Aaa Car Insurance Insurance
seems simple. You pay a premium and insurance pays your bills. The
insurance company takes your risk. However, there is more to it that
this. What does the insurance company do with your risk? When you
understand what the insurance company does, then you can better
evaluate your options and perhaps get a better deal.
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One
measure of risk is the potential for ups and downs. Having a stock
that pays $100 in dividends each year and seldom changes in price is
not very risky. Having a stock that goes up or down wildly from one
period to another is risky. The same is true for insurance. Paying
$100 each year for eyeglasses is not risky. Having a chance of winding
up in the hospital and having to pay $100,000 is risky.
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Risk
pooling is where people get together and share their losses by
averaging them together. It works because of the law of large numbers.
As you average together more and more numbers in a certain range, the
average becomes more and more stable. Unusually high or low numbers
tend to cancel each other out. For example, if you roll dice once, the
result can be anywhere from 2 to 12. If you roll dice more and more,
the average will get closer and closer to 7. By the time you roll the
dice 1,000 times, the average will be very stable around 7.
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Insurance
companies use risk pooling to get rid of the risk they take from you.
They charge a premium based on average cost plus their administrative
cost. When they pool many people, the average cost is very stable and
they have little risk themselves.
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In order
for risk pooling to work, the individual risks that are pooled must be
independent. Independent risks go up and down at different times. This
causes them to cancel each other out. For example, it is less risky to
provide accident insurance for 100 people traveling on 100 different
boats than for 100 people traveling on the same boat. This is one
reason why many insurance policies exclude losses from catastrophic
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