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
It’s more about shared cost. If 15 people buy it and only 2 people end up needing the insurance to pay out, the company makes the profit of 15 premiums – 2 claims (very rough math). The profit on their end is based on the idea that (1) more people will buy it than will need payouts each year and (2) everyone won’t need payouts at the same time.
An insurance company needs to make profit to stay afloat financially, but how they make profit is by spreading your risk. You might pay $1000/year to insure a house you own 30 years, and if you have no loss, you’re only out $30,000. If you have a fire, but no insurance, you could be out for the whole cost of the house. So, by spreading your risk among all the insured, it limits the amount you could lose.
Insurance is about spreading the risk and cost. If yo have 1/100,000 chance of needing to pay $100k, you pay insurance so you can not have to come up with $100k when you need it. Like of you were involved in a traffic accident, or needed a major surgery. The insurance company of course sets the rates so its profitable
The insurance company expects to make a profit on insuring thousands or more of you. It will take a loss on tens to a hundred or more in that thousand, but overall make a profit. It may even take a loss overall in a given year but make it up over any N year period.
You are free to not buy insurance but could have an issue if your loss is say a year or more in wages. For instance, it is unlikely a tornado will totally destroy your house. However if it does, can you afford to rebuild without insurance? The insurance company can afford to rebuild because tens of thousands of people bought insurance and only 10 people got hit by the tornado.
It’s not about you making a profit or loss — it’s about being protected from something catastrophic. Yes, the average person will pay 10% more in premiums than they see in claims benefits over their lifespan, but you’re protecting yourself from your house burning down, a car accident that totals your car and other while causing injuries, from getting cancer or needing an organ transplant which each might cost the insurance company many times what you’ve paid them.
In addition to what others have said about cost sharing and calculated risk, insurance companies also buy insurance. For example, if a hail storm destroys the roofs and siding of every house in town, the insurance company has an insurance policy to save them from the expense.
Of course… That’s why they are in business. And there’s nothing wrong with that. The whole point of insurance is to take a small loss, on the off chance that you might need assistance. It’s a strategic loss. Sure, health insurance might cost you $5000 a year. But one surgery might cost you $100,000. You are deliberately taking a small loss, as a risk mitigation strategy, to possibly avoid a huge financial hit. In fact, you are *hoping* to never cash in on insurance. And no, that’s not a good reason not to buy insurance. Insurance is important.
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.
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.
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.
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