Insurance

Leon has saved up his money and bought a phone. Lucky Leon! But he’s worried… it took so long to save for the phone — what if he breaks it? He’d be devastated! If only there were some way to make sure he could replace the phone, if it breaks, without saving up all over again… Lina, his sister, has an idea.

For a small fee, she will promise to buy Leon a new phone if he breaks his. How about… 20 dollars? Leon thinks about it, and accepts the deal! It’s a win-win. If Leon doesn’t break the phone, Lina is up 20 dollars, and if he does break it, he is guaranteed a new one.

What if Lina also made this deal with some of her friends? If 10 of Lina’s friends each give her 20 dollars to cover their phones, she’ll have 200 dollars. If one of those 10 people breaks their phone, and Lina pays 100 dollars for a replacement, she is still up 100 dollars! The students each have a fall-back if they break their phones and Lina has extra money in her pocket. This is the basic principle of insurance.

Many people take a small loss — in this case, 20 dollars, instead of one person taking a large loss — in this case, the full cost of a new phone. The risk is spread out among a number of people, so no one person is in trouble if disaster strikes. Of course, insurance agreements don’t usually happen between siblings or friends. Instead, someone looking to protect themselves in the case of damage to their phone, car, or anything else valuable goes to an insurance company. We can call the insurance company, simply, the insurer.

The person pays the insurer an agreed-on sum of money, called a premium. In return, the insurer provides a promise, written down in an insurance policy. The policy says that if the insured item is damaged, the insurer will pay for the repairs or a replacement. This is called a pay-out. The funds to cover the pay-out will come from the individual’s premium along with the premiums paid by others who don’t have losses.

The individuals paying the insurance company benefit from protection against a large, unforeseen expense, and the insurance company makes money, as long as they receive more from premiums than the amount they pay out for losses. People buy insurance to cover all sorts of things that would be expensive to replace or pay for. Home insurance protects a person’s home in case of a fire, flood, or storm. Health insurance covers a person’s medical bills if they get in an accident or fall ill. Insurance agreements come with a lot of different rules about exactly when the insurer will and will not pay out, but all insurance is built on the same principle: that spreading out risk among many, minimizes the losses of a few.