Insurance is an extremely important tool that individuals use to manage risk. This section will give you an introduction to the topic of insurance.
What is Insurance?
Insurance is purchased protection against a specific loss over a defined period of time.
Everyone will need to make decisions about whether or not and/or how to use insurance to manage risk during their lifetime. The following are a few of the most commonly purchased types of insurance:
- Auto insurance
- Homeowners or renters insurance
- Life insurance
- Health insurance
- Property replacement insurance (e.g., insurance for your cell phone or laptop)
To better understand how insurance works, it is helpful to understand the concept of “risk pooling” and the “law of large numbers.”
Risk Pooling (Transferring Risk)
Risk is transferred from many individual insurance customers to large insurance companies. Each customer pays a monthly (or maybe annual) premium to the company, but only some of those individuals experience a loss during the period of time for which they have purchased insurance. The total amount payed out by the insurance company for losses will be averaged across all customers and over all time periods.
Law of Large Numbers
The “law of large numbers” tells us, the larger the pool, the more predictable the losses. An insurance company’s average payout per customer over time becomes more predictable as the number of customers and the number of insured time periods gets larger.
Risk pooling by large companies helps make risk more manageable for everyone.