Insurance companies exist to pool individual risk. This pooling of risk allows a group of people to share the burden of paying the costs of a particular event, which reduces the likelihood of any one event financially devastating an individual. Due to the number of different risks a person will face during his lifetime, insurance companies have evolved over the years to provide insurance products that cover almost all of them.
How it Works
To reduce the financial impact caused by a particular event, an insurance company will offer to financially reimburse a person if the event occurs. In exchange for this reimbursement, the insurance company collects premiums from the insured person. The price of the premium is determined based upon the likelihood of the event happening, the financial cost of the event and the number of people whose risk can be pooled. For example, if 1,000 geographically disbursed people take out flood insurance on houses that are worth, on average, $250,000, and the odds of a flood happening that destroys a home is once every 100 years, the cost of insurance is going to be cheap. Alternatively, for a large number of members of the insurance pool who live on the coast on the tip of Florida experiencing damage at one time every couple of years is likely to be high. In these cases, the insurance premiums are much more expensive due to the higher and more frequent payouts the insurance company has to make .
Insurance companies provide life insurance to individuals to help pay for burial costs, to pay off debts or to replace lost income for the surviving spouse or family. Using a large pool of applicants, an insurance company can easily determine average mortality. For the members who live past the average mortality age, they effectively fund the payouts for the members who die prematurely. Because no one knows if they will die prematurely, life insurance helps mitigate a family’s risk.
Health insurance helps pool the risk of illness. Because some people will require treatments that cost hundreds of thousands of dollars, and some people can go through life without catching a cold, the costs of health care for any one person is smoothed out. Because no one knows how much care they will need or what their health will be, pooling the risk with other people makes sense. Additionally, younger and healthier people help fund the higher medical costs incurred by the older members of the insurance pool.
Unlike life and health insurance, car insurance has the potential to never be utilized. Car insurance is provided by insurance companies to share the risk of getting into an accident. Using actuarial tables, insurance companies can determine the probability of a member getting into an accident and how much the typical accident will cost them. This analysis is applied to the entire member pool, and then the total cost is divided among everyone.
With the decline in pensions, insurance companies have stepped up to provide a solution that eliminates the chance of a person running out of money during retirement. Annuities are provided to people who want a guaranteed stream of income, and they work based on the odds of how long you will live and the kind of returns they can generate from the money you paid them in exchange for the guaranteed income stream. Annuity payments are typically higher than what an individual could replicate for himself because the insurance company has the benefit of having a pool of members, some of which will die early, which provides additional capital for those who live longer than the average mortality rate.
- Uncertainty and Its Exigencies: The Critical Role of Insurance in the Free Market
- IRS. "Total Amount of Coverage." Accessed Oct. 26, 2020.
- Insurance Information Institute. "Choosing an Insurance Policy." Accessed Oct. 26, 2020.
- Insurance Information Institute. "Five Insurance Mistakes to Avoid (and Still Save Money)." Accessed Oct. 26, 2020.
Jonathan Roe enjoyed a liberal arts education at Miami University where he studied philosophy and business. He is currently working on an MBA at the Weatherhead School of Management in Cleveland, Ohio, while working full time as a corporate banker. Relying on his wide-ranging education, he writes for a variety of companies.