Insurance basics: How insurance works

I don't write a lot about insurance around here. For one thing, insurance is kind of boring. For another, I don't know a lot about it. Still, insurance is an important part of personal finance, and my silence on the subject hasn't gone unnoticed.

Josh wrote last week to make a request:

I've been reading your blog for about a year now, and I consider it a constant source of valuable information. However, one area that I find that it is lacking is in auto insurance. […] I'm not writing this to take anything away from your site, but rather to politely ask that you cover this topic sometime in the future.

Josh's wish is my command. For the next month or so, Get Rich Slowly will feature a weekly post on insurance. The first couple of articles will cover the basics of insurance, laying the groundwork for the last couple of articles, which will be specifically about auto insurance.

Note: These articles draw heavily from the insurance chapter in my book, Your Money: The Missing Manual from O'Reilly Media. (You can download a sample chapter here.)

An Introduction to Insurance

Insurance is a way to manage risk. As you go through your life, there's always a chance that you'll be in a car accident, twist your knee, or that your home will burn down. The risk of these accidents is small, but if one of them were to happen, the effects could be catastrophic. Without insurance, you'd have to come up with the money on your own to repair your car, have knee surgery, or rebuild your home.

Although these things happen to some people, they don't happen to everyone. With enough data, it's possible to know roughly how many people are likely to experience these setbacks — and how much it will cost to recover from them. Using this info, an insurance company can spread the risk among all its customers.

An Elementary Example

Imagine Eastside Elementary, a school with 100 students. Every year for the past 25 years, one Eastside Elementary student has broken an arm in the schoolyard, resulting in about $5,000 in medical expenses. Without insurance, every family would have to save $5,000 to cope with the odds that their little tyke would be the one with the broken arm. At the end of the year, 99 families would have paid nothing (and have $5,000 left in savings), but one family would have paid $5,000 (and have nothing left).

With insurance, the Eastside Elementary families can join together to spread out the risk. If they created an insurance fund, all 100 families would pay $50 at the start of the school year. This $5,000 total would then go to the family of the child with the broken arm.

By spreading the risk, each family only has to save $50 instead of $5,000. Sure, that $5,000 is gone if it's not your child who breaks her arm, but for most people, that's an acceptable trade. Instead of having to scrape together the full $5,000, they'd rather risk losing $50 for a chance to avoid $5,000 in medical bills.

But is it really fair to have every family pay $50 into the insurance fund? Some kids go to the library at lunch to read Harry Potter and Mysterious Benedict Society books; others climb around on the jungle gym and throw stones at each other. The bookworms are much less likely to break an arm, aren't they? And maybe the 25 years of data show that girls break their arms less often than boys. With enough info, the Eastside Elementary Insurance Fund could charge each family a different rate depending on how likely their child is to break an arm.

Note: This is why young drivers tend to have higher rates than older drivers. Yes, it sucks that your premiums are so high if you're under the age of 25, but there's a reason for that. The statistics show that drivers under the age of 25 have more accidents (and more costly accidents) than older drivers.

How Insurance is Like Gambling

Insurance is a bit like gambling. You're betting a little money now because you think the odds are good that you'll need a larger payout in the future. But there's one huge difference between gambling and insurance: Gamblers seek risk in an attempt to get more money; when you buy insurance, your goal is to reduce risk so you don't lose more money.

In fact, gambling casinos and insurance companies make use of the same statistical laws, especially the Law of Large Numbers, which says that the more you have of something, the more likely the characteristics of that something will tend toward average. The more people who roll the dice at the craps table, for instance, the better the casino can predict its earnings. And the more people in an insurance fund, the more accurately the insurance company can predict its losses (and its profits).

Insurance is a Good Thing

Most of the time, using insurance to spread risk is a good thing. That's why most states require car insurance, and why smart folks keep homeowners insurance even after their mortgage is paid off. But insurance can be expensive, especially if you have too much or the wrong kinds. Next week, we'll cover some general insurance tips. The week after that, we'll cover the basics of auto insurance.

Note: Wikipedia has a great article about insurance and how it works. Sure, it may seem like a dry topic, but the history section of that article is especially fascinating.


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