Insurance Basics – Spreading Risk

The Basics of InsuranceInsurance is on the forefront of everyone’s thoughts these days.  With the new healthcare roll out in the US, people are wanting to know more about insurance.  Insurance is actually a pretty easy topic to understand, but there are still people out there that don’t carry any insurance or just don’t really know how it actually works.  I am going to go over the simple basics of insurance and how it works, just on a top level.  There are many forms of insurance, which include health, car, home, marine, business, life, banking, and many more.  Insurance is a part of our life, so we should take just a little time to understand how it works.

The Beginning Of Insurance

Insurance has been a common practice for some time.  It even was a part of life before there were companies charging customers premiums.  There has been notations that when people started trading goods over the water, insurance was thought about.  Vessel owners would mitigate their risk of total loss by putting their goods on multiple vessels.  There is a lesser chance that something would happen to all the ships, so this was how the traders would insure their goods (all or in part) would reach their destination.

I mitigate my risk of losing money by diversifying when I invest (I invest through and recommend Scottrade).  I put my money into different buckets that are in different areas. There is a lesser chance that I will lose everything.  It all goes back to the old saying of “Don’t put all your eggs in one basket.”  This is just as important today as it was when traders just started shipping goods.

Insurance Spreads Risk

There are way too many risks around us these days.  We can get into a car accident, our home can catch on fire, our identity can be stolen, we can be sued, and much more.  We wade through the depths of risk each and every day.  The reason why we carry insurance is to spread the risk around.  This process is known as transfer of risk.  Since no insurance company can remove risk from our lives, it works by transferring the risk around to lessen the impact.

How Transfer of Risk Works

Insurance companies, like Lloyd’s, has to transfer the risk of events onto it’s member base.  Insurance works best when you have a large group of members.  The more members you have, the easier it is to transfer the risk throughout the group.  Each member pays to be a part of the group.  Since it is less likely to have a tragic event where most of the members are affected, insurance companies can easily pay for events that happen to a small subset.

This is the basics of the law of large numbers.  For the sake of making the law easy to understand, let’s apply it to insurance, which is what we are talking about.  The law would say that the more members that are a part of the group, an insurance company can expect the actual number of losses to equal the number of expected losses.  Insurance companies have to forecast how many losses they will have in any particular category.  This is in part of how they come up with their pricing model.  The more members they have, the better data they can get.  This allows them to forecast losses and the law of large numbers just puts that into perspective.


I am just going to say that I am not sure that most people who work in insurance even know how prices are created.  Most companies have a wide range of data points in order to come up with what their customers pay.  It all depends on what type of insurance is being purchased, but there are so many factors that will be a part of each pricing model.  Typically, the larger the group, the smaller the price you would pay.  Many people think that some insurance companies are too large, but that is how you spread risk around.  That is how insurance works.

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