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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There are 32 comments to "Insurance basics: How insurance works".

  1. Coley says 24 August 2010 at 04:58

    Great explanation; I love it when things are broken down to their simplest terms.

    Of course, it’s important to extend this out just a little bit further, even for this very basic introduction.

    If the East Side Elementary Insurance Fund was only going to charge $50 from 100 families, and you could assume that your child had an average risk of injury, then it would basically be a wash whether or not you wanted to take the gamble of an insurance policy. But in reality, the Fund has to cover its overhead and all expenses, and it’s in business to make a profit. So perhaps they would really be charging $60 from each of 100 families and expecting to pay only $5,000 in annual claims.

    Now this is a gamble that financially, the odds are against you, however you’re willing to accept the asymmetry because the potential loss is far more painful than spending the $60 it costs to insure against it. It’s a gamble that you’re expecting to lose, in fact, you’re hoping you lose.

    So in my case, I’ll happily carry insurance against catastrophic problems–house burning down, enormous medical issues. But, to continue with this example, while I might be willing to pay $50 to insure against a 1/100 chance of losing $5,000; I probably would not pay $60 to do so. Or $51 even. Because I’ve saved well over $5,000, I can afford to “self-insure” and not lose money here and there to the insurance company’s overhead and profits. In other words, there’s a certain cost to this protection above and beyond the pure probabilities of the event happening.

    I’m not being nitpicky here because this is important to remember, and I’m about to make my point. Insurance is a smart thing to protect against something that would be a terrible loss or burden for you. That doesn’t mean, however, that when Best Buy offers you the Product Protection Plan on your $500 TV that you should buy it. You ought to be able to self-insure against your TV breaking; if not, you really can’t afford the TV in the first place. This is also why, if you have a nice savings cushion in the bank, you should consider raising your car insurance deductible as high as reasonably possible.

    This is also why I carry a high-deductible health plan at work.

    • Cashif says 14 December 2012 at 05:56

      Nicely explained the explaination 🙂

  2. Nicole says 24 August 2010 at 05:42

    Neat. This looks like a lecture I’ll be giving in a few weeks. 🙂

    Hope you cover adverse selection and moral hazard too! Though those are difficult to explain… I have an unfinished post somewhere in our blog that tries to attack adverse selection in health and auto markets… I should finish that up sometime. It’s sitting there along with other difficult to write but potentially informative posts. Funny how that works.

  3. MM says 24 August 2010 at 05:45

    I read that wiki article, and it was very interesting. I wonder if ancient insurance lenders constantly battled claims like their modern day counter parts.

  4. Rob Ward says 24 August 2010 at 05:48

    @ Coley – great point about saving and using deductibles to your advantage. Insurance is great and all to protect against a loss, but you don’t want to spend too much on insurance or be over insured. Then you are just wasting money.

    You can save a lot of money by having a decent savings (self insurance) and keeping your deductibles high. I wish our lender would allow for a higher deductible on our house!

  5. MaryR says 24 August 2010 at 05:57

    One note on car insurance. It’s a good idea to get your driver’s licence while in your teens, even if you aren’t going to be driving. The insurance company charges extra for new as well as young drivers.

    A friend didn’t get hers, thought it was really cool to live in the city and not drive. However, when she and her husband bought their dream house in the country, their plans almost came undone when they found out how much insurance was going to cost with her as a new driver.

    As a corollary, I lived in the city for years, but when I moved somewhere where I needed a car, I got really cheap insurance because of a two decade “clean” driving record. Yes, not having accidents counts even if you don’t have a car to crash.

    It’s an oddball thing, but I do try to point it out to people. I’ve had friends whose kids didn’t get a license because of money issues get one just before leaving for college, just to get those clean years built up for later.

  6. Steve says 24 August 2010 at 06:24

    One of the best insurance policies you can buy is a homeowner’s policy. When I was 14 years old the refrigerator motor shorted out in our house while nobody was home and practically burned the thing to the ground. Thanks to a fantastic homeowners policy my parents were reimbursed for every expense and got full replacement or fair value (their choice) on all damaged items (which was everything). I walked away with a couple hundred dollars from old junk in the basement that I was able to claim fair value on.

    It took the contractor 9 months to get the house rebuilt, but with a little negotiation (and a little manual labor on our part to get some credit) we got them to modernize the floor plan. The house was also brought up to code. Two years later, when my parents decided to move, they put the house up for sale on a Friday and on Sunday it was sold.

    I wouldn’t wish such an event on anyone, but thanks to a good insurance policy it was a blessing in many ways.

  7. Everyday Tips says 24 August 2010 at 06:30

    My son just turned 16, and I dread what is going to happen to my insurance rates if he gets a car.

    I cannot imagine trying to get by without insurance. Yeah, I hate paying the insurance premiums, but I would hate to pay the medical/house repair/car repair bills even more if something catastrophic happened.

  8. J.R.C. says 24 August 2010 at 07:34

    I’ve read and heard that “you should only insure what you can’t afford to replace”. Your thoughts on this saying?

    I generally shy away from catch-all phrases, but this one seems to make a lot of sense initially… A home is difficult to replace out of pocket, hence home-insurance. Likewise an auto accident can cause severe injury and lots of vehicle and property damage. Same goes for health insurance (disasterous injury or sickness). As mentioned in the article, insurance on a $500 (or $2000) TV probably doesn’t make a lot of sense.

    Would you tweak this saying with any other caveats, or alter it in anyway? Or is it a pretty good mantra? Thanks!

  9. David/moneycrashers says 24 August 2010 at 07:40

    To expand on the “gambling” point, my mother always told me this about insurance.

    All insurance is a gamble.

    The insurance company is gambling that you’ll stay relatively healthy when they sell you the insurance, and actually, you are gambling that you’ll get sick enough times to justify the cost of it when you purchase it.

    For me, its a gamble worth taking.

    Especially considering that any of us could get hit by a truck tomorrow and have catstrophic health care costs.

    Sorry if that sound morbid

  10. Derek says 24 August 2010 at 07:57

    I’d love your thoughts on disability insurance. I am self employed with a consulting job….basically sitting at a computer most days. Love the work I do, but I pay DEARLY for this each and every month. I know the alternative of NOT having it, but are there alternatives? Suggestions? It puts a cerious damper on saving, general cash flow etc.

  11. Lonnie says 24 August 2010 at 08:28

    This post is timely for me. I am just now thinking about life insurance for the first time. I am a healthy 32 year old male, about to get married and have a two and a half year old daughter. Of course, I don’t know where to begin or what to expect when it comes to life insurance. Can’t wait for the posts!

  12. Christina Crowe says 24 August 2010 at 08:48

    This is a terrific article! Thanks for clearing up what exactly insurance is.

    I’m soon going to have to worry about finding my own insurance, so this series will definitely benefit me a great deal.

    @Coley You prove an interesting point. Not everyone has to pay for insurance and, sometimes, it’s actually beneficial and makes more sense not to pay.

    @MaryR Ouch! I still don’t have my driver’s license yet, though I’m 20. I just never really needed a license, though I’m going to start seriously thinking about getting one. Thanks for the warning!

  13. Brent says 24 August 2010 at 09:08

    There are 2 good reasons to insure.
    1. you are on the winning side of the statistics calculations. Either they omit something, or you have knowledge they don’t etc.
    2. you could not afford the costs of what would normally make a claim.
    3. group discounts because of the nature of the structure.
    In a perfect world we could decouple the group discounts from insurance and be free to use whatever service we desire. Also in this perfect world the insurance company would know just as much as you do and adjust your payments to match your risk.

  14. CF says 24 August 2010 at 09:13

    something on long term care insurance too, if you can. We’ve got the others — life insurance, long-term disability etc — but can’t figure out if the LTC is worth it.

  15. lawyerette says 24 August 2010 at 09:14

    another thought regarding insurance is make sure you understand your policy and what it covers – if something happens and your insurance won’t pay out, then it’s all for naught.

    another thing folks should have is renter’s insurance. the landlord’s insurance will not cover you, so you need to have your own. a friend of mine recently went through a home fire in which all his belongings were destroyed – but no renter’s insurance. he lost everything.

  16. Cheap Insurance Agent says 24 August 2010 at 09:40

    This is a really good explanation of how insurance works. Thanks, Coley, for the additional info! I almost always refuse product replacement plans if there’s already a warranty on the product. Once the original warranty runs out, most gadgets and even some appliances are getting old and outdated anyway — you may be able to buy an equivalent model for less than the cost of a product replacement plan!

  17. AC says 24 August 2010 at 09:45

    Has anyone tried to set up their own insurance with a small group of people? I read about it in a book recently about saving on big expenses. I currently have an HSA which is great trade-off for healthy people who don’t want to pay high premiums, but I wonder about other options out there.

  18. Debbie M says 24 August 2010 at 09:47

    I like the part about how it’s getting together with others to make it easier for everyone to handle tragedy.

    And I agree that a big part of this is that insurance companies have to collect not only the money to cover the claims and the paperwork and checking out the damage, but also the law suits and the sales commissions and the stockholder dividends and who knows what else.

    And whenever you make a claim, even a small claim, your rates go up. For small claims, they are likely to get all their money back and more just from your rate increases. So, it’s good to try never to make a claim. And if you’re good at never making a claim, it’s good to have the highest deductible they’ll let you have.

    And for some things, that means no insurance at all. I sure don’t need vision insurance to pay for vision tests and glasses. Especially now that I get my glasses online. But I do want health insurance and homeowner’s insurance and disability insurance (too poor for long-term care insurance).

  19. ROGER says 24 August 2010 at 10:01

    What happens if the insurance claim gets denied. The fine print says that the fracture has to occur under certain conditions. Now you are in the hole 5k plus $50. I’m not buying into this risk leverage thing. It seems more to me like a form of socialism made possible by the high premiums doctors charge. I mean, does anyone know the cost of fixing a simple broken bone? It would seem that the parents might be better off investing the $50, building up a bit of interest (whatever low), and leveraging with a larger margin of safety while getting their money back not only in interest, but when the kid gets out of school (unless he or she broke an arm and a deductible might apply.) IMHO

  20. Milissa says 24 August 2010 at 10:31

    Thankyou for this post. I am looking into life insurance and I don’t know where to begin. I can’t wait to read your future information.

  21. Daniel says 24 August 2010 at 10:53

    I hope you plan to cover whole-life. I’ve been toying with the concept a bit and can’t really seem to decide if we should get it. I’m thinking of this as an investment opportunity, the insurance coverage is just a side benefit.

    If I wanted life insurance for the sake of having it I would obviously purchase term.

  22. Tracy says 24 August 2010 at 11:31

    @Roger

    The system on risk leveraging you’re describing is not socialism, it’s pure profit-motivated (or liability-restricting) capitalism on all fronts.

    Also, the solution you advocate instead doesn’t actually make sense, because you say “(unless he or she broke an arm and a deductible might apply.)” – if there’s no insurance, there’s no deductible, you’re paying for all of it.

    Keep in mind, JD’s situation was broken down for absolute simplicity of explanation, rather than advocating insuring for every single event that could happen individually.

  23. chacha1 says 24 August 2010 at 12:49

    As to broken arms … my former dance coach broke his arm in a fall at home (down some stairs while moving a piece of furniture).

    His emergency-room care, CAT scan (required because of symptoms of concussion, and something that is done pretty routinely in case of accidental injuries), and surgery to pin the compound fracture of his humerus – so that he could start working again almost immediately, versus being in a cast for six to eight weeks – all came to over $80,000.

    Fortunately, because he was insured through a performers’ union, his “share” came to about 1 percent of that.

    I’m pretty sure he thinks his premiums were well spent!

    Coley, great points on “self-insuring.” I have high deductibles on our full-coverage auto plan and a high-deductible health plan, and between the two those choices ‘save’ me about $4000/yr in premiums.

  24. tmoney says 24 August 2010 at 20:27

    incidentally, this post also highlights exactly why “health insurance” is a misnomer most of the time these days. It used to be called major medical insurance, and for a good reason.

  25. Stuart says 25 August 2010 at 05:58

    AC >>> Insurance with a small group of people wouldn’t work. The idea behind insurance is that you take advantage of the law of large numbers. With a small sample size, the possibility of catastrophic loss isn’t spread out amongst a large enough group. Also, you really need someone to facilitate and administer the insurance transaction (the 3rd party role that the insurance company plays). You wouldn’t want to get a call from someone every time someone in your insurance pool went to the doctor so you could pay your share and you’d definitely want to make sure that others weren’t taking money out of the account if their reason wasn’t legitimate.

  26. Kate says 25 August 2010 at 06:43

    Insurance is so important and it is even more important for everyone to understand their policy. Our home burned down about 5 months ago after being hit by lightnening in the middle of the day – what are the chances I thought? Apparently it happens a lot more than we would think. My husband asked me what our insurance looked like and I had NO IDEA. We now know our policy very well and will take this knowledge going forward. I have been telling everyone that will listen to ask lots of questions and know what their home insurance, auto insurance, ect look like. I think in general everyone doesn’t spend much time evaluating their insurance options and the least expensive policy may not be enough coverage. Thanks for making us more aware of insurance.

  27. Regan says 25 August 2010 at 16:33

    Can you cover renter’s insurance as well? I have paid my premiums for years and read my policy, but still can’t figure out why I really need it.

  28. Curtis says 27 August 2010 at 18:35

    Insurance…Ahhhhhh!!!!!!!!!!!

    Let’s see. What insurance premiums do we pay?

    Health Insure.
    Auto Insurance.
    Life Insurance.
    Homeowners Insurance.
    Business Liability Insurance.
    Worker’s Compensation Insurance.
    Employee’s Unemployment Insurance.
    Homeowner’s policy for the Rental Houses.
    Umbrella Insurance Policy for Rental Houses.

    The above is a partial list. If I could just get back half the premiums for the last 30 years, I’d be rich.

  29. Ritz says 09 November 2012 at 12:52

    Roth

    Few things: Insurance basics are entirely different in Life Insurance and General insurance(except the risk part)

    U can never compare insurance with gambling.Gambling is either gain or loss and insurance works on no profit no loss(

  30. Sofia says 02 April 2013 at 11:51

    Very well said. There are alot of factors and things to consider in getting life insurance that is why getting the best Life Insurance Quotes from a trusted source is way better before deciding what life insurance suits for you according to your needs and the policies in it.

  31. Marnie Kawai says 18 April 2014 at 08:36

    I was more than happy to discover this site. I wanted to thank you for your time due to this wonderful read!! I definitely enjoyed every part of it and I have you bookmarked to look at new stuff on your website.

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