How Insurance Works

Insurance: good for everybody

Insurance seems to have got itself a bad name, one way or another. People tend to think that insurers are out to get them, are out to take their money and give them nothing in return.

Well, it ain't quite like that. Let's take a step back and look at when insurance is a good deal, and when it's something you shouldn't consider. On the way, we'll see how some of the most common forms of insurance fit into the patterns: auto insurance, home insurance, life insurance and many others all fit into the general pattern.

The first principle: outsource risks you can't bear yourself

The biggest benefit of insurance is that it turns a risk of uncertain, massive, life-destroying costs into predictable costs that are unpleasant but manageable.That's good because costs that you can't pay become even bigger than they alreadyt are, as you scrabble around trying to borrow money, beg forgiveness from your creditors, and go through stress and trauma.

It's this principle which explains why insuring your house is almost always a good idea, if you are a homeowner (it's a good idea if you rent your home as well, but I'll leave that for now because it's less clear-cut). Buying a home is likely the biggest investment you'll ever make, and if your home burns down you could easily be left on the verge of bankruptcy.

The same principle applies to various types of liability insurance. If you accidentally harm somebody else - by an mistaken professional decision (professional liability insurance) or by a road accident (auto insurance) - you could run up a bill running into thousands of dollars, tens of thousands of dollars, or even millions of dollars. You don't want to run the risk of one accident destroying you financially, so you pass on the risk to an insurance company.

The second principle: minimize the paperwork, and don't get caught up in court

There's a certain amount of administrative and legal wrangling inherent in the insurance process. But things work best when you keep this factor as low as possible. If you look at the most popular forms of insurance, you'll see that they are the ones where insurance companies have a clear obligation to pay out in some cases, and not in others. (Note that medical insurance and travel insurance don't fit with this general rule). It is obvious when your house burns down, and it is obvious when you die. This is what makes home insurance and life insurance sensible moves - claims don't lead to going nine rounds with your insurer in court.

As I just mentioned, medical insurance (and to a lesser extent travel insurance) is an exception to this. Liability for medical procedures is notoriously hard to assign, and some people do end up in interminable court battles to reclaim the costs of treatment from their health insurer. Healthcare isn't naturally suited to insurance, and from an economic perspective would be better served through a national healthcare system like that seen in the UK. But the political system of the United States has decided against providing state medical care, and in that situation medical insurance, however fraught with lawsuits, is the least bad option.

The third principle: insurance works best for peas in a pod

The third principle, and the last I'll mention in this article, is that insurance is best when it is a good deal for the insurer. If it's a good deal for the insurer, the cost gets passed on to you - one of the benefits of the cutthroat free-market competition between the nation's insurance brokers.

What makes a good deal for insurers? Insurers like a field where there are lots of little, independent, predictable risks. The reason that appeals to them is that when you combine small independent risks, you get a predictable overall cost. Look at travel medical insurance, for example. The insurer has no idea whether or not you will fall ill when you go on holiday. But put you together with ten thousand other holiday-makers, and they can make a pretty good guess at how many people will fall ill, and hence how much they will pay. They they split that payment between their customers, add on a bit for profit and admin costs, and that becomes your premium.

Now, look at the opposite case. Risks which are large, unpredictable, or closely related to other risks can't be insured, or can only be insured at a high price. Famously, you can't generally take out any insurance against "Acts of War". The reason is that if a war came, it wouldn't be just a few people claiming here or there. Thousands or millions of people could be affected, and the insurer would be bankrupted trying to deal with their claims. So, you can't insure against acts of war - and the same logic applies to other things, such as large natural disasters.