we understand externalities, let’s get back to car insurance.

It all has to do with the unique ability of cars to cause significant damage, either in the form of property damage or bodily injury.

“We force people to buy auto insurance to protect others,” says economist and writer Megan McArdle. “Drivers have a high potential to cause damage they can’t pay for.”

In a car insurance-less world, driving would be too financially risky; someone could smash into your car, send you to the ER with a broken leg, and that someone could be unable to pay for the damage that their recklessness caused.

In such a world you’d be stuck with the bill.

In short, McArdle says mandatory car insurance is “a social arrangement to minimize externalities.”

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