Eli5: If an insurance company is willing to sell you insurance, does that mean the insurance company is expecting to make profit and therefore you will make a loss and should not take up insurance?
In: Economics
Someone else in this thread suggested that you think of insurance like a bet, which isn’t exactly the case. Insurance doesn’t let you make new bets. It lets you remove bets that exist naturally. Without insurance, there are some states of the world where your house doesn’t burn down (you win!) and some where it does (you lose!). With insurance, you always make insurance payments, and you always have a house (because the insurance company will buy you a new one if it burns down). You went from an uncertain outcome to a certain one. To the extent the insurance company makes a profit, that is your payment to them for removing that uncertainty from your life.
Most people aren’t gamblers, so they don’t seek out new bets and would prefer to eliminate the natural ones. They buy insurance. If you ARE a gambler, go ahead and don’t buy insurance. In fact, you might even be able to up the ante if you can find someone who will give you money now but take it away if your house burns down.
You buy insurance for losses you cannot afford to absorb but the insurance company can. That ability to absorb larger losses than you is the product they are selling.
For example, if you purchase something that costs 20 times your disposable yearly income, that loss could be so great you could never fully recover and so you should never buy that product. However, if you could pay a fee to ensure that the loss would never happen (financially), then you could buy that something.
For this reason it’s not generally a good idea to buy insurance for things you can afford to replace, as the product has no value to you.
An insurance company works based on sharing the cost out.
The average user will ultimately make a loss – they will pay their insurance premiums, and never make any big claims – so saving that money instead would have been beneficial to them in the end.
The thing is however, that not everyone is the average user – if your are the person who was unlucky enough to experience a catastrophic house fire and lose your home and all of your possessions, then your insurance policy will pay out many times the amount you have paid in to it.
The insurance company is averaging out that risk over many people, so that just enough people are paying in money and taking out nothing to cover the few people that do need to claim, plus a little profit on top.
Yes. But there are still situations where insurance is useful:
– The law requires you to have insurance.
– A contract requires you to have insurance (often mortgage or auto lease).
– You would be unable to pay if you get unlucky.
– Certain situations involving death (e.g. your assets often get tied up in court when you die, but a life insurance policy is usually paid out quickly)
The short answer to your question is yes. Don’t buy insurance for anything you can afford to replace. The longer answer is that it’s complicated, and in some cases insurance does make sense.
The biggest benefit of insurance comes primarily from situations that *probably* won’t happen but will *definitely* bankrupt you if you do. Think of, say, your house. Most people never have their house burn down, or blow up from a gas leak, or get buried in a mudslide, or anything else like that. But for those very unlucky people who do, they’re now suddenly homeless and likely have almost nothing left. Insurance will (hopefully) step in to give them the money they need to rebuild their lives.
Because most houses don’t burn down, the insurance premiums you pay will end up costing you far less than a replacement house would. Most people who buy house insurance end up losing a couple tens of thousands of dollars to the insurance company (which sounds like a lot but isn’t really all that much money over the course of your lifetime), but in exchange they have the security of knowing that if they’re one of the unlucky ones that does lose their house, they’ll get the money to replace it.
When it comes to small things that break often (like, say, smartphones), insurance stops making sense. If most phones break and need to be replaced within 5 years, the only way the insurance company can make a profit is if they charge everyone more than the cost of a replacement phone over those five years. The only time I’d suggest buying smartphone insurance is if A) you’d lose your job or something equally disastrous without your phone, and B) you’re a clumsy person and you know you’re going to break it far more often than the average person.
In the first place, buying and selling goods and services (like insurance) should not be conceptualized as a win-lose scenario – trading benefits both parties if conducted rationally. For example purchasing food, the buyer values the food more than the money and the seller values the money more than the food they have in stock – both therefore gain from the trade.
In the case of insurance (which, in reality, is highly complex) the simplest model is that the insurance company maintains a large portfolio of customers. Each additional customer adds relatively little to their overall risk (risk in their case is equivalent to cost) – and therefore can be added at little additional cost or risk to the insurance company. Therefore the company can offer insurance at a reasonable cost (premium). To the insurance buyer, the individual risk is low (say fire) but if that eventuality occurs, the cost is very high. Therefore the buyer trades their low risk and high cost situation with the insurance company for a premium. Both parties “gain” from this exchange.
No. They’re spreading the risk around among thousands of clients. They expect they’ll lose money on some of their clients, but they’ll make a profit on enough of them to cancel out their losses.
Basically, if they’re selling life insurance, they know a few people will die before they’ve paid enough in dues to cancel out the payout the insurance company will pay to the surviving family, but *more* people will live long enough to pay more in dues than the payout would be if they had died.
That’s the point of insurance, it’s not an investment where the customer is trying to make money, the customer is merely trying to shield themselves from *risk*. Even if you “make a loss” (meaning you pay more in dues than you ever received in benefits/payouts), you still benefited from having the insurance, because part of what you were paying for was the peace of mind of not having to worry about a certain risk.
A lot of insurance companies actually don’t make a profit directly off the premiums they charge you: they make their money from investing the premiums in between when you pay it in and they have to pay it out to cover a claim.
Think of it like a bet.
You’re betting that your house will burn down, and the insurance company is betting it won’t.
If you “win” the bet, the insurance company pays out to you. If you “lose” the bet, then you pay a much smaller amount to the company but also you still have a house.
10 million people pay me $1 a year to buy them a replacement ice cream if they drop their ice cream, which costs them $2 to buy.
990,000 don’t drop it in any given year.
This means that I make $9 million 980 thousand a year, even though I am on the hook for the *risk* that I might have to theoretically pay $20 million (which ends up being a net $10 million loss) if everyone drops it.
Because the risk is low, I can make a profit while still taking care of the 10 thousand people who dropped their cones.
Insurance is about peace of mind. You are paying them for the peace of mind that if something happens to your property/life/etc. that you won’t have to worry about paying to replace the object/fix the problem. Because enough people are generally not going to have that problem (statistically speaking, remember it’s all about risk) they can still make money while meeting their obligations to the insured.
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