This is the second post in a multi-part series, Insurance Foundations.
In the last post, I ended by explaining that, in business, risk refers to the probability of experiencing a financial loss. I further explained that the purpose of insurance is to provide a stopgap against the loss after it happens; thus, insurance coverage is ideally the last link of a chain of risk management strategies, rather than being the first.
Insurance is Based on Risk Pooling
To understand how insurance works, it’s important to understand the concept of risk pooling. Risk pooling is a form of risk transfer that is rooted in the fact that, while the probability of an event can be calculated, the specificity can’t be. That’s a lot of mathematical terms in a relatively short sentence, so my usual tactic is to use an example:
Imagine a neighborhood that has 100 identical houses, each with a replacement value of $100,000. Now, imagine that the probability of a total loss due to a fire is 1 in 100. As such, it can be predicted that one house will burn down. But, since the houses are identical, it’s impossible to predict which one is going to burn or exactly when it’s going to happen.
To protect themselves against the financial impact of that loss, each individual homeowner could simply maintain $100,000 in savings at all times as a “hedge” against that loss. (This would be a perfect example of risk retention.) If all one hundred homeowners did this, there would be a total of $10,000,000 in savings in the entire neighborhood. That’s $10 million that isn’t circulating through the local economy. It also overlooks the fact that few homeowners can actually keep the total value of their house available in liquid savings.
But, since the probability of financial loss for the group has been calculated at 1 in 100, imagine that, instead, each homeowner contributes $1,000 to a shared fund — together saving $100,000 — which is then used to pay full replacement value after the loss occurs. When that predicted fire happens, the unlucky homeowner is paid full replacement value for their house.
This approach, which is far more manageable for an individual homeowner, frees up $99,000 per home — that is, $9.9 million — that can be used toward spending, investing, or other productive purposes.
In a nutshell, that’s what insurance is: the group absorbs the probability. Each individual homeowner faces only the uncertainty.
Insurance is a Real-World Concept
Of course, the above is a theoretical example that depends on a lot of assumptions. In the real world:
- House values vary widely.
- The probability of a loss varies by the property’s unique characteristics. For example, the house closest to the fire station has a lower probability of burning completely than does the house furthest away.
- The property owner themselves can take mitigating steps, such as having fire extinguishers, sprinkler systems, and/or monitored alarms.
- The 1-in-100 probability is calculated over a period of years and it’s an average. In any given year, there could potentially be two fires — or none.
That’s why insurance is more than a simple arithmetic problem. None of these complications invalidate the concept of risk pooling, but they can require that the group’s overall rating be adjusted. Some houses might be better placed in another group entirely; others might be given incentives to take additional loss-prevention steps. It’s not difficult to see how calculating the probabilities can become extraordinarily complex.
It’s All About Stability
But the principles underlying statistics and probability mean that larger pools produce more stable results. Over time, aggregate losses tend to average out. More data, gathered over time, makes predictions more accurate. Good years build up reserves that absorb the impact of bad years.
This statistical stability — which is stability, not certainty — is what makes homeowners’ insurance a viable risk transfer option. It also helps keep homeowners safely housed while freeing up more capital for the economy. In other words, while the insurance policy itself is usually a private arrangement, its positive effects ripple outward to the larger economy.
That is, essentially, how all insurance works. Auto insurance addresses financial loss resulting from a collision. Renters’ insurance addresses the loss of personal property or temporary housing. In each case, the insurance does not prevent the loss itself; it reimburses the insured after the fact. In industry terms, this is known as making the insured whole — or, more formally, indemnification.
In the next post, we’ll explore some of the things insurance can’t do, along with a few guidelines and common pitfalls. After that, we’ll turn specifically to life and health insurance.