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Insurance - Head Matters


1. How Insurance Works

When you buy insurance, your financial risk of loss, also called liability, is shared with insurance company.  To legally accept the risk, the insurance company enters into an agreement with you – you are referred to as the “insured.” The insurance company is willing to accept the risk of a possible large financial loss because you are paying a premium.  We discuss risk in more detail in the Money Management Unit.

There are several different types of private insurance and employers often offer group insurance plans of all types.  Most colleges also require you to have some type of health insurance and usually provide that as an option.  State laws require you to have insurance on your car. In addition, the government offers social programs to help those who don’t have insurance from other sources.

Because insurance can be confusing, Erin, who we’ve met in previous units, was able to interview a real live insurance policy for her college radio show… this should help clear up some of the mystery of insurance!

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Welcome to the show. Today, I have a very special guest: an insurance policy. Insurance policies are difficult to interview because they are often hidden away in file folders or in safe deposit boxes. But this one agreed to come to our studio and is willing to answer some questions. So, insurance policy, what actually are you?
I was developed by the company that sold me. I list all the losses that my company will cover if these losses happen to the person who buys me. The insurance company is actually selling protection to the consumer against loss from the risks I list.
Does this mean that one insurance policy generally covers all possible losses?
Oh no. Each policy states specifically which losses it covers. There are different policies for different types of losses like car accidents, losses because of illness and losses to a home because of fire, wind or theft. It’s possible to insure against almost any kind of economic loss you are willing.
Why should I be willing to buy insurance?
When you go to a store and buy jeans, you give the store money and the salesperson gives you the jeans. In the case of insurance companies, the buyer gives the insurance company money — we call this the insurance premium — in return for protection against loss. The premium is generally for a specific amount of time, such as a year. For example, I’m a homeowner’s policy. The homeowner paid the insurance company a premium for a year’s worth of coverage. The company will pay the homeowner if a loss that I cover occurs during the year. In other words, by paying the premium, my owner is asking the insurance company to take on the risk that something bad will happen to the house during the year. My owner is actually transferring the risk of loss to the insurance company in exchange for paying the premium.
But isn’t the premium quite expensive? When I buy jeans, I need to pay the total price for the jeans. Does your premium each year have to equal the total value of the property?
Oh no. That’s because of two other important insurance concepts: probability and sharing the risk. Most insurance companies sell policies to many different individuals and groups. The companies generally want large numbers of policyholders to keep the premiums reasonable. They then figure out the probability of losses within this group – or, in other words, the likelihood that losses will occur. Generally, everyone in the group won’t have a loss each year. So, if you pay a premium one year and do not have a loss, then part of your premium goes to pay for someone else’s loss. That’s why insurance involves the sharing of losses among the policyholders.
Wait a minute. I still don’t understand how the amount of the premium is determined.
People buy a certain type of insurance. Using a number of factors, the company determines how likely a loss for this group. It adds this probable loss to the costs of operating the business, plus a profit, and reaches a total figure. Then the company divides this figure by the number of policyholders, and the result is the premium.  The premium is the amount you pay regularly to protect you in case something happens to you or the stuff you own that’s covered by the policy.
So that’s why a policyholder does not pay a premium equal to the value of his or her potential loss.
Right. Whoops. (Pantomimes receiving a cell-phone call.) Sorry, my owner’s calling. She had me on her desk for a number of days, looking to see what kind of coverage she has. It seems as if she has figured out the answer and wants to put me away in that dark file folder. Glad I had some sunlight for a while. 
Thanks for your time – that was really helpful!

What’s a deductible?
Insurance would be more expensive if the companies had to pay for EVERY loss a person experiences.   So, insurance companies offer policies with varying levels of deductibles .  A deductible is the amount that you have to pay before your insurance kicks in. For example, if you have a homeowner’s policy with a $500 deductible and your bike is stolen, chances are that you won’t ask the insurance company to pay you for your loss or “make a claim  “ because the bike cost less than $500.  That saves the insurance company time and money and keeps premiums that everyone pays lower. However, if you have the same deductible on your auto insurance and your car is stolen, you will only pay up to $500 deductible and they’ll repair, replace or reimburse you for your loss, depending on the terms of your insurance. Because deductibles lower costs and administrative burden for insurance companies, policies with higher deductibles are usually less expensive.
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