Insurance

Insurance works by pooling risk. Many people each pay a relatively small premium into a common pool. The few who suffer a loss, such as a fire, accident or illness, are paid from that pool. Each person swaps the risk of a large, uncertain loss for a small, certain cost.

For example, if one home in a thousand suffers a serious fire each year, causing an average loss of 200,000, an insurer covering 10,000 homes can expect about ten fires. Charging each homeowner a few hundred a year can cover those claims and the insurer’s costs, so no single family has to bear a loss of 200,000 alone.

Insurance comes in many forms, including life, health, home, car, travel, liability and business insurance. Each policy sets out what is covered, what is excluded, the maximum payout and any amount the policyholder must pay first, called an excess or deductible.

Insurance is most valuable for losses that would be financially devastating but are unlikely. For small, frequent costs, paying directly or keeping an emergency fund is often cheaper.