At its core, insurance is the process of transferring risk from one party to another. Individuals who have risk, but do not want it, can actually pay someone else to assume the risk. In the insurance world, “risk” is any event which would cause significant financial harm to you or your family. This could be a house fire, an auto accident, a broken leg, missing an airplane, or a broken phone.
All of these costly events, and more, can be insured.
In this article we will explore what insurance is, basic vocabulary, the benefits of insurance, and what to look out for when purchasing insurance. After reading, you should feel more confident in the insurance marketplace and have an understanding of the basic types of insurance available.
Insurance – The Basics
To get an understanding of how insurance works, let’s first consider health insurance. For this example, we will discuss health insurance at a very high level so we may understand the process. There are a lot of complexities to health insurance, and if you’d like to dive deeper pleaseread this article.
As we mentioned, insurance is all about transferring risk. As you live your life, there is the risk that you will break an arm, come down with the flu, or need major surgery. The cost of these events can be enormous.
The table below shows the average cost of spending just one day in the hospital.
| State/Local Hospitals | Non-Profit Hospitals | For-Profit Hospitals | |
|---|---|---|---|
| United States Average | $1,974.00 | $2,346.00 | $1,798.00 |
| California | $2,774.00 | $3,533.00 | $2,060.00 |
| Arizona | $2,134.00 | $2,581.00 | $1,965.00 |
| Texas | $2,773.00 | $2,401.00 | $1,816.00 |
| Florida | $2,055.00 | $2,265.00 | $2,111.00 |
Data from Becker’s Hospital Review
Because of the huge cost of health care, many people look to transfer the risk of paying medical bills during the year to another party. When you sign up for health care, you are agreeing to pay an insurance company (or “carrier”) a monthly payment (or “premium”). In exchange for this premium, the health insurance carrier agrees to pay expenses related to your medical care during the year.
So it sounds like a pretty good deal. But with the cost of these medical expenses, why would an insurance carrier agree to pay for any medical care?
The Law of Large Numbers
Insurance carriers employ thousands of mathematicians and statisticians so they can understand exactly how many people will break an arm, come down with the flu, or need major surgery each year. They use a statistical concept called the law of large numbers to drive this process. Simply put, the law of large numbers states that if you have enough data points (people living their lives) you can accurately determine how many events (broken arms, the flu, surgery) will occur each year within a given population.
By determining how frequently the insured will need coverage, insurance companies are able to sell insurance policies and make money in the process. When these insurance companies have done their math right, they will collect more premium during a given year then they pay out in medical coverage for customers.
All insurance works under this same model, regardless of the risk that is being transferred. Health insurance is just one example within a massive insurance marketplace. What other types of insurance exist?
The Big Three: Home, Health and Auto Insurance
Most Americans will encounter home, health or auto insurance at some point during their lives. For this reason, they are the “big three” of the insurance industry, and the most important for consumers to understand.
When you buy a home using a home loan, a bank lends you money to purchase the house and expects monthly payments. In the event you can’t make payment, the bank has the right to repossess your house in order to recover the funds which were lent. If there is a fire, flood or other natural disaster the resale value of the home may be significantly lower and put the bank in a very tight spot. For this reason, home insurance is required by almost all banks as part of the home loan process.
Auto insurance is another big one, and is required under state law. These laws require that all drivers possess at least some type of auto insurance which covers costs of an accident. Imagine a world where auto insurance is not required. During an accident, it would be your responsibility to recover damages from the other driver. By requiring auto insurance, the risks associated with an accident are lowered – as all drivers should be covered.
Following the Affordable Care Act (ACA or Obama Care), health insurance is now federally required as well. This topic has become a major political issue, and will likely change to some degree under the Trump administration. With that said, in 2017 health insurance is still required under federal law and the penalties can be stiff for not complying. Click here to read our in-depth discussion of health insurance.
Life, Disability and Annuities
Life insurance covers the risks associated with an early death. It is most commonly used by families who have one primary bread-winner within a household. If this bread-winner were to pass away unexpectedly, the family could face significant financial difficulties. In exchange for a monthly premium, life insurance pays family members a lump sum in the event of an early death.
Disability is very similar to life insurance, but covers the risk of becoming disabled. This risk can present two problems for individuals and families:
- When a person becomes disabled, they may no longer be able to work the same job, or hours, they have historically.
- The cost of caring for a disabled family member can be enormous.
Annuities are just opposite from life insurance, as they cover the risk of living longer than an individual can afford. In exchange for paying an insurance carrier a large single premium (many times $100,000), the insurance carrier will provide a guaranteed stream of annual income for as long as you live. Many times, life or disability insurance is included within annuities. Read the fine print carefully and review the “what to look out for” section of this article before purchasing an annuity.
Business and Liability Insurance
For business owners, business and liability insurance are two of the most critical categories. This type of insurance covers your business (or you personally) in the event that you make a major mistake on the job.
Carpenters take out liability insurance to protect against accidents or mishaps during the building process. Stock brokers take out errors and omission insurance, which covers any mistakes they make when entering orders or completing large transactions. Restaurants can take out insurance policies which cover undercooked food or sanitary mistakes which may result in lawsuits.
All of these situations can be costly to resolve and these costs can even send a small or medium-sized business into bankruptcy. If you are a business owner, carefully consider the risks associated with your business and see if an insurance solution exists.
The Rest
When we said that almost anything can be insured, we meant it. Here other types of insurance that exist.
Celebrities which are known for a particular feature or talent have been insuring their body parts in recent years. The concept of insuring body parts remains the same: celebrities are looking to pay an insurance carrier to assume the risk of them losing the asset. According to Latina.com, America Ferrer’s smile is insured for $10 million, while Rihanna has a $1 million insurance policy on her legs.
If you’ve ever been to a charity golf tournament, you have probably seen a hole-in-one prize. This hole-in-one prize will award any player a car or large check for sinking the shot. For a charity golf tournament, making this payment could send the tournament into the red. Golf tournaments typically insure this risk by purchasing hole-in-one insurance. If someone sinks the shot, an insurance carrier foots the bill, rather than the event organizer.
Finally, crop insurance. This is one of the most common types of insurance used in the United States but still falls into the “other” category. If you are a farmer, you are very familiar with this type of insurance. For the rest of us, it may be a new concept. During the growing season, farmers carry a huge amount of weather related risk. A severe drought, massive rain or hail storm can wipe out a year’s crop. For this reason, the vast majority of farmers elect to ensure their crops on an annual basis.
What To Look Out For
A wise man once said, “Insurance is sold, not bought.”
While insurance can be a life-saver, it is important to understand that just like an auto dealership or a cable company – insurance is a for-profit business.
Insurance companies spend millions of dollars each year advertising their services and employ thousands of insurance salesmen across the United States in an effort to reach consumers. Many of these salesmen are paid on a commission basis, meaning the more insurance policies they sell, the more compensation they earn.
Keep this in mind when speaking with any financial advisor or insurance agent. Don’t hesitate to ask how they are paid on the policy they are recommending. If they won’t provide you a straight-forward answer, considering looking elsewhere. Any insurance agent who has your best interest in mind will not have a problem explaining to you how they are paid, and the benefits of the policy they are recommending.
Reading The Fine Print
At its core, an insurance policy is a contractual agreement. In exchange for your monthly premium, the company is agreeing to cover the event being insured. Any events which are not explicitly included in the insurance policy will not be covered.
There are horror stories of individuals thinking a specific event was covered within an insurance policy, only to learn later that the event is not. The best way to protect yourself from this is by reading the fine print and having a detailed conversation with your insurance provide. Ask them “what if” until you completely understand your coverage under the plan.
What if a pipe bursts, is this covered in flood insurance? What if my phone is damaged, but not lost, does the phone insurance cover this? If we leave our door unlocked, will renter’s insurance still cover stolen items? Ask these questions before you sign on the dotted line.
Final Thoughts
Insurance can be a fantastic thing. Many people have had their life savings protected during a house fire, major health scare or car accident. Carefully consider the risks in your own life and see how insurance can help mitigate these risks. You may be happy you did.