Eli5: How does insurance work ? How is it a good deal for both the customer and the company ?
In: Economics
Insurance companies collect premiums from customers. Over the course of time, some of those customers will need medical care, but most won’t. The ones who need it will get paid using the premiums of customers who didn’t need care. There are a couple of other complications here (like whether or not the insurance companies have cut deals with health care providers, or whether your employer is paying part of the premiums), but generally, people are paying more into insurance than they will get out it.
The point of insurance, for customers, is to protect yourself from financial hardship more than it is to get more money in the long run. If you get very sick, it can completely ruin your finances. So you’re paying a small amount regularly to avoid that possibility.
It’s a good deal for a company when they calculate all the people paying that will never take advantage of it or they will deny the claim.
For instance I haven’t filed an insurance claim in 20 years. But I’ve had home, multi car, renters, and high value item insurance for ever.
Insurance is a way to transfer risk, and it works by pooling the risk of many individuals. Your personal risk of a catastrophic loss is relatively low, but a major loss is more than the average person can retain. By collecting a relatively small amount of money from a large group of individuals, each individual benefits.
Insurance companies spread the risk of claims across their clients, and do a lot of math to predict outcomes.
Imagine an insurer who has 100 clients. Each client has some asset worth $100, and the insurer can very accurately predict that during a given period they’ll have to replace 1 of those items. All they have to do is charge each client more than $1 for the period.
(obviously this example ignores the insurers overhead, etc.)
Additionally, in practice, insurers take all the premiums and invest them so their big pile of money is making its own money.
Imagine there is a disease that has a one in a million chances to kill you every year, unless you pay 1 million dollars.
An insurer comes around and says “hey, pay me 2 dollars a year, and if the disease happens to you, I’ll pay for the treatment”. Does this sound like a good service for you?
From the point of view of the insurer, if they insure a million persons they are going to get 2 million dollars each year, but only have to pay for one treatment. Does this sound like a profitable business for you?
Mathematically it might make sense to save up the money and just pay it if it happens. From an odds point of view you are overpaying the insurance. But what if you’re unlucky and it happens to you in the first year? Odds are small, but it could happen.
Basically insurance is a known cost, that defends you from an unknown one. On average, most people lose money, but for people more unlucky than the average, insurance minimises risk.
Every year, you have a one in a million chance of having to pay a million bucks. You can’t save up a million to just have it ready should that happen. And besides it’s a one in a million chance. If you had the million wouldn’t you rather buy a house with it or something? So I make you a deal. I find a million other people with the same problem and you all pay be 2 bucks a year if I pay the one million when one of you is up. On average, I will get two million and have to pay out one million a year (one million people taking a one in a million chance). If you live for 100 years you have paid at most 200 bucks, never one million. Maybe you would have never had to pay the one million, but for a mere 200 bucks over your lifetime you never had to worry and if you had to pay the million, it wouldn’t be a problem at all. I, on the other hand, make a million bucks, every year.
In reality, the math works out a bit differently for every insurance, but this is the idea.
Let’s take car insurance as a simple example
100 people have cars. They all pay $50 car insurance (we all wish it was that low). That is $5000 in the pot. Most people won’t claim, but maybe a few do and the insurance company pays their claims and the insurance company keeps the rest for their expenses and profits
The people paying the premiums get peace of mind that they won’t get big bills. The people who claim get their claims handled. The insurance company has enough money to pay staff and have a bit of profits over.
The ‘trick’ is to get the figure for the premiums right so everyone is happy. The company has experts and computers to do this.
One rarely discussed factor in insurance companies is that it’s also an investment business.
If your insurance company takes $100 in premiums in a year, you design it so that you will pay out about $85 on average per year. It costs you about $20 to run the company, salaries, sourcing replacement goods, dealing with subcontractors and so on. That’s $105 in total. But because you pay the $85 out at different times, you can also invest the $100, and it returns $110 over the year. So you make $5 for doing absolutely nothing. A lot of competitive insurance markets end up working this way, where the actual profits come from investment returns.
One other interesting thing is reinsurance. This is basically insurance for insurance companies – they buy a policy from a special reinsurance company that says that they will pay the first $5m of any claim, but anything over that is paid by the reinsurer. This means that they’re protected from the really huge losses that do arise from time to time.
It’s similar to a business principle casinos run on, since it’s still functionally random events that pay out big occasionally but most of the time is paying the business for no return. I think the betting/casino scenario is simpler though
So imagine you create a game of chance, and in this game, it pays out a jackpot of $100 when they win, and you need to decide how much to charge per play. You do some math and realize that on average, players will get a jackpot every 20 plays. This means you want to charge over $5 per play, let’s say $6. This would mean every 20 plays, you have to pay the jackpot of $100, but you made $120
Now of course, it’s random chance, you may have 2 players win in a row, so now you paid out $200 and made $12. This happens, but the thing is, there’s TONS of customers playing this game, and while there’s some random chance involved, as you get more and more customers, the actual percentage of time you pay out will look very close to the 1 win per 20 times played.
A lot of insurance works like this, thru calculate how often they’d need to pay the customer, and craft the prices accordingly so that they come out top in the end, where across all customers, they’ll make $1.20 for every $1 they pay out (made up numbers, but the point is they look to craft prices to make more than they pay out)
You’ve likely heard of insurance charging some higher risk customers more, like charging smokers more for life insurance or young men more for car insurance, this is because that “1 win per 20 plays” might be closer to “1 win per 10 plays”, ie they need to charge more because they’re more likely to have to pay these people
The people who figure out the likelihood of paying out based on known things are called actuaries, and nothing works in insurance without their estimates of how likely they are to have to pay out.
The insurance company makes a profit because of course the payouts are less than the revenue. The customers on the other hand get to externalize risks that are too costly for them to deal with should they materialize. If your house burns down can you simply pull the money for a new one out of your back pocket? Most people can’t. So insurance is the way to deal with that risk and not end up on the street if the house does in fact burn down.
Where insurance doesn’t make sense is for risks that you can cover easily with your own means. A billionaire would have little use for typical consumer insurance services.
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