Monday, August 11, 2008

Word o' the Day: Insurance (ABC’s of Financial Planning)

Insurance is a risk transfer device.

For a fee, someone else will indemnify you, your possessions or property against loss for a certain time period.

The concept of insurance is based on the law of large numbers which states that the larger the number of observations of an activity, the more likely the observed outcomes of the activities will be equal to the expected outcomes. In essence, the more participants buying a particular type of insurance, the more likely the actual claims experience will match the expected claims experience. This allows insurance companies to price the risks they assume, knowing that a certain percentage of the insured population will submit a claim, but that a certain percentage will not. This is why insurance works – in some cases – or doesn’t work – in other cases.

I define “works” in this context as meaning the desired type of insurance is reasonably priced and readily available to those seeking the protection offered. Examples are auto insurance, life insurance and home insurance.

A good example of insurance that “doesn’t work” is health insurance in the U.S. It is – generally speaking – not reasonably priced and not readily available to those seeking protection. There are a number of reasons for this, but the basic reason is that health insurance in the U.S. is in violation of the law of large numbers. There are too many people who are not insured. If the U.S. were to somehow insure everyone living in the country, the cost of health insurance - on a per capita basis - would go down.

Questions? kimm@sweetwaterinv.com

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