How does insurance work, anyway?

Insurance exists to fill a need in society. When you buy insurance, you're buying protection from the high cost of financial loss. Insurance companies fill this societal need by gathering data about the type of claims paid, the amount of payment, and other information, and then coupling it with very sophisticated statistical models, probabilities, and predictive analytics to determine the expected cost of paying all claims for a particular year. With this cost information, insurance companies are able to offer insurance policies for purchase. An insurance policy is a contract between a policy owner and an insurer. When the policy owner upholds his or her end of the contract by paying the premium and abiding by the conditions set forth in the policy, the insurer is obligated to uphold its duties contained in the policy.

Calculating insurance costs is not a straightforward science. Insurace companies must consider all the data before estimating the cost of insurance. Because of the math involved, the larger the pool of data, the greater the insurance company's ability to accurately predict the true cost of claims. This is because of a mathematical principle called the law of large numbers, which states: as a sample size grows, the mean will grow closer and closer to the population average. This means that the actual performance of the group of policyholders will be closer to average and the insurer will have the ability to more accurately predict the cost of claims. Since there is so much uncertainty involved, sometimes the insurer makes money and sometimes they lose money.

Underwriting is the name for the process that insurance companies use to gather information and screen potential policyholders. You may be wondering why they ask so many questions.

Policyholders who buy this protection aren't guaranteeing that bad things won't happen, but they are avoiding some of the burdens of financial catastrophe by paying the insurance company to absorb the risks. The cost of an insurance policy is called the premium. A premium is the amount of money that is charged by the insurer for setting up and managing the insurance program. Insurance companies use the information about the cost and cause of claims to determine the premium amount. Sometimes the insurer earns a profit because the amount that they had to pay out in claims and expenses was less than the amount collected. The insurer exists to earn a profit so that it can build reserve funds and increase its financial stability.

Many forms of insurance do not shift the entire financial burden over to the insurance company. Instead, the policy owner continues to bear some burden as an incentive to the owner to avoid claims and losses. This is called a deductible or a retention. For example, you might buy insurance for a car, and pay the insurance company $300 for one year of coverage against a collision accident. You would select a deductible offered on the policy when establishing coverage - for example, $500. In general, policies with lower premiums will have higher deductibles. After you pay the premium and the coverage is in force, if you have no accidents, you and the insurance company both “win.” You avoided the possibility of having to pay for a costly repair out of pocket, and the insurance company was able to use the $300 premium to pay claims for others who were less fortunate than you because they were involved in an accident. If you do have an accident, you are responsible for paying the first $500 (your deductible) before the insurance company pays out. The insurance company has the ability to pay its portion because of the premiums it has collected from you and others. With a higher deductible, you have more “skin” in the game and are more apt to be careful to avoid any type of claim that you are able to prevent.

Use judgment when selecting a deductible. If you have a claim, it's really nice to not have to come up with a large amount of money in order to get the claim settled and the damage repaired. Over the course of a lifetime, however, my experience has shown that people prefer the savings that come from having a lower premium year after year. Ultimately, the decision of deductibles is one that you may need to debate after careful consideration of the available options.

While the ability to shift the risk of loss to an insurer is very important in some situations, in others it is more prudent for a person to absorb the risk of loss on their own. A good example of this is if you drive an older car whose value has decreased significantly from when the vehicle was brand new. For most people, it makes more sense to NOT purchase collision insurance because after paying the premium and deductible, the amount of recovery after a claim will not be enough for the insurance to be a wise investment. A good rule of thumb is to ask yourself, if (insert type of claim here) happens, do I want the insurance company to respond and help me out with the cost of the claim, or would I prefer to take my chances?

Similarly, even if you do have insurance coverage for a claim and could pursue payout from the insurance company, if the nature of the claim is small you may exercise the option of paying for the damage out of pocket instead of placing a small claim. Since the primary role of insurance is to avoid catastrophic financial burdens, it would be wise to avoid jeopardizing insurance coverage. Some insurers will raise rates or discontinue coverage if the frequency of claims is too high.