Basic Concept

The basic idea behind insurance is that a group of people can pool their money and bail out a member of the group who has fallen on hard times. In some societies, insurance is ad hoc, and/or part of the culture. In others it is more formalized. Some use a combination of both.

Informal Insurance

For example if your neighbor Joe's cornfield got destroyed by hail and yours didn't, you and your neighbors could each pitch in a little money and help Joe out. Maybe Joe pays his neighbors back when he gets on his feet, or maybe he doesn't but they know Joe is there for them if anything happens to them.

Problems with Informal Insurance

At some point someone figured out that informal insurance is kind of hit-and-miss. It depends on you having friends, and if the catastrophe is really huge, you have to have a lot of friends, or a few with a lot of money. And what if your whole social group falls on hard times? And what if you have helped others in your group but for whatever reason they decide to shun you? There is nothing that can force them to help you.

What is formal insurance?

We know that eventually something bad will happen to someone but we hope it doesn't happen too often. What if we just pool our money ahead of time into a group rainy day fund? While nothing bad happens to anyone in the group, we can invest the money and make more money off it. This increases the amount we can pay when (not if) something bad eventually does happen. We just need to make sure we always have money over and above what we need to pay out. We also have to be legally rigorous about what we will pay for. Voila! Formal insurance!

Now it's a business

In formalized insurance, someone designates themself as "holder of the rainy day fund." It is no longer a friendly thing. It is a business. Everyone in the group kicks in according to his or her risk, and if and when something bad that they have promised to cover happens to any individual, the insurance company pays for all or a part of it. The holder of the fund hopes to invest this money for profit while paying out as little of it as possible. The holder also wants a lot of diverse people to be insured. Diversification ensures that the company won't be wiped out by a catastrophe affecting a single group, and also gives them more money to invest. However, they don't want to insure people who are very high risk, because this increases the odds that they might have to pay out.

Policies and coverage

When an insurance company is formalized, they have to have a signed contract with the people that they insure. This contract specifies exactly what they will pay for and what they will not pay for. This is known as coverage and the contract is known as a policy. The people who have paid in are known as the insured.

How risk is calculated in dollar values

Insurance companies employ math whizes called actuaries to calculate risks based on odds that they will have to pay, figured in with what it typically costs to pay for one of these covered bad things that might happen to the insured. They also like to know factors in the insured's lifestyle or status that will increase or decrease the risks of certain bad things happening to them. Such factors are called demographics, and they include things such as age, gender, health, race, geographical location, occupation, and certain lifestyle decisions. The actuaries use all these factors to calculate how much money the insured person needs to kick in. This is what is called their premium. If you engage in extremely risky behaviors, such as motorcycle racing, be prepared for life insurance companies that won't insure you at all, or will charge you extremely high premiums for life insurance. This is because they have calculated that people who race motorcycles have a much higher risk of dying before they have paid in a lot of money.

What is a deductible?

That's the part of the expenses that you pay. To discourage insured from claiming every little thing, most insurance policies require the insured to pay a percentage, or a fixed amount. This can either be on a per claim basis or an annual basis. For example many medical insurances require a copay for every doctor visit. Usually the deductible is an amount you can afford. The part you can't afford is supposed to be covered by your insurance.

What are some problems with private insurance?

There are some risks you can control and some you can't. You can quit motorcycle racing, but if you have a chronic disease, or are 85 years old, there is not much you can do about that. Some people develop a chronic disease while working for a company that provides insurance for them. They are afraid to quit their job because if they quit, they would be uninsured, and even if they got a new job there is no guarantee that the new company would insure them. Some health insurance companies refuse to take people with pre-existing health conditions. People who most need insurance may have difficulty getting it because they are too high risk.

What is denial of claim?

Insurance companies try their hardest to deny paying claims based on tricky language in their policies. It is cheaper for them to pay someone to read the legalese and look for reasons to not pay claims because that way they get to keep more money and invest it.

What is insurance fraud?

That's when the insured or someone who receives payments from insurance (such as hospitals or car repair places) submit phony claims and just get money when in fact they did not perform the services that they claim that they did. Insurance fraud is a crime and you can do jail time for it.