At its core, insurance is the process of transferring risk from one party to another. Individuals who have risk, but do not want it, can actually pay someone else to assume the risk. In the insurance world, “risk” is any event which would cause significant financial harm to you or your family. This could be a house fire, an auto accident, a broken leg, missing an airplane, or a broken phone.
All of these costly events, and more, can be insured.
In this article we will explore what insurance is, basic vocabulary, the benefits of insurance, and what to look out for when purchasing insurance. After reading, you should feel more confident in the insurance marketplace and have an understanding of the basic types of insurance available.
Insurance – The Basics
To get an understanding of how insurance works, let’s first consider health insurance. For this example, we will discuss health insurance at a very high level so we may understand the process. There are a lot of complexities to health insurance, and if you’d like to dive deeper pleaseread this article.
As we mentioned, insurance is all about transferring risk. As you live your life, there is the risk that you will break an arm, come down with the flu, or need major surgery. The cost of these events can be enormous.
The table below shows the average cost of spending just one day in the hospital.
|State/Local Hospitals||Non-Profit Hospitals||For-Profit Hospitals|
|United States Average||$1,974.00||$2,346.00||$1,798.00|
Data from Becker’s Hospital Review
Because of the huge cost of health care, many people look to transfer the risk of paying medical bills during the year to another party. When you sign up for health care, you are agreeing to pay an insurance company (or “carrier”) a monthly payment (or “premium”). In exchange for this premium, the health insurance carrier agrees to pay expenses related to your medical care during the year.
So it sounds like a pretty good deal. But with the cost of these medical expenses, why would an insurance carrier agree to pay for any medical care?
The Law of Large Numbers
Insurance carriers employ thousands of mathematicians and statisticians so they can understand exactly how many people will break an arm, come down with the flu, or need major surgery each year. They use a statistical concept called the law of large numbers to drive this process. Simply put, the law of large numbers states that if you have enough data points (people living their lives) you can accurately determine how many events (broken arms, the flu, surgery) will occur each year within a given population.
By determining how frequently the insured will need coverage, insurance companies are able to sell insurance policies and make money in the process. When these insurance companies have done their math right, they will collect more premium during a given year then they pay out in medical coverage for customers.
All insurance works under this same model, regardless of the risk that is being transferred. Health insurance is just one example within a massive insurance marketplace. What other types of insurance exist?
The Big Three: Home, Health and Auto Insurance
Most Americans will encounter home, health or auto insurance at some point during their lives. For this reason, they are the “big three” of the insurance industry, and the most important for consumers to understand.
When you buy a home using a home loan, a bank lends you money to purchase the house and expects monthly payments. In the event you can’t make payment, the bank has the right to repossess your house in order to recover the funds which were lent. If there is a fire, flood or other natural disaster the resale value of the home may be significantly lower and put the bank in a very tight spot. For this reason, home insurance is required by almost all banks as part of the home loan process.
Auto insurance is another big one, and is required under state law. These laws require that all drivers possess at least some type of auto insurance which covers costs of an accident. Imagine a world where auto insura