What is insurance?
Insurance is a contract between an individual (the policyholder) and an
insurance company. This contract provides that the insurance company
will cover some portion of a policyholder’s loss as long as the
policyholder meets certain conditions stipulated in the insurance
contract. The policyholder pays a premium
to obtain insurance coverage. If the policyholder experiences a loss,
such as a car accident or a house fire, the policyholder files a claim
for reimbursement with the insurance company. The policyholder will pay a
deductible to cover part of the loss, and the insurance company will
pay the rest.
For example, suppose you have a homeowners insurance policy. You pay
$1,000 per year in premiums for a policy with a face value of $200,000,
which is what the insurance company estimates it would cost to
completely rebuild your house in the event of a total loss. One day, a
huge wildfire envelopes your neighborhood and your house burns to the
ground. You file a claim for $200,000 with your insurance company. The
company approves the claim. You pay your $1,000 deductible, and the
insurance company covers the remaining $199,000 of your loss. You then
take that money and use it to hire contractors to rebuild your house.
When
you buy an insurance policy, you’re pooling your loss risk with the
loss risk of everyone else who has purchased insurance from the same
company. If you get your homeowners insurance from State Farm, which
sells far more homeowners insurance policies than any of its
competitors, you’re joining forces with millions of other homeowners to
collectively protect each other against loss. Each homeowner pays
annual premiums; State Farm collected more than $15 billion in premiums
in 2011, according to data from A.M. Best, a major insurance ratings company. Only a small percentage of homeowners will experience losses each year – 5.3% of insured homeowners filed a claim in 2014, for example. And most of those losses will be relatively small; the average homeowners insurance claim was for $11,402 in 2015,
which is more than most people could comfortably pay out of pocket on
their own, but far from a worst-case scenario. Further, the average homeowner only files a claim once every 9 or 10 years.
Insurance companies are therefore able to use the premiums from
homeowners who don’t file a claim in a given year to pay for the losses
of homeowners who do file a claim, which is called risk pooling. (For
background reading, see The History Of Insurance In America.)
Insurance is available to provide financial protection against a wide variety of losses:
- house fires
- apartment burglaries
- auto body damage from a car accident
- medical payments to occupants injured in a car accident
- long-term disability
- death of someone that others rely on for financial or caretaking support
- emergency room visits
- surgery
- a lawsuit brought by a visitor who slips and falls on your icy front porch
- help with basic activities of daily living
- and many more.