From crossing the street, to purchasing a new home, to traveling on an airplane, we all face risks daily. We’ve found ways of avoiding or minimizing certain risks, but it isn’t possible to avoid them all. Some risks are trivial, like feeding and burping a baby after work while still wearing your suit. Other risks are significant, like the loss of a house, auto or income due to disability or premature death. Proper risk management is essential to securing your financial future. This means effectively using insurance to protect against events that would significantly impact your financial future if they occurred.
Insurance is the means by which you secure protection for yourself and your family against unforeseen circumstances. Auto insurance helps protect you from financial loss on an automobile due to accident or theft. Health insurance provides financial support for medical-related costs. Life insurance is designed to protect your dependents from a sudden loss of income caused by your untimely death.
Insurance is a way of transferring risk. In the face of a possible loss, an insurance plan shares the cost of the loss among a group of people facing a similar risk. In this way, none of the participants bears the entire cost alone. For example, consider a neighborhood of 400 houses in which, on the average, one house burns down every year. If the cost to replace a house averages $200,000, then the cost of that loss—spread out among all the homeowners—averages only $500 a year.
The purpose of an insurance company is to organize this risk transfer. Continuing with the previous example, an insurance company would collect a large enough premium from each homeowner to cover the aggregate annual loss of $200,000. By adding somewhat to the premium, and by building and maintaining a cash reserve during years when no houses burn down, the insurance company can also cover the less likely eventuality that two or more houses burn down in the same year. Following a loss, the insurance company is then responsible for validating and paying the resulting claims.
Of course, the actual calculations used by insurance companies to price risk are far more complex than the example above, since they must account for multiple risk factors (fire, flood, storm, etc.) as well as location, demographics, and a host of other issues.
Based on such calculations, insurance companies determine what are insurable risks. An insurable risk must meet the following criteria:
- The risk must be definite and difficult to falsify. Death is the best example of a definite, easy-to-validate risk.
- The risk must be unexpected, i.e. have a likelihood of occurrence of less than 100%. The risk of an automobile accident is insurable, while the risk that your carpeting will eventually wear out is not insurable.
- The risk must be large enough to cause a financial hardship. An insignificant risk, such as the risk that you’ll lose a pocket comb, is not insurable.
The above points illustrate a central truth about insurance: it is a business, and insurance companies are not in business in order to lose money. In order to remain profitable, insurance companies have expended prodigious resources over many decades—centuries, in some cases—to achieve an increasingly precise, quantitative understanding of the risk factors influencing nearly any conceivable loss. The resulting policy decisions sometimes feel like rank discrimination—a male teenager, for example, will pay several times as much to insure the same car as a married man in his mid-thirties with a similar driving record—but the risk factors underlying these differences are no less real.
A direct consequence of the nature of insurance as a profit-driven business is that, in the theoretical long run, it will always cost more to insure a set of potential losses than it would cost simply to pay for the losses as they arise (otherwise known as self-insurance).
So why bother? Two reasons:
- Most people do not have the ability to keep $200,000 in a savings account against the possibility that their house might burn down, or that they might sustain a partially disabling injury.
- Even if a person had such resources, he would be much better served to grow them through investment. Most significant investments—such as real estate, or interest in a business—limit the immediate availability of resources in the event of a loss.
In other words, insurance is best viewed as a single component of an integrated financial plan. A well-organized set of insurance policies can free funds for more profitable investment, the returns from which can more than offset the cost of the insurance. Based on these considerations, a competent insurance agent or financial planner can assist you in choosing types and levels of insurance coverage that provide an optimal overall return, and the best possible financial security and stability for you and your family.
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