How Insurance Works

Most people think of insurance as purchasing coverage for specific future events, which does explain insurance pretty well, but this does leave the economics of the situation somewhat unexplained. Are insurance companies making windfalls from the premiums they charge?  Do we get what could be considered fair value from buying insurance?

In a sense, insurance companies are a lot like banks insofar as they serve as financial intermediaries between people saving up to cover future expenses for certain events and those who need the money.

How Insurance WorksLet’s say someone wants to save for a certain life event. The risks involved are undetermined, meaning that you may not even know how much you will need to save up, and there’s also a lag between the amount you have and the amount you may need. Quite likely, something may happen and you won’t have the money to cover it, which means that you aren’t fully protected and may not be protected in a satisfactory way at all.

So this isn’t an effective way to cover yourself for these incidents for the vast majority of people and even for large businesses. Even insurance companies themselves take out insurance with other insurance companies so that they can cover these risks that occur.

So individuals might engage in a venture where the group all contributes a certain amount per month and this would end up accelerating the savings to the point where if an incident happened to one of the members of the group, they could draw upon the pool of money collected to cover it.

This is called pooled assets and leads to spreading the risk among more people, which is basically what insurance companies do, they just do it on a much larger scale. The bigger the scale here, the better, as the law of large numbers kicks in which makes outcomes more predictable.

Insurance Is A Lot Like Casino Gambling

A casino only has a small edge on players, and on any given bet, the chances of the casino winning are only slightly better than their losing. However, when we account for many bets, thousands or millions, the more bets are made, the more likely that the outcome will deviate less from the normal distribution of probability, meaning that the casino will enjoy the mathematical edge it has over the mass of bets made, which adds a lot more certainty to the outcomes over time.

To be able to do this, the casino needs lots of customers and lots of bets, and also needs the resources to handle the variances. So if an individual or a small group of people tried this, they could run into some bad luck and be busted. Casinos are far less likely to even be able to be busted, and this is a rare occurrence. Since this would put them out of business, they just make sure this doesn’t happen.

There’s also some expertise involved, the casino needs to know what they are doing, making sure that the odds and the maximum stakes are set to manageable levels, to manage their risk. They also need to be well run to ensure that this economic edge that they have on their players will translate into a profit each year.

This is a lot like what insurance companies do, although the insurance business is quite a bit more competitive than the casino business. Casinos compete with each other with various things, but generally don’t compete that much in terms of return to the player, their edge.

Casinos compete on price though to a certain extent, and some regular casino players do pay attention to these things, in order to look to get more value from their gambling dollar. This is more the case online, which tends to be more transparent, than at land based casinos, especially those catering to tourists.

So insurance companies do business with a lot of clients and collect money from all of them, and the sheer magnitude of the funds they collect and the risks that get pooled among the large group allow them to both handle the payouts and predict the extent of the risks to an acceptable degree.

So a certain person may have a certain probability of something happening due to bad luck, but as many bets take the luck out managing casino action, the large amount of people involved in insurance schemes take the luck out of covering for the cost of future events for the insurance company.

Just like casinos, insurance companies get by on pretty thin margins, and make their money from the sheer volume of the business that they are doing, and a good part of their profit is made by investing this money they hold, making insurance even more efficient.

So by buying insurance, you are engaging in a managed co-operative of sorts, and while the insurance company does get a cut of this, it’s a quite small one on average, and they do add a lot of value to the proposition, to the extent that it is necessary to insure in most cases to even be well protected.

The Pricing of Insurance

The pricing of insurance isn’t as transparent as most other goods and services, due to the often more personal nature of pricing, and this is why people get invited to obtain quotes rather than rates being advertised generally like you would see with a lot of other things.

This does lead to some inefficiencies, and people are often surprised by the variance in the cost between insurers, which does tell us that it certainly does pay to shop around for this. This is particularly the case since policies and relationships with particular insurance companies tend to be long term relationships, and you want to make sure that these long term deals are at least competitively priced.

The nature of managing insurance does lead to these variances though, and one company simply may be able to manage this better than another, perhaps due to sounder management or things like economies of scale. Some insurance companies may also be happy getting by with smaller margins and may be shooting for more volume, where another may be relying more on things like relationships or marketing.

Since there are so many different situations that occur in insurance, this makes it less likely that the market will be as efficient as it would be with something more like a commodity. Insurance companies assess risk taking into account a broad number of things, for instance with car insurance, the type of car, how it is driven, the age and experience of the driver, their driving record, and so on.

So it’s not that they could just offer a deal such as this much a month for car insurance, as the price is going to depend on a number of things, and prices must be provided on an individual basis. So that’s what people must do when shopping for insurance, get quotes from several providers, and while this can take some real time, it’s generally time well spent.

Insurance Is A Legal Contract

When you purchase insurance, you are entering into a legal contract with the insurance company. They agree to indemnify you against certain specific events, and you agree to disclose all relevant information and pay a premium for the coverage.

There are often a lot of terms and conditions to an insurance contract and while people usually skip over these things, it’s not a bad idea in this case to actually read the terms of the deal, because otherwise you aren’t even going to be sure what you are buying.

If an event happens and it turns out that you thought your policy covered it but it did not, you could be left uninsured for the event. You may have been able to purchase additional coverage in this policy or in another policy, maybe from a different company, if you were aware of this, and the time to become aware is not after the incident takes place, because it’s always too late.

Some people think that it may be a good idea to provide false or incomplete information on an insurance policy, since this can mean lower rates. However, if this is discovered while making a claim, the insurance company will refuse to pay the claim. They do not have to provide any sort of refund either, so this can lead to your not only not being covered for the incident, it also can lead to your wasting the money you paid for the policy.

So it is important to take this into account, and this is a case where honesty is generally the best policy. Insurance companies aren’t going to investigate your information when they sell you the policy, but they certainly might when it comes time to paying you, as they now have a financial stake in the accuracy of your information,.

Making Risks Manageable

The goal of insurance isn’t necessarily to eliminate all risks, but to make them manageable. This starts with making sure that what you insure is something that is going to provide at least some financial hardship, as it really doesn’t make sense to pay a risk premium for something that you aren’t going to be bothered by very much if it happens.

In some cases this can also mean sharing some of the risk, for instance by being responsible for paying a deductible. So if something happens, you wreck your car for instance, you may have to pay a certain amount out your own pocket, an amount you would be fairly comfortable with, and have the insurance company pay the amount you would not be comfortable with or could not otherwise make.

This actually makes a lot of sense because once again you only want to insure against the financial hardship that occurs with events, not the part that isn’t hardship. Deductibles also keep the cost of insurance down as it prevents people from making claims for negligible amounts and the more claims that are paid out, the higher the premiums must be.

Other than that, one can buy insurance to protect themselves against virtually any risk that they may likely encounter. One needs to have an insurable interest in the matter, for instance you can’t insure your neighbor’s car, and this wouldn’t make sense anyway as you don’t have any economic interest in it so there wouldn’t be anything to protect.

The goal of insurance is not to profit, it is to minimize risk, and therefore it is only when one is looking to reduce risk that insurance even comes into the conversation.

Insurance is a great way, and in many regards a necessary way, to protect ourselves against life’s uncertainties.



Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

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Topics of interest: News & updates from the Federal Deposit Insurance Corporation, Retirement, Insurance, Mortgage & more.