Just over a year ago, the restoration of water service in the aftermath of Hurricane Matthew caused thousands of dollars in damage to my home. My family and I had gone out to eat, and when we returned, several rooms of the house were flooded. What would we have done without insurance? When we bought our homeowners policy, my wife and I essentially transferred the risk (of major damage to our home) to the insurance company. And that same risk transference is what all of us rely on when we purchase automobile, disability, life, long-term care or similar insurance policies.
How are insurance companies able to bear all that risk? They are able to do so because large numbers of people (the insured) become members of one big pool. Actuaries figure out, through metrics and mathematics, the level of risk the insurance company is able to assume and at what cost. Let’s look at a fictitious example for life insurance. “Marty” had a 20-year term life insurance policy. In year 18, at age 68, Marty passed away, and the insurance company had to pay Marty’s beneficiaries $250,000. For every “Marty,” there may be thousands of “Dans,” “Bills” and “Sams” who pay into the same policy, but who don’t pass away during the 20-year term. Consequently, their beneficiaries don’t collect any money. Dan’s, Bill’s and Sam’s premium payments “fund” the payout for the policyholder who was not so lucky (“Marty”). It’s the job of the actuary to figure out, based on life expectancy projections and a host of other factors, the amount of risk the life insurance company can assume – the “risk” of that risk – and the appropriate premium costs. It’s a little like the Las Vegas casinos. The odds are all figured out ahead of time, so the “House” (the insurance company) always comes out on top. And that’s a good thing because, when you choose an insurance company, you want one that is financially stable and well-rated.
Aside from ratings, you should also consider: 1. the size of the insurance company; 2. how long it has been in business; and 3. how long it has been selling the product you are about to purchase. Don’t be shy about asking questions of your adviser or insurance agent: “If an incident occurs, will you be available to help me? If so, how will we engage with the insurance company? What steps will be taken? How does the insurance company pay out?” Shopping carefully, and knowing the answers to these questions ahead of time, will keep you from making an imprudent “bet” with your insurance premium dollars!
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