This is part of a mini-series I hope to continue about breaking down how insurance works. If there are any topics people would like to see covered, please let me know. I hope to cover a lot of different topics, as insurance is a major contributor to the U.S. economy. About 1% of the U.S. population is employed by some type of insurance organization. With that being said, I'll jump right in...
How Insurance Works:
The model for insurance is simple. Many pay for the losses of the few. Everyone that is part of an insured group contributes a certain amount to a group fund (a premium). From this group fund, loss payments are made, expenses are met, taxes are paid, and assets are set aside to pay for future losses.
Why Insurance Can Be Handy
Imagine a village of 1,000 families with homes each valued at $100,000. Suppose, on average, one home is destroyed by fire annually. If each household pooled $100 a year into a group fund, this would cover the value of the destroyed home each year. In essence, each villager is paying $100 a year to waive the chance of being without a home. Insurance is a win for all parties involved in this village.
The Challenge of Insurance:
The village described above is not perfect by any means. Losses will vary by frequency (it is not set in stone that one home will be destroyed each year) and magnitude (you can lose more, or less, than the $100,000 value of the home). Not everyone is the same, and eventually people will need to be classified by loss behavior in order to rate each member of the village properly. The challenge is classifying each prospective policyholder properly with other policyholders having similar loss potentials, so that the rate for the group would be sufficient for covering its losses. $100 might be able to cover the average house in the village, but what if someone builds a New House that is worth $200,000? Realistically, a New House is less likely to burn down in a year than an old house. Each classification of villager represents a refinement of the rate for each group member. The principle is the same: many pay for the losses of the few.
How Do We Define Insurance?
The best way I have seen insurance described is in Insurance Words and Their Meanings by Robert Strain. He breaks insurance down into 10 parts:
The transfer of risk (the chance of loss) from one party (the insured) to another party (the insurer) in which the insurer promises (as usually specified in a written contract or insurance policy) to pay the insured (or to pay others on the insured's behalf) an amount of money (or to supply the insured with insurer-paid-for services, or both) for economic losses sustained from an unexpected (accidental) event, during a period of time for which the insured makes a premium payment to the insurer
When the villager purchases insurance, he is exchanging the certainty of a small loss (the guaranteed payment of $100) for the uncertainty of a large loss (the event he is insured against--his house burning down). This membership fee seems pretty reasonable for removing the uncertainty of such a large loss. In fact, it sounds like a bargain.
Certainty
When you merge a multitude of individual uncertainties into a group of policyholders, they are converted into "predictable certainty" for a group by the law of large numbers (I'll let you google that). Combining individual uncertainties into a group doesn't achieve perfect certainty, you get "near certainty" -- and there are certain criteria that need to be more before achieving "near certainty".
The Requirements (according to Casualty Insurance, An Analysis of Hazards, Policies, Insurers, and Rates)
- Homogenity of Exposure Units: Everyone in the group should have the same exposure to loss, or as similar as possible. Otherwise, the average loss per group member isn't useful in determining the average insurance rate per member. The number of people in the group must also be large enough for the law of large numbers to apply.
- Measurable Loss: The loss must somehow be measurable/quantifiable in nature. A measure of time, place, and dollar amount.
- Accidental Loss: The insured loss must be an accident to the insured party. To cover an insured member in a plan for intentional destruction of insured property would cause bankruptcy for the plan (and is illegal).
- No Incalculable Catastrophe Risk: An insurance plan should not be exposed to some catastrophe risk that cannot be measured.
Will do my best to answer any questions.
