We’re digging into a topic I don’t know much about. Insurance. One of my favorite parts of this newsletter is that I get to learn about new areas of finance and the economy, too. Let’s talk about insurance.
TL;DR
Insurance kind of like a shared savings account for unexpected events.
Some insurance is required (eg. healthcare, auto.) and other insurance is optional (eg. life insurance).
Consider insuring valuable, critical assets that you would have a difficult time paying for again if something were to happen to it.
What is Insurance:
Ok, so we’ve probably used insurance before. You likely have health insurance, on your own or through an employer (thanks Obamacare!). Maybe you own a car, which requires car insurance. But how exactly does it all work, and why does it matter?
Insurance is a pot of money that a group of people add to to save for an unexpected event. An insurance company manages who can access the pot. The unexpected event could be anything - a house fire, a medical emergency, a pet needing to go to the vet. It’s kind of like a shared savings account, where everyone contributes and only some people end up needing to spend it. And if you do need to use the pot of money, you won’t have needed to save as much.
The trick with insurance is this - a lot of people need to participate so the pot of money is large enough to support the number of people who need to dip into the pool. Economists call this ”pooled risk”. If you think you’re more likely to need to use insurance, you’re more like to buy insurance. If you’re not at a high risk, you’re may not buy insurance. Wait a minute. If only people who think they will need insurance contribute to it, that defeats the purpose of insurance. All the insurance money would all run out! Economists call this “adverse selection.
Insurance companies and governments often try to incentive people to buy insurance before they might need it. Obamacare required everyone buy health insurance. US states require car insurance to register your car.
How Does Insurance Work:
Insurance, at a high level, is pretty simple.
For my car insurance, I pay $100 every month (my premium). My premium is based on how likely I am to use the insurance. My car was broken into a few years ago. I called State Farm, and my insurance covered the cost of replacing the window plus the value of a few stolen items. I had to pay $50 upfront (my “copay”) and my insurance covered the rest.
The copay helps makes sure you don’t use your insurance every month just for fun, because we all love our cars getting broken into so much! (or at least that’s my understanding - holler if you’re in insurance and have a more in depth understanding).
Healthcare insurance includes an additional term you may have heard of - deductibles. A deductible is the amount you have to pay into your insurance pool before you use the insurance. Typically, the higher your premium, the lower your deductible and vice versa.
Insurance companies make money from your deductible, and lose money when it pays out an insurance claim. Insurance companies need to accurately understand how likely one of their customers is to need to use the insurance policy in order to make money. Because insurance companies make more money the less they pay out in claims, the insurance company is incentivized to insure people who are unlikely to use the insurance and not pay out insurance claims. This is really important to understand as a consumer. We’ve probably all been on the phone with our insurance companies trying to get a healthcare bill paid. It can be painful!
Insurance companies also typically invest the money they have sitting around from customer premiums to help make more money. AIG, a large insurance company, was infamously bailed out by the government during the financial crisis when it had over invested customer premiums in bad loans. The government lent AIG an $185B loan in order to keep the company from going out of business.
Why Does Insurance Matter:
I think insurance gets a bad rap. It’s kind of a cool, collective, collaborative way for us to help one another. If I don’t happen to need to use my health insurance, my participation in the healthcare pool helps give other people access to services. But, we often buy insurance because we fear something happening. And buying peace of mind is ok too.
The idea of pooled risk and adverse selection are why Obamacare required everyone to get insurance. Obamacare got a bunch of flack because it requires all US citizens to have health insurance, otherwise you had to pay a fine during tax season. The idea is to help reduce healthcare costs for everyone. The more people who contribute to the pool, the lower the overall cost for everyone. Note - health insurance is kind of it’s own beast. Obamacare helped set some guidelines around the data healthcare companies can use to insure you.
There’s some insurance that’s required - health insurance, car insurance, renters insurance. If you own a business, you often need things like D&O insurance and other stuff. I teach yoga, and I buy insurance to cover myself should someone get hurt in one of my classes and try and sue me. Sure, it’s a total long shot, but I likely wouldn’t be able to manage those potential costs on my own.
I think about insurance this way - what are my most valuable assets, and do I have enough money to cover myself if something happens? Home and life insurance are great examples. If you own a home, you may not have enough money to buy another one should say, Cascadia, happen. Insurance becomes a great option to help give you some peace of mind. And, you can help a few others out if something unexpected happens to them.
Additional Reading:
How Plans Set Your Premiums, Healthcare.gov
Berkshire Hathaway - Acquired Part 1 (check out all three parts if you can!)
How Do Insurance Companies Make Money
Insurtech Three Part Series https://medium.com/@clove_10213