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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 insurance is not required. During an accident, it would be your responsibility to recover damages from the other driver. By requiring auto insurance, the risks associated with an accident are lowered – as all drivers should be covered.
Following the Affordable Care Act (ACA or Obama Care), health insurance is now federally required as well. This topic has become a major political issue, and will likely change to some degree under the Trump administration. With that said, in 2017 health insurance is still required under federal law and the penalties can be stiff for not complying. Click here to read our in-depth discussion of health insurance.
Life, Disability and Annuities
Life insurance covers the risks associated with an early death. It is most commonly used by families who have one primary bread-winner within a household. If this bread-winner were to pass away unexpectedly, the family could face significant financial difficulties. In exchange for a monthly premium, life insurance pays family members a lump sum in the event of an early death.
Disability is very similar to life insurance, but covers the risk of becoming disabled. This risk can present two problems for individuals and families:
- When a person becomes disabled, they may no longer be able to work the same job, or hours, they have historically.
- The cost of caring for a disabled family member can be enormous.
Annuities are just opposite from life insurance, as they cover the risk of living longer than an individual can afford. In exchange for paying an insurance carrier a large single premium (many times $100,000), the insurance carrier will provide a guaranteed stream of annual income for as long as you live. Many times, life or disability insurance is included within annuities. Read the fine print carefully and review the “what to look out for” section of this article before purchasing an annuity.
Business and Liability Insurance
For business owners, business and liability insurance are two of the most critical categories. This type of insurance cover