Life Insurance

 
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Life 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 events such as war.

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